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Essay Number 9
November 1998  

Fiscal & Monetary Policy in China:

Riding the Crisis Tiger

thin rule
By Satya J. Gabriel

Across the street from the Bank of China building at the Xinjiekou circle and down a bit is one of Nanjing's new McDonald's restaurants (I always feel a bit odd describing McDonald's as a restaurant). It was an odd sight, cheery Disneyesque colors, against the old and pollution dirty buildings of the city center. All of this is close enough to Sun Yat-sen's statue -- the real center of the center of Nanjing -- that the old man, should he come to life, could probably get a glimpse of Ronald McDonald. The money changers, dressed like a local version of the Mafia, were always within a hop-skip-and-jump of the front entrance of the Bank of China (sometimes even closer than that), offering their "street exchange rates." They wanted cash for cash. In other words, they wanted more of those little green slips of paper with the dead American presidents on them. "In God We Trust." Or, more accurately, "In the U.S.A. We Trust." Hard Currency in its most liquid form. The Bank of China, on the other hand, would accept checks written on American banks, if you had an American Express card, and give you either U.S. dollars or yuan (or any other currency they had in stock, for that matter). You could even open an account there and earn interest on your idle dollars or yuan (your choice). The interest rate on dollars was considerably higher than that on renminbi. Like in many countries, the demand for U.S. dollars is very strong and the banks recognize this value in the interest they pay to "safe-keep" your U.S. dollar deposits.

I saw some odd sights in that particular Bank of China, the Bank of China had a number of branch offices in Nanjing, although this was the main building. One day I saw a man come into the bank with a black briefcase that he opened and pulled out bricks of hundred dollar bills. He casually placed these blocks of green paper on the counter of the foreign exchange window -- one brick at a time -- and the teller, a young, serious looking fellow, never showed any emotion. Was this sort of thing that commonplace? This had to be more money than this young man could ever dream of possessing (unless his dreams leaned towards hyperbole or he had a particular skill at embezzlement), yet he showed no sign of astonishment that someone could have been walking the streets of Nanjing with a black briefcase so chock full of hard currency.

China's economic growth has been so phenomenal that it has bred this sort of scene over and over again throughout China.[1]   It may not be commonplace in an individual bank (the teller could have probably told me whether this was or wasn't the case, but I didn't ask), but it is not uncommon for some bank somewhere in China on any given day. Even during this period of region-wide economic crisis, China's government can take pride in having engineered the fastest growth rates in all of Asia. Most recently, gross domestic product (GDP) growth was a healthy 7.6 percent (in the third quarter of 1998). And those blocks of dollars keep rolling in on the waves of export earnings. China had a trade surplus of almost $45 billion in September of this year and a total current account surplus just shy of $30 billion. The more China exports, the more foreign exchange reserves (primarily U.S. dollars) pour into the country and find their way to banks like the Bank of China and, eventually, to the nation's central bank, the People's Bank of China (a separate entity from the aforementioned Bank of China). These foreign exchange reserves allow China's leadership to protect the value of the yuan, despite regional competitive currency devaluations that have devastated the savings and incomes of millions of people. In addition, these reserves give the Chinese government and Chinese enterprises the power to project a certain degree of financial clout around the world, even in the United States. The greater the reserves, the more China's government can buy large blocks of U.S. government bonds. The greater China's holding of bonds, the more it can impact the price of U.S. government bonds and U.S. interest rates. China's reserves have actually increased to $141.1 billion in September from $134.1 billion in the prior year. The relevance of the potential clout that China gains by accumulating U.S. government bonds should not be too easily dismissed. What would happen if the Chinese leadership decided to dump their holdings of bonds onto the market (to disinvest their holdings of U.S. government securities)? Does this side-effect of the successful export-led growth strategy of the pragmatic modernists (the "Dengists") provide some evidence that they are correct in arguing that their approach, despite the rapid growth in foreign involvement in the Chinese economy, is hardly a return to the days when foreign investment in China was part of a broader "Western imperialism" that resulted in the domination, even humiliation, of the Chinese people?

Despite the continued economic growth in the Chinese economy, the growth in exports and foreign reserves, there has, nevertheless, been some negative impact on China from the region-wide economic crisis. China exports mostly labor-intensive goods. Labor intensive goods are those for which the largest share of the unit cost is the cost of labor. The kind of labor that goes into producing these goods is also relatively unskilled labor. Goods like textiles and toys come to mind. In order to provide these goods to buyers at competitive prices, Chinese manufacturers must keep their costs down. Since the primary cost is the cost of labor (the wage rate), then this means keeping wages relatively low. The wage that matters in international competition is, however, not the wage as denominated in the domestic currency, but the wage as translated into U.S. dollars. Chinese workers are paid in renminbi but the goods are sold for dollars. Thus, the real cost that is relevant is the U.S. dollar wage of these Chinese workers. To get this U.S. dollar equivalent wage of Chinese workers you would need to know the yuan wage and the exchange rate between renminbi and dollars. Why is this relevant? The reason is that the region-wide economic crisis in Asia was sparked by a series of competitive devaluations of currencies. The first currency to fall was, in fact, the yuan when it was devalued in 1994. More recently, we've seen devaluations of the Thai baht, the South Korean won, the Indonesian rupiah, the Phillipine peso, and so on. Only the yuan and the Hong Kong dollar have held fast against this wave of recent devaluations. When, for example, the Thai baht was devalued against the U.S. dollar then the U.S. dollar buys more Thai baht than before the devaluation. If a worker is paid in Thailand in Thai baht and her pay does not increase (in Thai baht) after the devaluation, then the dollar cost of this worker has fallen. Thus, in dollar terms the unit cost of the goods can fall (assuming, for the moment, there are zero or very small U.S. dollar costs, which would typically come from purchasing imported inputs, included in these unit costs). Thai goods become "cheaper" in dollar terms. If China does not devalue, then Chinese manufacturers selling the same goods (with a similar underlying mix of inputs) are placed at a competitive disadvantage. Their costs do not change, but the Thai manufacturer's costs have fallen. The Thai manufacturers can lower their unit price and, presumably, take market share from the Chinese manufacturers. This is mitigated to some extent by the fact that even labor-intensive production may require significant dollar-denominated inputs (whose cost in Thai baht rises with a devaluation of the baht). This becomes all the more important over time, as manufacturers attempt to "upgrade" their technology by importing more advanced technology (which must be paid for in dollars). Thus, in the long-run the country that does not devalue (China) may gain a competitive edge over the countries that do (such as Thailand). But in the short-run, China has seen its export growth slow because of the economic crisis, although this can only partly be attributed to the effects of China's losing some competitive advantage to countries that did devalue (many of the countries that have devalued have actually seen their exports fall!).

Nevertheless, the crisis has touched Chinese shores and slowed the rate of growth. The legitimacy of the pragmatic modernist leadership is, to a large extent, dependent upon economic successes. Thus, the Chinese government has moved aggressively to keep China growing rapidly and to counteract the effects of the region-wide crisis. The administration of Premier Zhu Ronji is using its entire arsenal of government policy instruments towards this purpose. In order to protect Chinese workers from the job destroying impact of the crisis, the administration of Premier Zhu Rongji and the People's Bank of China have deployed an array of fiscal and monetary policy measures designed to stimulate the Chinese economy and keep economic growth between 6 and 9 percent, despite significant declines in the rate of growth of export earnings and absolute declines in foreign direct investment.

Zhu Rongji's biggest concern is a financial sector crisis. He has stated this publicly. He believes that a financial sector crisis, starting perhaps with the commercial banks (including the policy banks and formerly so-called specialized banks) that are overburdened with bad loans, could cause widespread economic collapse and trigger social unrest. Thus, his first priority is to keep this from happening. Towards this objective, Premier Zhu has enlisted the People's Bank of China (PBOC).

The People's Bank of China was formerly the sole governor of both monetary policies and "commercial" banking but has, as a result of the reforms of the post-1978 period, come to serve as the primary monetary policy making institution in China. It is the Chinese central bank (the equivalent of the U.S. Federal Reserve Banking System or the German Bundesbank). Premier Zhu's concerns about a financial sector crisis were grounded in recognition that China was quietly moving into the grips of a credit squeeze, wherein it was becoming increasingly difficult for firms to find financing for new investment and to pay for replacement of depreciating plant and equipment (old investment), and in some cases to finance operations. This credit squeeze was happening partly as a result of banks having been granted greater autonomy in making loans. These banks, components of an elaborate governmental bureaucracy, had for years acted as state functionaries implementing a political plan for the economy. In this regard, bank officials approved politically-motivated loans to state-owned enterprises (SOE) that were also components in the bureaucracy and many of these past loans are in default. In other words, the bureaucratic machinery had become clogged when the lending process continued to function normally, providing a steady stream of money capital to the SOEs, but the claims (in the form of interest and principal payments) of the banks on SOE surplus value were not met: the flow was going in only one direction. Thus, when given the opportunity, even obligation, to unclog the machinery, the banks decided to sharply cut back on lending and the roll-over of existing debt, creating the first stages of a credit squeeze. This seemed, from the bankers standpoint, to be the most rational response to a situation wherein their loan portfolios were pock-marked with bad loans. Indeed, books and articles in China have made a big deal of the fact that the banks had so many bad loans. It even seemed to be a civic duty for the bankers to get their house in order by tightening the standards for granting new loans or rolling over old ones. But, of course, the tightening of credit can lead to firms that are viable becoming unviable. It can lead to a wholesale deterioration in the health of the "real sector" of enterprises that produce needed goods. The People's Bank of China decided to head off this credit crunch by cutting the reserve requirement from between 16 and 20 percent (depending upon the size of the bank's asset base and other factors) to a single rate of 8 percent. The money multiplier (MM = 1/RRR, where MM is the money multiplier and RRR is the required reserve ratio) tells us that a cut of this magnitude would double the lending capacity of the banking system.

The hope is that banks will continue to provide loans to "healthy" firms and avoid a financial sector crisis. We will discuss whether or not this is likely to succeed, but a key point that you should consider in this regard is not only whether or not banks will actually continue lending to the best available borrowers, but whether "healthy" firms would actually want to borrow under current conditions.

If export growth is slowing, foreign direct investment is falling, and firms are starting to show strains in generating enough revenues to pay interest (and maturing principal) on loans, then we can conclude that the demand side of the Chinese economy is weakening. If the economy is weakening then firms are not as likely to be out aggressively hiring recent graduates or more workers. Some of the former graduate students I worked with in China have confirmed that the employment situation in China is not quite as good as it was in 1996 and 1997. There is some concern that the employment situation could get worse if the government doesn't counteract the aforementioned negative effects on aggregate demand for products and services.

The Zhu administration is not willing to rely solely on monetary policy to keep the economy growing. He has also moved to stimulate spending directly. The Zhu administration has proposed a record budget with about 122 billion dollars in spending for the coming fiscal year. This spending is designed to dramatically boost aggregate demand for goods and services (via the respending multiplier effect) and provide firms with the needed market for their output. If firms can sell their output and generate revenues, then they will be in a better position to pay the interest (and maturing principal) on their loans. The financial sector crisis, hopefully, can be averted and unemployment also reduced. These policies are designed to avoid the potential social unrest from an economic crisis. Premier Zhu and the rest of the Chinese leadership do not want to see anything like Indonesia's social problems within China's boundaries (or, even, the sort of unrest that is growing in Malaysia).

In order to finance the government fiscal stimulus package, the Zhu administration has decided to take the Keynesian approach of increased deficit spending. Zhu Rongji's administration wants to partly finance the government budget by a record 44 billion dollars in government debt (double the debt issue of only three years ago). This debt would constitute about 36 percent of the total 122 billion dollars of expenditures in this year's budget with the remainder covered by government revenues from taxes and fees. Final approval of administration budgets comes from the national People's Congress, which has shown no inclination for going against the top leadership's proposals.

In a further effort to avoid financial problems, the Zhu administration has also decided to finance a special fund to recapitalize commercial banks (buy bad loans from the commercial banks and, therefore, add more to the capital base of the banks) by issuing almost 33 billion dollars in special 30-year bonds. This is in addition to the aforementioned 44 billion dollars in debt, bringing the total debt issuance to 77 billion dollars. The fact that the government is willing to borrow such a large amount is indicative of the concerns about an economic slow-down. The Chinese leadership has traditionally been much more conservative about their borrowing.

Is the Chinese government's debt load excessive? How much risk does this add to Chinese public finance and, therefore, to the Chinese economy? The bond-balance-to-GDP ratio in China has grown from 2.45 percent in 1991 to 4.2 percent last year. It is expected that this ratio will rise to 5.95 percent this year. This ratio is still a relatively modest bond-balance-to-GDP ratio and nothing like what one would find in Thailand or Indonesia or South Korea. However, the trend is somewhat troubling. At the moment, the rate of growth of the Chinese economy continues to exceed this bond-balance-to-GDP ratio, indicating that the Chinese economy can generate enough revenues to continue paying for the debt. In addition, the ratio of bond-balance-to-household-savings is expected to be about 9 percent this year, not a particularly large number either (especially given the relatively few options for Chinese household savers). This means the Chinese government should be able to find a ready market for these bonds. And China's overall debt load is miniscule compared to that of a country like Italy, which has a debt-to-GDP ratio of about 120%. These factors indicate that the Chinese government still has some flexibility in using debt to finance public expenditures and infrastructure investments. However, this also indicates that the current leadership is willing to "mortgage" future revenues to pay for current spending. In other words, the current leadership is so concerned about the impact of an economic slowdown that they are willing to borrow much more heavily than has been traditional among the post-1949 governments and let someone else figure out how to pay the interest and principal. Does this sound familiar?

None of the above should be taken as my disagreement with the current policies. I just think we need to keep a clear head about the possible burden that will be placed on future Chinese leaders if these debts continue to escalate. If, on the other hand, this current spending stimulates a new wave of economic growth, then the current levels of debt could end up looking very small. And the Chinese leadership still has substantial assets that could be used to raise funds, both domestically and abroad. Given the commitment of the current leadership to further development of Chinese capitalism, there remains a good deal of room for privatization of state owned enterprises. The Chinese government and related institutions control about 75% of the stock of publicly traded state-owned enterprises and there remains a large number of state-owned enterprises that are not even publicly traded as yet. In addition, the banking system remains fairly underdeveloped and centralized. It may be possible to improve economic performance and the health of the banking system by further decentralization of the banking system, including the development of grassroots banking institutions, such as the urban and rural credit cooperatives.

China has avoided the worse of the Asia-wide economic crisis. Growth has slowed but is still both positive and greater in magnitude than the growth rates of most countries. If the pragmatic modernists are correct in their assumption that continued "modernization" is a prerequisite for social progress (for reinforcing socialism and clearing the path for communism), then we can view their current policies as not only an attempt to avoid social unrest and keep the leftists at bay, but also as consistent with their overall philosophy of building "socialism with Chinese characteristics."


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[1] During the period from the beginning of economic reforms in 1979 to 1994 the rate of real (inflation-adjusted) economic growth in China averaged over 9% per year.  This rate of growth was far in excess of most nations and surprised mainstream development economists who had predicted that China faced a rather difficult future, was likely to struggle to achieve positive rates of growth, and, even after the early successes, was unlikely to sustain rapid economic growth without following a so-called "Big Bang" approach to economic reform.

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Copyright © 1999 Satya J. Gabriel, Mount Holyoke College.  
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