Redesigning the Dragon Financial Reform in the Peoples Republic of China

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In order to make the above tax policy changes effective, the tax collection system must be revamped and greatly improved. The current structure is based on a system of revenue contracts between enterprise and government unit, and between local and central governments. One of the necessary reforms involves tax exemptions, which local governments often have the authority to grant to enterprises who for one reason or another are unable to pay their taxes. This is a fundamental weakness in the
Chinese fiscal system: local government has decision-making authority to grant exemptions on a tax the proceeds of which may in large part be assigned to governments above. Numerous conflicts of interest can appear to reduce incentives to enforce the tax at the local level.[17]

To address these changes, China in 1994 initiated the setting up of a centrally-managed National Tax Service. This would replace the contract system with a national “tax system,” based on uniform rules of tax assignment and tax sharing. Certain assignments will be assigned to local governments, and others to central government; others will be shared according to predetermined formulas. Interestingly, in 1995, a special police unit was set up to protect tax collectors under this new program.[18]

A potential obstacle to tax reform comes from local governments.
Local governments have traditionally supported reforms. But this is because the reforms have usually given them greater autonomy. The tax system reforms need to restore some control over investment and spending back to the central government, which could encounter local opposition.
Allowing local governments some discretion over local tax rates can give them some of the autonomy they desire, and provide greater incentive for intergovernmental cooperation.

Few reports exist at present on the implementation of these reforms.
Certainly, the spirit and scope of the reforms has been well-received by analysts, though more changes are advocated. But it will take several more years to determine the success of the reform of tax collection structures at the local level.

Intergovernmental Fiscal Relationships

A product of economic reforms in transitional economies is often a shift in intergovernmental fiscal relationships. In the transition from centralized economy to market economy it is often from a relationship where the local or provincial government is the receiver of the “plan” to the local or provincial government proceeds with a greater autonomy. The evolution of this relationship in the PRC has been very similar. However, the provincial or local governments were at an advantage over many other transitional economies because the Chinese system had the following characteristics 1)local implementation capacity was already established in the rural areas 2)China in most areas has a high ethnic homogeneity and 3) there was much to gain by inter-province trading[19]

The very nature of Chinese economic reforms, gradual and incremental, allowed “scaffolding” of behavior. Partial reforms provided the environment to learn behaviors that could then be applied to the next level of reform.
Chinese economic reform was also structured on the idea of decentralization. The establishment of Special Economic Zones (SEZs) encouraged the local areas to develop their own strategies to attract business and allowed them the freedom to implement the strategies. The very earliest reforms, breaking up of farm communes, were also carried out at the local level.

Many of the SEZs are doing very well and people living in these areas are enjoying a higher standard of living than they had previously enjoyed.
However, tax collection still remains a difficult endeavor with compliance at only 70%. In order to improve the poorest areas in China, policies and programs that are able to move this revenue to the poorer areas will be needed. This can take the form of a better accounting system to ensure that all taxes due the central government for infrastructure development actually arrive there.

Banking Reforms, State Owned Enterprises and the Social Safety Net

In order to put current economic reforms in perspective, understand the recommendations made by the international economic community, and fully address the quagmire of State Owned Enterprises (SOEs), a more in depth look at the interconnectedness of the SOEs and the banking system must be taken. We will attempt to do just that using the context of bank development in the PRC, monetary policy, and ongoing reforms to SOEs.

Reform of the banking system in the PRC has taken on similar characteristics to reform in other areas: i.e., gradual and experimental.
At the beginning of reforms the financial sector in the PRC could hardly be called a financial sector[20]. Financial sector development and implementation is a complex undertaking which should include the development of institutions, instruments and markets[21]. Currently in the
PRC, banking reform lags behind other areas of reform[22]. This is due to a complex array of policy decisions. No discussion of banking reform in the
PRC would be complete without an examination of the current state of SOEs restructuring. Many macroeconomic initiatives are being put on hold in order to bolster a failing state sector and postpone the social upheavals that may be associated with the needed reforms of this sector.
Background

The Central Bank was established in 1984. In 1987 two additional universal banks were formed and non-bank financial institutions were started. In 1988 new capital markets were formed and the secondary trade of government bonds was allowed. In 1990 the Shanghai and Shenzhen stock exchanges were opened. In 1992 all treasury bonds were issued through underwriters[23]. At the end of 1994, the PRC had a total of 13 banks (of which 3 were specialized banks and 3 were comprehensive banks). The new
“financial system” contained 20 insurance companies, 391 trust and investment companies and greater than 60,000 credit cooperatives that operate in local areas[24].

During the summer of 1995 the central government announced a series of new banking laws would be established. These laws were the People’s 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 hadn’t been clearly defined. These laws begin to lay the comprehensive groundwork for financial transactions[25]. The People’s Bank of China Law which was established in the summer of 1995 addresses the internal organization of the People’s 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 People’s 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[26].
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%[27]). 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 (FEC’s) 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 FEC’s. Since doing away with FEC’s , RMB convertibility was relegated to official “swap shops”[28]. 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[29].
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[30]. 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[31]. SOEs account for only 34% of industrial output but consume
73.5% of government investment[32]. Most have an average debt equal to 75% of total assets[33]. 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.[34]

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.”[35] 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[36].

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”[37].
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[38] 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.
2) Improve the Central Bank’s 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.
3) 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.
5) 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.

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