China: Why are China's Financial and Fiscal Sector Reforms so Intertwined and Arduous?

2006

Lynette Ong

Since 1999, the central government has pumped in a few trillion Chinese renminbi into the state-owned banking system to help clean up their balance sheets. Money has either been drawn from the country's foreign exchange reserves or banks' bad loans have been transferred to asset management companies; the latter is a strategy learnt from the US experience. Whichever method the central government has adopted, the outcome of each is similarly ineffective in cleaning up bad assets in the state-owned banking system. The fiscal system, on the other hand, has gone through several rounds of reform in the last 25 years: from decentralizing tax and spending powers to local governments in the 1980s in order to induce local industrial activities; to re-centralizing power so as to increase the central government's revenue share in the mid-1990s. One of the many challenges of the fiscal system is getting the funding to pay for public goods, such as primary education and healthcare, in poor areas of China in which over two-thirds of its people still live.

In theory, financial and fiscal systems each perform different functions in the economy. The financial sector takes savings from depositors, and lends to borrowers who need capital to undertake investment and consumption activities. Banks make profits by charging higher lending rates than the interest rates they pay depositors. Moving capital from areas of excess supply to those of excess demand - so-called 'financial intermediation' - is the key role of the financial sector. It helps entrepreneurs get start-up funding, enterprises get working capital, and consumers get finance for mortgages. Money goes around in a circle; the amount of deposits savers put in banks will eventually have to be returned to them, even though they go through several hands in the process. On the other hand, the fiscal system collects money from taxpayers and spends it on public goods and services. How the taxes are spent depends on the government's priorities and objectives.

This all sounds good in theory. But, what happens when the fiscal system does not have sufficient resources to perform its functions, such as building schools and hospitals, paying teachers' salaries or the wages of healthcare workers? 'Well, raise more taxes!' common-sense logic tells us. For many reasons, this is easier said than done in a transitional economy like China. One reason is that the people - and tax collection officers alike - are still rather new to the idea of paying and collecting taxes. It was not so long ago that 'everyone ate from the same rice bowl'. Even if there is sufficient revenue, the question is how it is to be distributed so that the various levels of government that have to finance local public goods and services get the resources they need to do their job. On the other hand, the banking sector in China is cash-rich, owing to the thrifty nature of the Chinese people and tremendous growth in incomes. In terms of resources, the financial system in China is strong while the fiscal system is weak.

Local governments in China are entrusted with the task of financing public goods, but are given insufficient resources to do their job properly. This is particularly the case after the re-centralization of tax powers in the mid-1990s. But, local government officials still need to survive - and to show their bosses some results in order to climb the political ladder. But where do they get the money? They turn to local banks or local branches of the national banks. The desire by Communist Party's bosses to control all facets of society and the economy has meant that the party's apparatus is omnipresent, which includes banks and non-banking financial institutions. Key decision makers in these organizations are party members, and they are accountable to local party bosses. The result is that local party bosses can influence party subordinates in the banks to make certain decisions - if not by outright instructions. The implication is clear: bank savings are often mobilized to finance local government's budgetary or fiscal expenditures. Essentially, this means that the Chinese financial system is a quasi-fiscal apparatus. Along with the resources siphoned off to finance public goods, some has gone into the private pockets of local officials.

For more than a decade now, the central government has been trying to crack down on what they call the 'persistence of local government interference in the banking system' which results in rampant corruption, counter-effects on the national monetary policy (local officials keep on borrowing and spending when the central government tries to reduce money supply) and, potentially, social instability, if the banks run out of liquidity to keep themselves afloat. But, how feasible is it to put the banks in order if the local folk are given insufficient resources to do their jobs? The central policy makers have to give this serious thought.

WATCHPOINT: To put either the financial or fiscal system in order, it is imperative for the central government to first recognize the nexus between the two systems; and, to find ways to break the inter-relationship.

 

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