BANKING REFORM IN CHINA: CONSTRUCTING AN ECONOMIC LEVER

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP04T00794R000100620001-0
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 27
• Document Creation Date: December 22, 2016
• Document Release Date: May 12, 2011
• Sequence Number: 1
• Publication Date: February 1, 1986
• Content Type: REPORT

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Directorate of
Intelligence
Banking Reform in China:
Constructing an
Economic Lever
EA 86-10007
February 1986
339
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Directorate of
Intelligence
Banking Reform in China:
Constructing an
Economic Lever
A Research Paper
This paper was prepared by ~ Office of
East Asian Analysis. Comments and queries are
welcome and may be directed to the Chief, China
Division, OEA,
Confidential
EA 86-10007
February 1986
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Banking Reform in China:
Constructing an
Economic Lever
Summary Chinese reformers are counting on a revitalized banking system to play a
Information available critical role in controlling economic activity as Beijing implements its
as of 21 January 1986 ambitious. economic reform program. For more than 30 years under
was used in this report.
China's centrally planned economic system, banks were little more than
cashiers and accountants for the Ministry of Finance, and bank managers
often were appointed on the basis of political orthodoxy rather than
economic acumen. Efforts to improve efficiency throughout the economy
by reducing the scope of mandatory planning and employing material
incentives, however, forced Beijing to reconsider the role of banks in the
economy.
In the complex political struggle that surrounds economic reform in China,
restructuring the banking system is an important testing ground for the
reformers. When reforms were launched in 1979, conservatives warned
that Beijing could lose control of the economy if the central planning
mechanism was weakened-and argued that strict limits should therefore
be placed on economic decentralization. Reformers countered that indirect
economic levers-such as credit levels or interest rates-could be used to
regulate economic activity occurring outside the plan.
China's banking system, however, was woefully unprepared to provide
those economic levers. The central bank lacked tools for conducting
monetary policy and was hampered by having to conduct both commercial
and oversight activities. Senior bank officials often had only a dim view of
modern banking practices, and lower level bank managers-used to being
told to whom to loan money-had almost no experience conducting project
evaluations or basing lending decisions on economic criteria.
In the past seven years, and particularly since 1982, Beijing has made a
major overhaul of its financial system to enable banks to meet the
monetary demands accompanying economic reforms. Beijing has expanded
the authority of, and increased the monetary tools available to, its central
bank so that it can flexibly adjust credit levels to maintain macroeconomic
stability while the old regulatory mechanism of central planning and
administrative directives is partially dismantled. To improve the allocation
of funds, local banks simultaneously have been given greater autonomy
over lending decisions, and bank loans increasingly are replacing govern-
ment budget grants for enterprise investment.
iii Confidential
EA 86-10007
February 1986
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By reducing the scope of central planning and delegating decisionmaking
authority to lower levels, Beijing has increased the responsiveness of
China's economy to monetary policy. Beijing intends to conduct a more
active monetary policy to maintain macroeconomic stability, but poorly
formulated or inappropriately executed monetary policy now will have
a much more deleterious impact on the economy than before the
reforms.
The danger of proceeding with industrial reforms before the banking
system is capable of regulating the economy was illustrated during the past
two years. Beijing's reform program suffered a major setback in 1984,
when currency in circulation and loans to industrial enterprises increased
50 percent. This contributed to runaway industrial growth, a jump in
inflation, and a sharp drop in China's foreign exchange reserves. The credit
surge was sparked by increased enterprise autonomy and central instruc-
tions to banks to provide loans to promote reform. Lax oversight and
muddled accounting by the central bank allowed credit to increase much
more than Beijing intended. A tight monetary policy implemented in the
spring of 1985 has gradually slowed the economy, but continuing investiga-
tions of credit practices within the banking system suggests that Beijing
has not recovered from the credit binge.
Despite the painful adjustments of the 1984-85 period, we believe China
has been benefiting from bank reform. The increased use of loans in place
of budget grants, for instance, has sped the turnover of working capital and
reduced construction periods, and greater flexibility by rural banks to issue
loans has boosted the development of specialized farming and rural
industries. Bank willingness to loan more to family and small-scale
enterprises clearly has stimulated important growth in the private and
collective sectors of the economy-goals long sought by economic reform-
ers. Benefits of bank reform have been limited, however, by a shortage of
skilled bank managers and by continued interference in lending decisions
by local government and party officials. We believe, moreover, that
monetary control techniques are not yet reliable, and Beijing faces
substantial risks that monetary policy may actually be destabilizing-as it
was in 1984.
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At the party conference in September 1985, Beijing reiterated its determi-
nation to complete the transformation of the banking system during the
next five years. We believe Beijing will increase the use of interest rates as
economic levers, promote greater competition among banks, broaden the
range of financial instruments available, and establish a short-term capital
market. Even when the reforms are implemented fully, however, the state
will continue to dominate the banking sector. Thus, the banking system
will retain many of the characteristics of a monopoly bank and will provide
Beijing with a powerful economic control mechanism.
Bank reform probably will facilitate increased US trade with China.
Chinese banks may become more willing to lend for imports or joint
ventures as Beijing grants them greater flexibility in handling foreign
exchange. Proceeds from the sale of foreign-currency-denominated
bonds-recently issued for public purchase outside China for the first time
since 1949-may go toward Chinese imports of US industrial equipment
and high-technology products. Beijing's decision to allow foreign banks to
establish wholly owned or joint-venture branches in China's four Special
Economic Zones will increase opportunities for US banks to set up offices
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Contents
Summary
The Need for Banking Reform
Changing the Structure of the Banking System
6
How the PBOC Conducts Monetary Policy
7
Microeconomic Reforms To Improve the Allocation of Funds
9
Financial Experiments
10
Popular Credit Institutions
10
Domestic Trust and Investment Corporations
10
Enterprise Shares
10
Bank Bonds
10
Branches of Foreign Banks
11
Risks of Reform
11
The 1984 Credit Binge
12
Causes of the Credit Binge
12
Monetary Policy Response to the Credit Binge
12
Aftermath of the Credit Binge
14
Bank Reform Balance Sheet: Benefits and Unresolved Problems
14
Tenuous Monetary Control Techniques
15
Improper Banking Practices
15
Shortage of Skilled Managers and Inadequate Infrastructure
15
Irrational Price Structure
15
Absence of Enterprise Bankruptcy Laws
15
Implications for the United States
17
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Banking Reform in China:
Constructing an
Economic Lever
The Need for Banking Reform
As Premier Zhao Ziyang stated in a recent interview,
one of the key problems Beijing's reform program
faces is how to maintain macroeconomic stability
while reducing direct government control over state
enterprises. Before industrial reforms were imple-
mented, overall economic control was maintained
through mandatory plans and administrative direc-
tives. Central planners established output targets for
key products, and the wages of staff and workers-
and most prices-were fixed by the state. Central and
provincial governments determined the scale of invest-
ment spending, while the Ministry of Foreign Trade
monopolized imports and exports and strictly con-
trolled external capital flows. Given these pervasive
economic controls, unplanned changes in aggregate
demand could arise only from fluctuations in consum-
er spending.' An unexpected increase in consumer
spending, moreover, had little effect on prices or
employment; its main impact was to increase short-
ages of retail goods.
Reforms implemented since 1978 have sharply dimin-
ished administrative control over economic activity. In
hopes of improving industrial performance, Beijing
has reduced the scope of mandatory planning while
giving enterprise managers greater decisionmaking
authority. Enterprises now retain a much larger share
of earnings-which they can use for investment, or
wages and bonuses-and are permitted to sell over-
quota production of industrial goods at prices above
state-set levels. Price and wage controls have been
relaxed, and more retail goods are marketed outside
government-run commercial channels.
Central planning still plays an important role in
China's economy. By allowing enterprises increased
autonomy over production decisions, however, Beijing
Aggregate demand refers to the total demand for goods and
services produced in an economy, and is made up of consumer
demand, desired investment spending, government expenditures,
and net exports (exports minus desired imports).
has given up an element of direct control over aggre-
gate demand. As enterprise managers determine in-
vestment spending and wage payments on their own,
rather than following guidelines set by central plan-
ners, much sharper fluctuations in aggregate demand
may occur.
Reformers hope to control aggregate demand-and
maintain economic stability-through indirect eco-
nomic levers employed by a revitalized banking sys-
tem.s Monetary authorities in particular have been
assigned responsibility for adjusting interest rates and
credit levels to offset undesirable changes in invest-
ment or consumer spending.
Beijing also intends to have the banking system play
an increasingly large role in funding investment pro-
jects. Reformers recognize that interest-free budget
grants in the past encouraged wasteful use of invest-
ment funds and extended construction periods. Beijing
hopes that interest rates will serve as a lever to speed
up the turnover of funds, and that banks will investi- 25X1
gate projects more closely for their potential profit-
ability.
When China's economic reform program was
launched in 1979, the banking system was woefully
unprepared to undertake an active monetary role.
Bank managers, used to following administrative dir-
ectives, had little knowlege of modern banking tech-
niques. Moreover, China's central bank lacked the
tools for controlling credit used by Western central 25X1
banks (such as open market sales of government
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securities and changes in the central bank discount
rate), and was hampered by having to conduct both
commercial and regulatory activities. The primary
problem reformers faced was that for more than three
decades Chinese banks had not been allowed to
operate like banks.
Within the confines of China's centrally planned
economy, the banking system was charged with facili-
tating attainment of the national economic plan, but,
because most credit was provided from government
budget grants, banks often served as little more than
cashiers and accountants for the Ministry of Finance.
Monetary policy was "passive" in that credit levels
were not purposefully adjusted to counter changes in
aggregate demand, and the banking system played
little role in maintaining financial stability. The bank-
ing system's close monitoring of currency and credit
flows, however, provided economic planners with im-
portant financial data.
The Ministry of Finance used government revenues to
supply investment funds and enough working capital
to enterprises to meet planned production targets.
Interest was not charged on these budget grants, and
principal was not expected to be repaid, because the
allocation of funds was determined by the central plan
and because enterprises were required to turn over all
profits to the state anyway. Banks did not offer loans
for investment, but supplied short-term financing to
meet enterprises' unplanned needs for funds. Banks
charged interest on working capital loans primarily so
they could cover interest payments on household
savings accounts.
Banks were supposed to keep the growth of household
currency holdings in line with available supplies of
consumer goods, but most of the factors affecting
household currency holdings were outside the control
of banking authorities. Credit entered circulation
mainly through wage payments to urban workers and
through state purchases of agricultural products. Cur-
rency was withdrawn when consumers purchased
goods from state and cooperative firms. The banks'
role in adjusting currency supplies was to encourage
additions to, or withdrawals from, household savings
deposits. Interest rates were set by the state and rarely
Suppliers of Credit
Under Political Duress
During the Great Leap Forward (1958-60) and the
Cultural Revolution (1966-76), banking policies and
operations were subject to political criteria to an
unprecedented extent. During the Great Leap For-
ward, boosting output rapidly became a means for
factory managers and local officials to show adher-
ence to the party line. Banks were instructed to grant
loans whenever enterprises requested funds to meet
production targets, and it became almost impossible
for banks to refuse any loan request. During the
Cultural Revolution, China's central bank was sub-
sumed under the Ministry of Finance, and its local
branches were taken over by party committees that
used them as personal suppliers of funds for the
expansion of enterprise output.
changed, however, so moral suasion was the main tool
that banks had to induce changes in savings deposits.
Banks used the ratio of retail sales to currency in
circulation as a key currency indicator. If the ratio fell
below a target level-indicating excessive amounts of
currency in circulation-banks did not have the power
to stop payment of excess wages or withhold credit
used to procure agricultural products. Instead, they
could only alert the appropriate government supervi-
sory authorities.
The banking sector used administrative controls to
keep financial developments in the enterprise sector
separate from developments in the household sector.
Enterprises and government units were required to
settle accounts with each other by bank transfers that
were closely scrutinized to ensure compliance with the
economic plan. Enterprises could hold currency only
under very restrictive conditions, and were not al-
lowed to extend credit to other enterprises. To prevent
banks from competing for business, enterprises were
assigned to particular banks. Individuals received
cash for wages and sales of agricultural products, but
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Figure 1
China's Banking Structure Today
Formal control
- - Operational
supervision
Ministry of Finance People's Bank of China a - - ,
Agricultural Bank of China - - - - -
Rural Credit Cooperatives
People's Construction Bank of China - - - - -
Industrial and Commercial Bank of China - - - - -
Bank of China - - - -
China International Trust and
Investment Corporation
a The specialized banks, CITIC, and PICC are directly subordinate to the operations independently of the PBOC. The People's Bank initially was
State Council, but Beijing has delegated supervision of their banking limited to recommending policies for the specialized banks, but its control
activities to the People's Bank. The specialized banks, however, handle over banking activities has been strengthened since 1983.
matters such as wage payments, personnel decisions, and internal
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For 35 years the People's Bank of China (PBOC) was
China's central bank and also its largest commercial
bank. Since 1983, when its commercial banking
operations were split off, the People's Bank increas-
ingly has functioned as a true central bank. The
PBOC has the status of a ministry directly under the
State Council and is charged with formulating mone-
tary policy and developing credit and currency targets
that are consistent with annual economic plans and
long-run development goals. The central bank con-
trols the issue of currency, sets interest rates, and
approves the establishment, closure, or merger of
financial organizations. The central bank is responsi-
bleforauditing financial institutions, and, since
August 1985, has managed the State Treasury-
overseeing the collection and distribution of govern-
ment revenues. The PBOC also sets China's exchange
rate, controls state holdings of foreign exchange,
regulates the issuance offoreign-currency-denominat-
ed bonds, and represents the government in interac-
tions with international monetary organizations.
The Agricultural Bank of China (ABC) was created in
1955, then abolished in 1957 when its duties were
taken over by the PBOC. It was reestablished in
February 1979 to handle banking operations in rural
areas. The ABC specializes in collecting saving de-
posits from peasants and offering loans in support of
agricultural production and rural industry. It is the
main channel for state loans and investment to
agriculture, and is responsible for collecting revenue
in the countryside. The ABC also oversees the opera-
tions of the rural credit cooperatives.
The rural credit cooperatives (RCCs) were created in
the countryside during the period of rural collectiv-
ization in the 1950s. Although collectively owned,
they operate essentially as grassroots units of the
Agricultural Bank. Their resources come mostly
from farmers' deposits and borrowings from the
Agricultural Bank, and their funds are invested
mainly in the rural economy. The RCCs recently
have been given an expanded role in extending credit
in the countryside.
The People's Construction Bank of China (PCBC)
was established in 1954 to manage the state's capital
construction funds. Prior to 1979, its primary func-
tion was to distribute state budget allocations to
enterprises for investment projects, and to oversee the
operations of state construction units. Until 1979, the
Construction Bank was subordinate to the Ministry
of Finance and the State Capital Construction Com-
mission, and operated more like a fiscal agent of the
Ministry than as a bank. The role of the Construction
Bank has changed significantly during the past few
years. In August 1979, the PCBC issued repayable,
interest-bearing bank loans for construction projects
on a trial basis. The experiment was broadened when
the State Council decided in November 1980 that all
capital construction appropriations to enterprises that
had been granted independent accounting authority
would assume the form of bank loans. The Construc-
tion Bank now distributes both appropriations and
loans for capital construction. It also extends loans
for the production of industrial commodities for
export, and takes deposits from construction organi-
zations and geological prospecting units.
The Industrial and Commercial Bank of China
(ICBC) was created in January 1984 to take over the
commercial operations of the People's Bank of China.
The Industrial and Commercial Bank accepts savings
deposits from urban residents, enterprises, and
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government organizations, and offers working capital
loans to state-run and urban collective enterprises as
well as to individuals engaged in industry and com-
merce. The ICBC also settles accounts between firms,
and monitors financial accounts particularly wage
funds-of state-run enterprises.
Since 1949 the Bank of China (BOC) has specialized
in the management of foreign exchange and the
settlement of China's international trade and service
accounts. The BOC handles foreign currency loans
and deposits in China, including remittances from
overseas Chinese. Besides carrying out investment
overseas, the BOC offers Chinese and foreign curren-
cy loans to Chinese enterprises and domestic joint
ventures. The Bank of China maintains correspon-
dent relationships with about 1,200 foreign banks in
1 50 countries, and has opened more than 280 over-
seas branches (including two in the United States).
The BOC is also authorized to sell foreign-currency-
denominated bonds for the central government. Be-
cause of recent bank reforms, the BOC no longer
monopolizes China's international financial dealings.
China International Trust and Investment Corpora-
tion (CITIC) was established in October 1979 to
serve as an intermediary in arranging joint ventures
between Chinese and foreign firms. The goal of the
corporation is to introduce foreign funds and technol-
ogy and promote investment in China. Since January
1982, Beijing has allowed CITIC to raise capital by
selling foreign-currency-denominated bonds. Besides
lending funds to domestic joint ventures, CITIC also
has made equity investments in joint ventures. F_
The China Investment Bank (CIB) was created in
December 1981 with World Bank funds to provide
loans for small-scale industrial modernization pro-
jects. Unlike CITIC, which seeks investment funds
primarily from private sources, the Investment
Bank's main business consists of arranging long- and
medium-term loans from international monetary or- 25X1
ganizations-primarily the World Bank. The CIB
also engages in capital participation with joint ven-
tures and organizes syndicate loans. The China In-
vestment Bank works closely with the Ministry of
Finance and the Construction Bank.
After being virtually suspended in 1958, the insur-
ance business was revived when the People's Insur-
ance Company of China (PICC) was reinstated in
1980 to provide property and transportation insur-
ance for households and enterprises. In January 1984
the People's Insurance Company was split off from
the People's Bank of China. The PICC handles both
domestic and overseas insurance and recently has
developed life, health, auto, and agricultural insur-
ance.
Beijing created the Central Bank Council in January 25X1
1984 to serve as the key advisory body within the
banking system. The council is headed by the presi-
dent of the People's Bank and is composed of vice
presidents and financial advisors of the PBOC, presi-
dents of the specialized banks, and one vice-minister
each from the Ministry of Finance, the State Plan-
ning Commission, and the State Economic Commis-
sion. The Central Bank Council gives advice on
monetary policy, analyzes the adequacy of credit
policies in relation to the economic plan, and exam-
ines institutional developments within the banking 25X1
system. 25X1
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could use their currency only to purchase consumer
goods or increase their savings deposits. Banks did not
offer loans to individuals.
Changing the Structure of the Banking System
Recognizing that banking reform must accompany
other economic reforms, Beijing has been making
major institutional changes in its banking system
during the past seven years. Beijing has reestablished
a network of rural banks, stopped using its construc-
tion banks solely as conduits for Ministry of Finance
funds, spun off the commercial banking operations
formerly conducted by its central bank, and ended the
monopoly on international financial transactions held
by its foreign exchange banks. After key reforms in
1983 and 1984, China's banking system now consists
of a central bank and a number of banks that
specialize in particular types of financial operations.
The centerpiece of Beijing's bank reform strategy is to
strengthen the powers of the People's Bank of China
(PBOC) to enable it to function as a true central bank.
After being subsumed under the Ministry of Finance
during the Cultural Revolution, the PBOC was rein-
stated as a direct adjunct of the State Council by a
decision of the National People's Congress in 1978.
The People's Bank, however, continued to be ham-
pered in its oversight role by having to conduct daily
commercial operations-including monitoring finan-
cial activities of state enterprises. A series of banking
reforms announced by the State Council in September
1983 significantly enhanced the powers of the PBOC
as a central bank:
? The PBOC was designated as China's sole central
bank, its right to manage the specialized banks and
other financial institutions was expanded, and the
status of the specialized banks, China International
Trust and Investment Corporation (CITIC), and
People's Insurance Company of China (PICC) was
downgraded correspondingly.
? The PBOC's deposit and lending divisions were
separated from its central banking divisions (and
transferred to the ICBC when it was formally
established on 1 January 1984.)
? The PBOC's guidance over loans offered by the
Construction Bank was strengthened.
? The State Administration of Exchange Control was
transferred from the Bank of China to the PBOC.'
Central Bank Council.
control over the banking system.
Although the banking reforms in September 1983
strengthened the power of the PBOC over the special-
ized banks, the Ministry of Finance continued to exert
a strong influence over the banking system through its
authority to establish economic policy guidelines and
to interpret regulations. We believe, however, that the
Ministry's influence was eroded in 1985. A State
Council decision late in July 1985, for instance, gave
the PBOC control of the State Treasury-an econom-
ic department we believe was run formerly by the
Ministry of Finance. In our view, the Ministry proba-
bly now exercises very little direct administrative
The PBOC supervises the banking system through its
network of branch banks. The People's Bank has
branches in China's provinces-which are subordi-
nate to the head office in Beijing-and secondary
branches in prefectures, large cities, and some coun-
ties-which are subordinate to the provincial offices.
Branch banks regulate credit and currency flows in
their localities and supervise the operations of the
specialized banks and other financial institutions
within their jurisdictions. Beijing's goal is for the
PBOC increasingly to use economic levers-such as
changes in the central bank lending rate-rather than
administrative edicts, to guide the credit practices of
the specialized banks.
' The State Administration of Exchange Control, established in
March 1979, is a specialized financial organ that formulates
regulations governing the use of foreign exchange, supervises all
foreign exchange receipts and disbursements, and periodically
announces new exchange rates.F____1
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Figure 2
Lines of Supervision in
China's Banking System
Head offices of
the specialized banks
Provincial offices
of the PBOC
Provincial offices of
the specialized banks
Local branches of
the specialized banks
How the PBOC Conducts Monetary Policy
The main focus of monetary policy in China remains
the development of credit and currency targets that
complement the economic plan, but Beijing increas-
ingly is calling on the People's Bank to play a more
active role managing macroeconomic activity. Central
banks in market economies use open market opera-
tions, discount rate adjustments, and changes in re-
serve requirements to regulate the volume of credit.'
Open market operations refer to central bank sales (or purchases)
of government securities to (or from) commercial banks and the
public. Discount rate changes are changes in the interest rate paid
by commercial banks when borrowing from the central bank.
Reserve requirement changes refer to changes in the amount of
reserves a commercial bank must maintain in relation to its total
deposits. Open market sales of securities, increases in the discount
rate, or increases in reserve requirements tend to decrease the
amount of reserves available to the banking system, and thus, the
total volume of credit in the economy.
The primary monetary tools used by the People's
Bank are quantitative restrictions on the amount of
loans that the specialized banks can offer. Beijing is
moving quickly, however, to expand the number of
monetary control instruments available to the PBOC,
including reserve requirement and discount rate
changes.
The head office of the People's Bank approves credit
plans for each of the specialized banks-including
target levels for loans, deposits, and borrowing from
the PBOC. The specialized banks then assign credit
ceilings to their provincial branches. On the basis of
the provincial ceilings established by the specialized
banks, the PBOC head office instructs its branches on
how much they can lend to the specialized banks in
each province. The People's Bank may set additional
restrictions on particular types of loans and, in the
wake of excessive credit expansion in 1984, the PBOC
now maintains quarterly credit limits for the special-
ized banks. There are no formal penalties, however,
for exceeding credit limits, and the PBOC has had
problems keeping specialized banks from exceeding
their ceilings.
China instituted a reserve requirement system in
1984, whereby financial institutions were required to
turn over a stipulated percentage of their deposits to
the PBOC. Originally, the reserve percentage was
based on the type of deposits, but in 1985 a uniform
reserve ratio of 10 percent was set for all banks.
The People's Bank increased its discount rate in 1985
to tighten control over specialized bank borrowing
from the PBOC. In 1984, the PBOC charged the
same interest rate on loans to the specialized banks as
it paid the specialized banks for their reserve depos-
its-thereby greatly limiting the effectiveness of hav-
ing a reserve requirement. In 1985 the PBOC in-
creased its discount rate to 4.68 percent annually,
while holding the rate on specialized bank deposits
with the PBOC to 4.32 percent. If a specialized bank
needed funds in excess of its limit in the credit plan, it
could borrow short-term funds from the PBOC at a
5.04-percent annual rate. We expect that in the next
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China:
Annual Interest Rates
on Deposits and Loans
After 1980
Increase
5.40
6.12
5.04
5.04
After 1982 After 1984 After April After August
Increase Increase 1985 Increase 1985 Increase
year Beijing will widen the difference between the
discount rate and the rate paid on reserve deposits of
the specialized banks.
China also is making greater use of interest rates on
commercial loans and savings accounts as levers to
enhance macroeconomic stability. After keeping in-
terest rates almost unchanged during 1965-78, Beij-
ing raised the general structure of interest rates five
times in the past seven years. Beijing hopes that
higher rates on savings deposits will encourage in-
creased consumer saving-reducing the demand pres-
sure caused by rapid increases in personal income and
providing funds for priority investment projects.
Higher rates on loans are to discourage wasteful or
unproductive enterprise investment. We judge it prob-
able that Beijing will raise interest rates again in 1986
(see table).
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The People's Bank continues to use administrative
controls to supplement credit quotas and indirect
monetary levers. For instance, when central officials
became alarmed that wage payments were growing
too rapidly in 1985, they reinstated the requirement
that enterprises conduct all wage disbursements
through separate bank accounts. The Industrial and
Commercial Bank is to monitor enterprise accounts,
and alert the appropriate government authorities if
enterprises divert bank deposits designated for tax
payments, investment, or retirement funds into wage
payments.
Because China lacks a secondary market for govern-
ment securities, the People's Bank cannot employ the
primary monetary control tool used by central banks
in market economies-open market operations-and
we do not believe this will be possible for some time.
Direct sales of treasury bonds by the government,
however, do provide an important means of absorbing
excess funds. After being suspended in 1958, Beijing
resumed issuing treasury bonds in 1981. Initially,
sales were restricted to state-owned and collective
enterprises and government organizations, but sales to
individuals began in 1982 and have accounted for
about half of the 4 billion yuan sold each year since
then. Beijing planned to sell 6 billion yuan of bonds in
1985, with the increase in sales aimed at individual
buyers.' Reselling government bonds is prohibited, but
in 1985 for the first time, bonds can be discounted at
banks to allow individuals to recover their funds if
they need cash before the bonds mature, and the
bonds can be used as collateral for bank borrowing.
Microeconomic Reforms To Improve
the Allocation of Funds
on how loans are being used by the borrowers. Banks
now can lengthen or shorten the terms of loans, and
some banks may adjust loan rates within a 20-percent
range of the rates set by the PBOC. If branches are
able to attract more savings deposits, they have the
right to extend more loans rather than remit the extra
funds to their head office, but branches still must
meet a target established by their head office for the
net amount of deposits and loans outstanding at the
end of the year. F_~
Beijing has given banks much more flexibility to meet
the needs of customers. In 1982 enterprises and
organizations for the first time were allowed to hold
time deposits (which earn much higher rates of return
than the sight deposits they were required to hold
previously). Banks also have introduced new types of
loans, such as housing loans. Some banks have im-
proved the convenience of their services by organizing
mobile bank teams that go door-to-door to collect
savings deposits. F__1
To improve the allocation of funds between regions,
Beijing has granted permission for branches of a
specialized bank to transfer funds among themselves,
and for a specialized bank to borrow from other
specialized banks.
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vincial offices of the PBOC have been encouraged to
organize a market for interbank funds. Apparently, a
specialized bank's excess deposits and unutilized cred-
it may be released to other specialized banks for a
maximum of 10 days. The interest rate charged for
these short-term funds is to be linked to the PBOC 25X1
discount rate. Although in its infancy, we believe that
regional differences in rates of return on capital will
spur rapid development of this interbank funds mar-
ket-if Beijing permits.'
China's specialized banks are gradually being trans-
formed into independent enterprises-responsible for
their own profits and losses-that operate under
broad PBOC supervision. Local branches of the spe-
cialized banks have been given greater flexibility in
allocating their overall credit targets between differ-
ent types of loans, and have the right to restrict credit
to inefficient enterprises or deny loans that would go
toward financing excessive stocks of goods. The
PBOC encourages local banks to conduct feasibility
studies before issuing loans, and to check periodically
' In 1985, the bonds offered a 9-percent interest rate for individuals
and a 5-percent interest rate for institution buyers (which are
comparable to yields on bank savings accounts). The bonds had a
five-year maturity with interest and principal to be paid at maturi-
ty. The PBOC handles the issuance of treasury bonds and the
payment of principal and interest, and receives a fee from the
Ministry of Finance for acting as its agent.=
6 Xue Muqiao, an eminent reform economist, has stated that banks
in northwest China tend to have surplus funds, while banks in the
southeast are short of funds. Allowing interregional borrowing
apparently has caused a flow of funds from the northwest to the
southeast.
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Bank loans increasingly are supplanting budget grants
in financing both working capital of enterprises and
investment spending.' For instance, a middle-level
official with the State Economic Commission reported
to Embassy Beijing that, in the next five years, almost
all funds for technical transformation of state enter-
prises will be in the form of bank loans. Beijing hopes
that allocation of investment funds will be improved
when profit-seeking banks carefully screen prospec-
tive borrowers and when enterprises are forced to bear
the costs of financial capital.F_~
To absorb surplus funds that are outside the banking
system, and to prod banks to improve their operations,
Beijing in the past year has begun to experiment with
new financial forms and instruments such as private
credit institutions, enterprise shares, and bank
"bonds." Beijing also is allowing foreign banks to
increase operations in China, albeit on a limited scale.
Practical and ideological problems, however, have
caused some wavering of leadership attitudes toward
these experiments.
Popular Credit Institutions
In what perhaps is a concession to an already flourish-
ing practice, Beijing is encouraging peasants to pool
their earnings and form private credit institutions to
support the development of rural industry and agricul-
tural production. These "popular" credit institu-
tions-often taking the form of local credit unions or
joint-stock operations-were praised by Vice Premier
Wan Li in a speech at a national rural work confer-
ence in December 1984 as important supplements to
the Agricultural Bank and the rural credit coopera-
tives. Provincial officials, too, have urged peasants to
rely on their own efforts in raising funds for invest-
ment. According to provincial media, popular credit
' Funds for investment spending come from budget allocations,
bank loans, self-raised funds, and retained earnings of enterprises.
Most budget allocations for capital construction now are made as
interest-bearing loans instead of grants. When loans are extended
on the basis of budget allocations, the Ministry of Finance has
claim on repayment of principal, but banks retain interest pay-
ments. When banks use their own funds to extend loans, the banks
have claim on both principal and interest.
institutions often outbid rural banks and credit coop-
eratives for funds by offering higher rates of return,
and extend loans at above-bank rates to peasants and
enterprises that have no other source of credit.
We believe that Beijing's willingness to loosen control
of rural credit by sanctioning the development of
private credit institutions reflects disappointment with
the pace of reform in the rural banking system. In his
speech, Wan referred to unresolved structural prob-
lems thatdimit rural banks and credit cooperatives.
Chinese press reports in January 1986, however,
suggest that policymakers are concerned with the high
interest rates often charged on loans by these institu-
tions.
Domestic Trust and Investment Corporations
With PBOC approval, branches of the specialized
banks, and some provinces and cities, have set up trust
and investment corporations to channel surplus finan-
cial resources of enterprises and local governments
into new investment activities. The corporations han-
dle trust loans, trust investments, trust leasing, and
provide consulting services. Provincial media suggest,
however, that Beijing temporarily called a halt to
trust loans in some provinces in August 1985-
apparently because of concerns about excessively rap-
id and unregulated growth of these loans.
Enterprise Shares
According to a banking journal published by the
PBOC, 58 cities that are designated as "laboratories
for reform" have allowed some state enterprises to
issue bonds to their own staff and workers. Chinese
media suggest that local authorities also are issuing
bonds or shares to raise funds for local capital invest-
ment.
Bank Bonds
In August 1985 Beijing announced that the Agricul-
tural Bank would be allowed to sell 1.5 billion yuan of
bonds in the countryside to raise funds for rural
enterprises producing goods for export or firms under-
taking investment projects that banks deem profit-
able. The bonds have a one-year term and pay
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are in short supply.
9-percent interest on maturity, and funds are to be
loaned out at interest rates of 12 to 14 percent.
Beijing also authorized the Industrial and Commer-
cial Bank to issue 500 million yuan of bonds bearing
the same rate and maturity to urban residents. Pro-
ceeds of the ICBC bond sale are to be loaned to urban
collective enterprises producing consumer goods that
holds.
Because bank bonds cannot be traded or discounted,
they actually are more akin to certificates of deposits
than bonds, in the Western use of the terms. An
Agricultural Bank official told Embassy Beijing that
this type of financing could become an increasingly
important source of funds. Because the bank bonds
carry higher interest rates than bank deposits of
comparable maturity, we expect these financial in-
struments to be very popular with Chinese house-
Chinese exchange rate.
Branches of Foreign Banks 8
In April 1985 Beijing promulgated an ordinance
allowing foreign banks to establish wholly owned or
joint-venture branches in the four Special Economic
Zones (Shenzhen, Zhuhai, Shantou, and Xiamen).
Upon approval of the PBOC, branches of foreign
banks will be allowed to settle foreign trade transac-
tions and handle foreign currency deposits and loans
and remit foreign exchange earnings for joint ven-
tures. Foreign banks, however, must follow strict state
guidelines in setting interest rates on loans and depos-
its, and can offer foreign currency only at the official
Chinese reform proponents have stressed the need to
establish links between the world financial market
and China's banking system. We believe Beijing
hopes that, by allowing foreign banks to establish
branches only in the Special Economic Zones, it can
gain experience and draw in foreign investment funds
while limiting the influence of foreign banks on the
Chinese economy. Beijing also may hope that compe-
tition from foreign banks will force Chinese banks in
' Since 1980 over 70 foreign banks have set up 140 representative
offices in Beijing and other major Chinese cities, according to
Chinese press reports. The representative offices, however, are
restricted largely to providing liaison and consultation services and
promoting trade.
the Special Economic Zones to improve their services.
We believe that allowing foreign banks to open
branches in the Special Economic Zones may be, in
part, a tacit admission that China's banking system is
not capable of handling the burgeoning trade between
China and Western countries.
By the end of 1985, one joint-venture bank had been
established in Xiamen, and four foreign banks had
been granted permission to open branches in Shenz-
hen (the first allowed to open in China since 1949).
Although press reports indicate other banks are inter-
ested in opening branches, we believe many foreign
bankers remain wary of restrictions on bank activities
and potential problems in remitting foreign currency
earnings.
We believe Beijing faces two significant challenges to
carrying out its bank reform program, both of which
are illustrated by the 1984 credit surge and its
aftermath. The first stems from a potential conflict
between granting specialized banks increased autono-
my, and strengthening the regulatory powers of the
People's Bank. A primary goal of local banks is to
maximize bank revenues by increasing the amount of
outstanding loans, while a main concern of the central
bank is to maintain macroeconomic stability by-
among other things-preventing credit from expand-
ing too rapidly. Therefore, Beijing must carefully
match increases in bank autonomy with improve-
ments in central bank control techniques.
The increased responsiveness of industrial production
to monetary levers poses a second potential problem
for Beijing. The state plan is no longer the sole
determinant of the amount of investment spending by
enterprises.' Bank loans constitute a growing portion
of investment funds, and with the devolution of
decisionmaking authority to enterprises, output has
' In 1978, over 85 percent of total capital construction investment
was funded through the state budget, but by 1984, this had dropped
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become more responsive to the total amount of bank
credit in the economy. Beijing plans to conduct a more
active monetary policy to maintain macroeconomic
equilibrium, but poorly formulated or inappropriately
executed monetary policy now will have a much more
deleterious impact on the economy. Increasing or
decreasing credit levels at the wrong time will cause
sharper fluctuations in output than before the re-
forms. Beijing, therefore, must be especially cautious
in formulating and monitoring credit policy.
The 1984 Credit Binge
The dangers inherent in bank reform were highlighted
by the performance of China's banking system during
the past 18 months. Inappropriate monetary policy
and lax oversight caused both currency in circulation
and loans to industrial enterprises to grow by about 50
percent in 1984, with almost two-thirds of the in-
crease coming in the fourth quarter. The credit surge
continued in early 1985-with the PBOC reporting,
for instance, that in the first quarter of 1985 the
Agricultural Bank issued 3.2 times the amount of
loans to rural enterprises as it did in the first quarter
of 1984. According to China's State Statistical Bu-
reau, enterprises used the growth in credit to launch
new capital construction projects and hike wage
funds-both of which grew at almost 40-percent
annual rates during the first half of 1985. Strong
consumer and investment demands caused industrial
output to increase at a 23-percent annual rate during
the same period. The excessive credit expansion
caused China's official inflation rate to triple during
1985, and contributed to a 35-percent drop in its
foreign exchange reserves between September 1984
and June 1985.
increase support to economic development before the
PBOC had developed adequate oversight and control
mechanisms
The money supply surge actually began at midyear in
1984, rather than in the fourth quarter as Beijing
claims. Figure 3 shows that the increase in currency
in circulation in the third quarter of 1984 was twice
the increase that occurred in the third quarter of any
recent year. Growth of currency and credit acceler-
ated after the Third Plenum of the 12th Party
Congress in October 1984 placed the party's stamp of
approval on measures designed to extend decision-
making authority to lower levels throughout the econ-
omy. Demand for credit grew as enterprise managers
used their increased autonomy to undertake invest-
ment projects and increase wage and bonus payments
to workers. At the same time, government directives
appearing in the Chinese press-as late as January
1985-called for specialized banks to support reform
by expanding their loan business. We believe some
bank managers thought that their bonuses would be
based on the total amount of loans issued.
We believe problems monitoring and controlling the
credit surge arose because the PBOC had been slow to
disentangle its accounts from those of the specialized
banks.
(separate clearing accounts for each
specialized bank were not established with the PBOC
until April 1985. We believe specialized banks re-
sponded to relaxed credit controls by boosting loans,
and covered the extra lending by running up over-
drafts with the PBOC. Press statements by central
bank officials that the PBOC is not a cornucopia of
funds suggest to us that the PBOC, whether witting or
not, accommodated the specialized banks' increased
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Causes of the Credit Binge
Premier Zhao, in his March 1985 report to the
National People's Congress, attributed the unexpect-
ed increase in credit to an accidental leak late in the
year of a government decision to base 1985 credit
limits on 1984 loan totals. In our view, while this may
have exacerbated the problem, the credit and curren-
cy surges were caused by much more fundamental
errors in Beijing's bank reform policy. We believe that
policy was bungled when Beijing ordered the special-
ized banks to use their newly enhanced autonomy to
demand for funds.
Monetary Policy Response to the Credit Binge
In April 1985 Beijing clamped down on credit, using a
combination of administrative controls and indirect
monetary levers. At the time, Beijing announced its
intention to restore monetary equilibrium gradually,
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Figure 3
Change in Currency in Circulation by Quartera
1 11 111 IV 1 11 111 IV
1981 82
a The highly pronounced seasonality of China's currency in circulation is
caused by the pattern of agricultural procurement and wage payments, and
by the absence of countervailing monetary policy. According to reports in
China's press, 60 to 70 percent of Chinese currency circulates in rural areas.
I II III IV I II III IV 1 11
83 84 85
State purchases of agricultural products after the harvest inject currency
into the economy, and end-of-year bonuses for staff and industrial workers
add to the late-year money supply increase.
while strengthening oversight and control, without
backtracking on fundamental bank reforms:
? The People's Bank was ordered to set and enforce
quarterly credit limits for its branches and the
specialized banks.
? Separate clearing accounts with the PBOC were
established for each specialized bank.
? Interest rates were raised on time deposits held by
individuals and enterprises, and on working capital
and capital construction loans. (Interest rates were
raised again in August 1985).
? To prevent indiscriminate increases in wages and
bonuses, enterprises were required to place wage
funds in special bank accounts to be monitored by
the banks. Apparently, the payroll accounts of some
units were frozen.
? Banks were ordered to stop offering loans to ineffi-
cient enterprises and to firms that produce poor-
quality products for which there is little demand.
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? Banks were prohibited from extending credit for
capital construction projects whose spending ex-
ceeds the state quota or for projects not listed in the
state plan.
? Enterprises and individuals requesting credit were
required to pledge collateral equaling as much as 50
percent of the value of the loan.
? Banks were ordered to make a better effort at
collecting overdue loans, and were urged to make
use of a regulation, promulgated in March 1985,
that allows banks to acquire the pledged collateral
of borrowers who cannot repay their loans.
Aftermath of the Credit Binge
Although having only a mild impact on the pace of
industrial production in the six months after it was
implemented, Beijing's restrictive monetary policy
caused severe credit shortages in some rural areas.
Chinese newspapers reported that credit shortages
contributed to sharp drops in purchases of fertilizer
and farm implements, and in some provinces farmers
were forced to accept IOUs when state procurement
units ran out of funds to purchase the summer
harvest.
Banks and enterprises in other regions have circum-
vented or ignored the tight money policies. Chinese
press reports suggest that rural industries have proved
particularly adept at raising funds outside the bank-
ing system to support rapid expansion of investment
and output. Recent statements by the president of the
PBOC that the volume of credit is still excessive, and
a continuing widespread investigation of credit prac-
tices within the banking system, suggest to us that
Beijing has not yet recovered from the credit binge.
Bank Reform Balance Sheet:
Benefits and Unresolved Problems
We believe China already has received substantial
benefits from bank reform. Agricultural Bank credit
probably played an important role supporting the
development of livestock and cash crops by specialized
The State Council appointed Chen Muhua president
of the People's Bank of China in March 1985,
probably to restore order to the banking system.
Chen, formerly the head of the Ministry of Foreign
Economic Relations and Trade (MOFERT), is an
alternate member of the Politburo and has a reputa-
tion as a tough administrator. When Chen was head
of MOFERT, she recentralized the trade apparatus,
regained control over imports, and helped put an end
to the trade deficits and foreign exchange problems
that plagued China in the late 1970s and early 1980s.
Unlike her predecessor, Chen holds the rank of State
Councilor, which gives her equal status with the
heads of the State Planning Commission, the State
Economic Commission, and the Ministry of Finance.
Her position as a Politburo alternate, however, gives
her higher party status than the heads of the three
superministries. We believe her appointment to the
People's Bank is not only consistent with Beijing's
plans to increase the authority of the PBOC but may
presage an unprecedented PBOC role in policymak-
ing.
households during the transformation of the agricul-
tural sector from commune-based production to
household farming. Rapid growth of rural industrial
production, to a large extent, has been a result of loan
support from rural banks. We believe that greater
BOC flexibility in handling foreign exchange has
facilitated increased trade and promoted development
of joint ventures in China. Chinese press reports
suggest that the increased use of loans in place of
budget grants has sped up turnover of working capital
and reduced construction periods. The introduction of
new financial institutions and instruments probably
has helped tap some of the substantial cash hoards
reportedly held by peasants. We believe, however,
that Beijing will be unable to realize the potential
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benefits from bank reform until it has resolved five
major deficiencies.
Tenuous Monetary Control Techniques
By reducing the scope of central planning and dele-
gating decisionmaking authority to lower levels, Beij-
ing has increased the responsiveness of economic
activity to monetary policy. In our view, monetary
control techniques are not yet reliable, and Beijing
faces substantial risks that monetary policy actually
may be destabilizing-as it was in 1984. The potential
danger is compounded by the fact that Beijing does
not appear to know how sensitive the economy is to
monetary tools-and the responsiveness of enterprises
and consumers probably is changing as the economic
reforms proceed.10 In meetings with Western econo-
mists, Chinese officials have indicated that they are
unsure what the appropriate rate of monetary growth
should be. Beijing's policy of developing a profit-
oriented banking system by granting specialized
banks greater flexibility in issuing loans may be at
odds with its desire for better PBOC control over
credit.
Improper Banking Practices
The specialized banks do not always use their in-
creased autonomy in ways that Beijing intended.
Chinese media report that bank competition for bor-
rowers has resulted in the issuance of inadequately
secured loans and the slashing of interest rates (in
excess of regulations) to unprofitably low levels. Chi-
nese media also report that local political pressures,
not economic criteria, continue to determine the
direction of loans. Some local party officials have
threatened bankers with the loss of party membership
if they do not accede to their demands for loans.
Other press reports tell of local officials browbeating
bankers for loans, and then using the funds to set up
illegal companies. Banks apparently have no effective
way of stopping enterprises from using loans for
10 The large magnitude of China's currency flows relative to the
total amount of currency in circulation makes it more difficult to
maintain monetary equilibrium. In 1984, retail sales were over four
times higher than currency in circulation, and the value of the
increase in gross agricultural production corresponded to 50 percent
of the average stock of currency during the year. A small variation,
therefore, in wages, prices of agricultural products, or farm output
could have a large impact on the stock of currency. F__~
purposes other than those laid down in the loan
contract, or compelling enterprises to repay them.
Shortage of Skilled Managers and
Inadequate Infrastructure
China faces a critical shortage of skilled bank manag-
ers. Under the Maoist banking system, managers for
the most part did not have to make decisions based on
economic criteria, or conduct loan and project evalua-
tions, and therefore did not develop the skills required
by modern banking practices. Beijing also lacks the
physical infrastructure-such as modern telecom-
munications and an integrated computer network-
necessary for sophisticated banking operations (al-
though Beijing increasingly is introducing computers
in the banking system).
Irrational Price Structure
We believe that banking reform may not bring about
a significant improvement in the allocation of funds if
China's present irrational price system is not also
reformed. In the absence of price reforms, the use of
indirect monetary tools to control aggregate demand
might cause a greater misallocation of resources than
administratively set credit limits. For instance, if the
PBOC decides to raise interest rates to slow invest-
ment spending, enterprises that sell goods at high
state-set prices may continue to afford loans, even if
the enterprises are poorly managed. On the other
hand, higher interest rates may force efficient firms to
reduce borrowing and scale back production if their
output must be sold at irrationally low prices. Initial
efforts to reform urban food prices in 1985 caused the
cost of living to soar and met with stiff consumer
resistance, and Chinese officials are now saying that
price stability-rather than price reform-will be
emphasized in 1986.
Absence of Enterprise Bankruptcy Laws
In our view, the lack of bankruptcy laws for Chinese
enterprises has contributed to Beijing's difficulty con-
trolling excessive credit. Managers have taken advan-
tage of their new decisionmaking authority by bor-
rowing funds to increase investment or employee's
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wages, but, because Beijing still pays the operating
expenses of state enterprises that lose money, firms
can expand their borrowing without worrying about
bankruptcy. Local banks, similarly, expand credit
freely because they believe higher authorities will bail
them out if they make bad loans. Beijing recognizes
the need to allow enterprises to go bankrupt, but the
irrational price system makes it difficult to determine
which enterprises should be closed. Beijing, moreover,
is reluctant to proceed with price reform while infla-
tionary pressures-caused by excessive credit-are
still strong. We believe Beijing will resolve its dilem-
ma by proceeding with reforms on two fronts. First,
Beijing will improve its ability to conduct active
monetary policy by increasing and sharpening the
monetary instruments at the PBOC's command, and,
temporarily, allow the PBOC greater use of adminis-
trative controls over credit. Second, Beijing will grad-
ually implement the other components of its reform
program, thereby making economic entities more
responsive to market forces-including monetary
levers.
Progress rectifying the five deficiencies will not only
boost the economic returns from bank reform, but
also will pay political dividends to Chinese reformers.
Since the reforms began party conservatives have
argued that mandatory planning should play the
primary role in maintaining macroeconomic stability,
and that strict limits, therefore, must be placed on
economic decentralization. We believe that reforms
have proceeded, in part, because leaders are convinced
that they can control economic activity successfully
by employing indirect economic levers-such as inter-
est rates and credit levels. Conservatives are quick to
attack shortcomings, however, and have criticized
Deng Xiaoping and members of his reform coalition
for mismanaging the economy during the past year.
Successfully transforming the People's Bank into a
central bank capable of using indirect monetary tools
to regulate credit in a decentralized banking system
would, in our view, strengthen the hand of the
reformers and improve the chances for the overall
reform program.
To meet China's ambitious development goals, banks
and enterprises must make better use of existing
financial resources. Enhancing the flexibility of banks
to meet local credit needs and increasingly using
interest rates to ration funds should, we believe,
improve the allocation of resources while satisfying
enterprises' demands for funds without resorting to
inflationary issuance of currency.
Progress to date suggests to us that the following
trends probably will emerge in China's banking
reform:
? Increased Use of Interest Rates as Economic Le-
vers. Beijing will adjust the structure of interest
rates more frequently to compensate for changes in
economic conditions-rates probably will be raised
again within the next year. Banks also will be given
greater flexibility in setting interest rates on loans.
? Increased Competition Among Banks. Beijing grad-
ually will allow increased competition among banks,
both by allowing domestic banks to undertake bank-
ing operations formerly reserved to a particular
specialized bank, and by granting foreign banks a
wider range of activities. Experiments with bank
competition will be limited at first to the Special
Economic Zones and then may spread to other areas
in China.
? Increased Range of Financial Instruments. Beijing
will continue to experiment with new financial
instruments such as bank bonds (certificates of
deposit), enterprise shares, and mutual funds.
? Establishing a Short-Term Capital Market. Ac-
cording to a party journal, the president of the
People's Bank recently said that "conditions for
opening a short-term capital market are ripening."
Beijing's initial steps include: allowing banks to
borrow from each other, permitting the discounting
or mortgaging of government bonds, authorizing
interenterprise credit, and allowing banks to raise
funds by issuing bonds. The president of the PBOC
made it clear, however, that in the near future
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a large scale.
Beijing will not allow stocks and bonds to be issued on
over lending.
Beijing probably will introduce new banking reforms
at a slow, measured pace, particularly during 1986-
87. Some financial reforms, however, such as the
development of private credit institutions, may prove
difficult to control. In the short run Beijing will
closely monitor credit. Although we do not expect a
repetition of the 1984 credit surge this year, we do
expect Beijing to experience cycles of overexpansion
and contraction of credit as it refines central bank
monetary tools and gives local banks more flexibility
ate inflation or recession.
Even if the PBOC successfully develops sophisticated
monetary tools, we believe Beijing's reforms will
fundamentally alter macroeconomic conditions in
China, and the economy may begin to experience the
periodic bouts of inflation that occur in market econo-
mies. Poorly formulated monetary policy will accentu-
conditions.
When bank reforms are implemented fully, the state
will continue to dominate the banking sector, and
foreign or nongovernmental banks will have only a
limited scope of operations. As such, the banking
system will retain many of the characteristics of a
monopoly bank and will provide Beijing with a power-
ful economic control mechanism. In our view, a
stronger and more active central bank is compatible
with an economic system that combines mandatory
planning and market forces. Monetary policy will
remain subordinate to the needs of the economic
plan-and banks will continue to be required to offer
preferential interest rates to priority sectors and to
support designated loss making enterprises-but the
banking system will be able to respond much more
efficiently and flexibly to credit needs and economic
We believe bank reform will facilitate increased trade
with China. As the People's Bank increasingly func-
tions as a true central bank, the BOC will operate
more as a commercial bank-and less like a foreign
exchange bank for the state-and may be more
willing to lend foreign exchange for imports and joint 25X1
ventures. Greater competition between the BOC and
the CITIC for customers may foster trade, as will
enhanced flexibility in conducting banking operations.
As a result of bank reform, China probably will play a
larger role in the international financial system. For
the first time since 1949, China has issued foreign-
currency-denominated bonds for public subscription
outside China, and in the next few years, the BOC or
the CITIC may consider issuing bonds in the United
States. Proceeds from sales of foreign currency bonds 25X1
may go toward Chinese imports of industrial equip-
ment and high-technology products.
Successful bank reform would increase opportunities
for US banks to set up offices in China. The US
Consulate in Hong Kong reported last summer that
one US bank already was negotiating to form a joint-
venture bank in the Xiamen Special Economic Zone. 25X1
Foreign branch banking is in its infancy, but, as the
PBOC gains experience regulating foreign branches,
we expect Beijing to allow more foreign banks in
China, and permit them to broaden the scope of their
operations. In the short run, Beijing will continue to
restrict foreign branches to the Special Economic
Zones, and to foreign trade and investment financing.
Reform, however, should provide opportunities for US
banks to offer managerial services to Chinese finan-
cial institutions.
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Declassified in Part - Sanitized Copy Approved for Release 2011/12/30: CIA-RDP04T00794R000100620001-0