China - Macroeconomic stability in a decentralized economy

This report concludes that monetary accommodation of a rising consolidated government deficit (CGD) and of surges in local-government-led investment demand is the main cause of recurring inflationary pressure in the Chinese economy. Over the past five years, direct and indirect government borrowing from the central bank has on average financed more than two thirds of the CGD. Excessive devolution of decision-making authority to lower levels of government, along with insufficient enterprise and financial sector reform, has impaired the central government's control over the size of the CGD and over the conduct of monetary policy. For China to achieve its goal of a high and sustainable growth rate, it needs to reduce its dependence on the central bank for financing the consolidated deficit and contain the size of the deficit. This will require structural reform. First and foremost, the primacy of the central government in the area of macroeconomic management needs to be clearly and permanently established. Second, state-owned enterprises (SOEs) and state-owned banks need to become more autonomous. This report identifies five causes for the size of the CGD, and they are: 1) falling revenue-to-GDP ratio due to the absence of a national tax service; 2) dwindling share of central government revenue as a result of fiscal decentralization; 3) rising government investment expenditures; 4) heavy burden of subsidies to SOEs; and 5) poor budgetary coverage and procedures. Heavy reliance on central bank financing of the CGD has impaired the conduct of monetary policy in China. This study identifies two main causes of weakening monetary control: 1) monetary financing of the deficit; and 2) decline of the credit plan, more specifically, institutional weaknesses within the People's Bank of China (PBC) and poor and deteriorating interagency coordination on the formulation of macroeconomic policy. The study presents and examines the following recommendations: 1) raise the revenue-to-GDP ratio; 2) contain government investment expenditures; 3) control government current expenditures; 4) improve budgetary procedures; 5) assign roles to different levels of government; 6) strengthen PBC; 7) tighten regulatory control over non-Bank financial institutions; 8) improve control over PBC policy loans; 9) reduce PBC financing and redefine the role of government securities; 10) develop open-market operations and phase out the Credit Plan; 11) interest rate reform; and 12) improve coordination of macroeconomic policy.