Redesigning the Dragon Financial Reform in the Peoples Republic of China

Prior to economic reforms, Chinas tax structure was based on the Soviet model. Enterprises remitted their profit to the government,

Redesigning the Dragon Financial Reform in the Peoples Republic of China



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ter than 60,000 credit cooperatives that operate in local areas.

During the summer of 1995 the central government announced a series of new banking laws would be established. These laws were the Peoples Bank of China Law, the Commercial Banking Law, the Negotiable Instruments Law and the Guarantee Law. Up until this time the roles of each party in the framework of financial transaction hadnt been clearly defined. These laws begin to lay the comprehensive groundwork for financial transactions. The Peoples Bank of China Law which was established in the summer of 1995 addresses the internal organization of the Peoples Bank of China, its monetary policy, its supervision and tries to establish its autonomy from provincial and local governments (it is still under the control of the State Council). This law has provisions in it for setting the prime lending rate, rediscount window, amount of funds to be lent to commercial banks, and the trade of treasury bonds, government securities and foreign exchange. It also bars the Peoples Bank of China from financing the budget deficits of the central government and local governments. The Commercial Banking Law addresses the mission of commercial banks. These are still under the guidance of the State Council and still must issue policy loans (although the law also states that any losses due to defaults on these loans will be compensated by the State Council).

The Negotiable Instruments Law is similar to the United States Uniform Commercial Code. The Guarantee Law deals with mortgages, pledges, and liens. Both of these laws are hoped to standardize and regulate credit transactions in the PRC.

Monetary Policy

Monetary policy in the PRC is currently administered through a central “credit plan”. This plan, which is administered by the State Council, sets credit quotas for each bank and also facilitates direct bank financing of enterprises. In the current system the major objectives of the specialized banks is to provide loans for various projects, agriculture and foreign trade. The main recipients of these loans are the state owned enterprises (SOEs). The terms and rates of these loans are very favorable (usually 12%). Therefore the demand for these loans is higher than the supply and private companies have to rely on other sources. This can take on various means and can often lead to underground lending operations.

The convertibility of RMB has also been undergoing changes. Prior to January 1, 1994, there were two money systems in China. One for local use, the other for foreigners. These Foreign Exchange Certificates (FECs) were redeemable only in state operated stores and restaurants. Only higher level officials were able to use these and most imported goods required the use of FECs. Since doing away with FECs , RMB convertibility was relegated to official “swap shops”. Now, with the correct permit businesses can use any large bank to exchange money. However, the government has also begun to establish hard currency audits as well as trying to force businesses to use the same bank for all of their transactions (a way of tracking how much money is being exchanged). The new convertibility does meet IMF requirements.

State Owned Enterprises and the Social Safety Net

As illustrated above, the banking system and state owned enterprises are closely linked (see Table 7 in Appendix, page 24, for financing of SOEs). According to Chinese government statistics, up to 20% of the debt of state banks is bad debt. International estimates place this figure at almost double that amount. Recently in Jiangsu province, 30 SOEs declared bankruptcy telling the banks they were not going to pay their debts. If all the banks in China did this it would lead to bankruptcy of the banks. SOEs account for only 34% of industrial output but consume 73.5% of government investment. Most have an average debt equal to 75% of total assets. According to an Oxford Analytica study, in the first eight months of 1995, SOE industrial output expanded by only 8.3% compared with a 13.7% increase for all industry. And according to estimates, non-SOEs, on average, required less than a third as much investment to achieve equivalent industrial output.

These are serious problems. The ninth five year economic plan (1996-2000) places priority on their eradication, calling for SOEs to lay off workers to boost efficiency, and encouraging SOEs to “declare bankruptcy if their liabilities outstrip assets, if they make long-term losses and if they lose out in market competition.” Up until now current reforms and lessening of government controls have not only not reigned in this problem but have also created new ones such as asset stripping of the SOE by management, workers and local governments.

However, the central and local governments are still hesitant to shut down even the most inefficient SOE. Currently, 7 out of 10 industrial workers work in a SOE. The SOE provides not only a job but housing, education, pensions, insurance and often energy sources and commodity shops on site. The World Bank estimates that only 56% of total expenditure by SOEs is actually on wages, the rest is on “social spending”. Therefore, any reform involving the SOEs must also involve reform and development of a social safety net. Pilot programs have been started where local governments create pension pools and are putting aside payroll taxes for education, health and unemployment benefits. It is also important to note that the question of “social security” reform is being worsened by additional factors. Population in the PRC is progressively growing older. This phenomenon can be attributed to increase in life expectancy due to better living conditions and the one child per family policy.

How Should Reforms be Implemented?

Due to the interconnectedness of these areas of society, many of these reforms need to be implemented simultaneously. In May of this year the World Bank published a Country Study that attempts to address these issues. The following are proposed reforms from this study.

  1. Reduce the role of government in the directing of resources.

This over time would lesson the State Councils role in directing the day to day functions of the banks and eventually do away with the credit plan. Banks would be able to allocate resources appropriately and to set their own interest rates.

  1. Improve the Central Banks management of monetary aggregates.

This over time would improve the consistency of banking laws by ensuring that they are used and would also remove policy lending from the banks and put it into the budget where it should be. This would also allow for the development of the Central Bank as an institution.

  1. Transform state commercial banks into real commercial banks.

This step would help to free the banks from the current crises of bad debt and allow them to loan money to the newly emerging private sector.

4) Improve governance, diversify ownership and lower subsidies for SOEs.

In the short term this would include implementing an accounting system and independent audits, give autonomy to the managers, getting rid of unviable businesses and restructuring those SOEs that can be.

  1. Transfer social services to the government.

This would reduce the burden on newly restructured enterprises. Over time this would allow for a national system to be implemented.




In comparison with other countries undergoing transition from centrally-planned economic systems, China had the luxury of initiating its reforms at a time when it faced no macroeconomic or serious political crisis. It was able to adopt a two-track approach to economic reform: China continued state control of existing enterprises while loosening economic controls enough to permit growth of a new, nonstate sector. This was possible in part because the inefficient state sector was a small share of the economy, compared to most socialist nations.

Chinas reform experience thus far has been one of “enabling” reform, allowing “marketization” instead of forcing “privatization,” getting government to “step out of the way” of the flows of commerce. The results have been good to excellent in the productive sectors, but the reform has not yet succeeded in the fiscal and monetary sectors, which are the domains of government. Here the government cant step out of the way; it must build the proper tools and structures to manage these sectors. It is in these areas, and in the efforts to reduce administration, dismantle SOEs, and provide an adequate social insurance system for displaced workers and affected citizens that China faces its true reform challenges.

To further evaluate how far China has come down the path of economic transition, we look to a definition of transition used by the World Bank, which describes these three components:

  • Liberalization: freeing prices, trade and entry to markets from state controls, while stabilizing the economy. Stabilization is an essential component to liberalization.
  • Clarifying property rights and privatizing them where necessary. Requires re-creating the institutions that support market exchange and shape ownership, and especially the rule of law.
  • Reshaping social services and the social safety net to ease the pain of transition while propelling the reform process forward.


Examination of the Chinese experience shows that liberalization has taken place to some degree, though much reform of prices, trade and markets is still to be done. However, privatization and the assignment of property rights are still very undevel

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