装 JOURNAL OF Development Journal of Development Economics ECONOMICS ELSEVIER vol.61(2000111-135 www.elsevier.com/locate/econbase Stagflationary effect of government bond financing in the transforming Chinese economy a general equilibrium analysis al g Ho, LIJing zhu Department of Decision Sciences and Managerial Economics, Faculry of Business Administration, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong, China b York University and Universiry of waterloo,Canada National Universiry of Singapore, Singapore This paper studies how the method of government debt financing affects the macroeco- nomic performance of the transforming Chinese economy. The investigation is conducted within the context of an endogenous growth model that incorporates the major institutional features of the Chinese economy. Using this framework, we evaluate the effects on the growth rate of output and inflation if the Chinese government relies more on bonds and less on money creation for budget deficit and debt repayment financing. It is shown that although this policy change can reduce the growth rate of the money supply, it can generate a stagflationary effect: reducing the rate of output growth while raising the rate of inflation, if the initial fraction of government deficit and debt repayment financed by bonds ufficiently small and the tax rate on labor income is sufficiently low. C 2000 Elsevier Science B v. All rights reserved Keywords: Economic transformation; Government debt finance, Endogenous growth model; Stagfla- tionary effect; The Chinese economy orresponding author. Fax: +852-2603-5104; e-mail: michael@ msmail baf cuhk. edu. hk 0304-3878/00/S- see front matter C 2000 Elsevier Science B.v. All rights reserved PI:S0304-3878(99)00063-2
Journal of Development Economics Vol. 61 2000 111–135 Ž . www.elsevier.comrlocatereconbase Stagflationary effect of government bond financing in the transforming Chinese economy: a general equilibrium analysis Michael K.Y. Fung a,), Wai-Ming Ho b , Lijing Zhu c a Department of Decision Sciences and Managerial Economics, Faculty of Business Administration, The Chinese UniÕersity of Hong Kong, Shatin, N.T., Hong Kong, China b York UniÕersity and UniÕersity of Waterloo, Canada c National UniÕersity of Singapore, Singapore Received 1 January 1997; accepted 1 April 1999 Abstract This paper studies how the method of government debt financing affects the macroeconomic performance of the transforming Chinese economy. The investigation is conducted within the context of an endogenous growth model that incorporates the major institutional features of the Chinese economy. Using this framework, we evaluate the effects on the growth rate of output and inflation if the Chinese government relies more on bonds and less on money creation for budget deficit and debt repayment financing. It is shown that although this policy change can reduce the growth rate of the money supply, it can generate a stagflationary effect: reducing the rate of output growth while raising the rate of inflation, if the initial fraction of government deficit and debt repayment financed by bonds is sufficiently small and the tax rate on labor income is sufficiently low. q 2000 Elsevier Science B.V. All rights reserved. JEL classification: E6; O4; P2 Keywords: Economic transformation; Government debt finance; Endogenous growth model; Stagflationary effect; The Chinese economy ) Corresponding author. Fax: q852-2603-5104; e-mail: michael@msmail.baf.cuhk.edu.hk 0304-3878r00r$ - see front matter q 2000 Elsevier Science B.V. All rights reserved. PII: S0304- 3878 99 00063-2 Ž
W.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 1. Introduction In 1993, only I year after Deng pushed the on-going economic reform further by visiting South China, the Chinese economy appeared to overheat considerably Investment projects were undertaken everywhere in the country, especially in the coastal regions, the general price level rose rapidly, indicating an excessive aggregate demand. To cool off the economy, the Chinese government initiated an economic "soft-landing'' at the end of June 1993. In addition to raising interest rates on government bonds and bank deposits, the government made a serious attempt to reduce the growth rate of the money supply by tightening bank credit o lower inflationary expectations, certain measures of price control were im- osed. Moreover, the government increased the quantity of bonds issued to the public to soak up liquidity(the value of outstanding state bond increased from 4.8% of gnp in1992to5.7%in1995) Surprisingly, the measures undertaken to cool off the economy generated a period of stagflation. On the one hand, the growth rate of GDP declined (14.1% in 992. 13.1% in 1993. 12.6% in 1994 and 9.0% in 1995). on the other. inflation accelerated654%in1992,13.2%in1993,21.7%in1994,andl48%in1995) and did not drop to 6.1% until 1996 By identifying the exchange rate policy adopted during the period of 1993-1994 as a major destabilizing factor, Naughton(1995)offers a reason why the inflation rate in China did not drop for 2 years. In January 1994, China devalued its urrency at a rate around 8.7 yuan to the dollar. Exports increased in response to the devaluation and the trade balance swung from a deficit of US$12. 2 billion to a surplus of US$5.35 billion. This increase in the trade surplus resulted in a huge inflow of foreign currency and the Chinese central bank opted to purchase foreign urrency earned by exporters. As a result, the government injected about 250 billion yuan into the domestic economy To our knowledge, there is no explanation given as to why stagflation took place in China during that period. The objective of this paper is to provide a possible explanation. We do so by studying how the method of government debt financing affects the macroeconomic performance of the transforming Chinese economy. In particular, we investigate the effects on the growth rate of output and inflation if the Chinese government relies more on issuing bonds and less on printing money for budget deficit and debt repayment financing As is commonly agreed, the overheating of China's economy was mainly due to monetization of government deficit, which is caused by the combination of the The data quoted here are obtained from Watanabe(1997)
112 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 1. Introduction In 1993, only 1 year after Deng pushed the on-going economic reform further by visiting South China, the Chinese economy appeared to overheat considerably. Investment projects were undertaken everywhere in the country, especially in the coastal regions; the general price level rose rapidly, indicating an excessive aggregate demand. To cool off the economy, the Chinese government initiated an economic ‘‘soft-landing’’ at the end of June 1993. In addition to raising interest rates on government bonds and bank deposits, the government made a serious attempt to reduce the growth rate of the money supply by tightening bank credit. To lower inflationary expectations, certain measures of price control were imposed. Moreover, the government increased the quantity of bonds issued to the public to soak up liquidity the value of outstanding state bond increased from Ž . 1 4.8% of GNP in 1992 to 5.7% in 1995 . Surprisingly, the measures undertaken to cool off the economy generated a period of stagflation. On the one hand, the growth rate of GDP declined 14.1% in Ž 1992, 13.1% in 1993, 12.6% in 1994, and 9.0% in 1995 , on the other, inflation . accelerated 5.4% in 1992, 13.2% in 1993, 21.7% in 1994, and 14.8% in 1995 Ž . and did not drop to 6.1% until 1996. By identifying the exchange rate policy adopted during the period of 1993–1994 as a major destabilizing factor, Naughton 1995 offers a reason why the inflation Ž . rate in China did not drop for 2 years. In January 1994, China devalued its currency at a rate around 8.7 yuan to the dollar. Exports increased in response to the devaluation and the trade balance swung from a deficit of US$12.2 billion to a surplus of US$5.35 billion. This increase in the trade surplus resulted in a huge inflow of foreign currency and the Chinese central bank opted to purchase foreign currency earned by exporters. As a result, the government injected about 250 billion yuan into the domestic economy. To our knowledge, there is no explanation given as to why stagflation took place in China during that period. The objective of this paper is to provide a possible explanation. We do so by studying how the method of government debt financing affects the macroeconomic performance of the transforming Chinese economy. In particular, we investigate the effects on the growth rate of output and inflation if the Chinese government relies more on issuing bonds and less on printing money for budget deficit and debt repayment financing. As is commonly agreed, the overheating of China’s economy was mainly due to monetization of government deficit, which is caused by the combination of the 1 The data quoted here are obtained from Watanabe 1997 . Ž
M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 decline in government fiscal revenue and the lack of a mechanism that imposes effective financial control over the state sector. In the process of reforms, as marketization deepened, many state-owned enterprises began to suffer heavy losses and could no longer generate as much revenue for the state as they did in the years before 1978. Moreover, without an effective internal revenue system, the government had a great difficulty in collecting taxes from the newly developed non-state sector. Consequently, there was a sharp decline in the consolidated government budget revenue, falling from over 34% of GNP in 1978 to just above 10% in the early 1990 On the other hand, the overall investment level in the state sector remained hig and even exhibited an increasing trend in 1990s(see Naughton, 1995). With the onopolization of the financial sector, the state relied heavily on the state-con- trolled banking system directly and indirectly to raise funds so as to substitute for declining direct budgetary revenues. Both local governments and the central government compelled the banking system to provide credit for their priority investment projects. Further, the government allowed the loss-making state-owned enterprises to borrow from the state-controlled banking system. This perverse flow of bank credits constituted monetizing the government expenditure and thus, was the major cause for the loss of control over the money supply, which in turn led to the rapid increase in the general price level The presence of a large government deficit is a common problem in many economies burdened with either social welfare programs or producer subsidization schemes, or both. Usually, there are two ways to finance the government deficit printing money and/or issuing bonds. Financing deficit through money creation constitutes taxing the money holders through inflation; and bond financing is to shift the fiscal burden from the current generation to the future generations Conventional wisdom suggests that financing budget deficit by money creation will generate high inflation and thus social instability. It is for this reason that In China, the process of decentralization and marketization in the financial sector has been rather limited. Although the banking system has been restructured, and now consists of a central bank and a group of specialized banks, it remains state-controlled. The central bank can tightly control the llocation of bank loans whenever it is necessary. In addition, only government agencies and tate-owned enterprises are permitted to raise funds by issuing bonds. The estimated total budget deficit was 6% of GDP in 1988 and 1989, and 8% of GDP in 1990 and 1991(See Wong et al., 1996) tandard textbooks suggest that, by using the traditional IS-LM model, monetization alw to more inflation. This conclusion is first questioned by Sargent and Wallace (1981). They conditions under which the conclusion is exactly reversed, and term it "unpleasant me arithmetic". Subsequent authors have debated on the theoretical and empirical validity of these conditions. See for example, Darby(1984), Scarth(1987), Papadia and Rossi (1990), Dotsey (1996) and Bhattacharya et al. (1998)
M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 113 decline in government fiscal revenue and the lack of a mechanism that imposes effective financial control over the state sector. In the process of reforms, as marketization deepened, many state-owned enterprises began to suffer heavy losses and could no longer generate as much revenue for the state as they did in the years before 1978. Moreover, without an effective internal revenue system, the government had a great difficulty in collecting taxes from the newly developed non-state sector. Consequently, there was a sharp decline in the consolidated government budget revenue, falling from over 34% of GNP in 1978 to just above 10% in the early 1990s. On the other hand, the overall investment level in the state sector remained high and even exhibited an increasing trend in 1990s see Naughton, 1995 . With the Ž . monopolization of the financial sector, 2 the state relied heavily on the state-controlled banking system directly and indirectly to raise funds so as to substitute for its declining direct budgetary revenues. 3 Both local governments and the central government compelled the banking system to provide credit for their priority investment projects. Further, the government allowed the loss-making state-owned enterprises to borrow from the state-controlled banking system. This perverse flow of bank credits constituted monetizing the government expenditure and thus, was the major cause for the loss of control over the money supply, which in turn led to the rapid increase in the general price level. The presence of a large government deficit is a common problem in many economies burdened with either social welfare programs or producer subsidization schemes, or both. Usually, there are two ways to finance the government deficit: printing money andror issuing bonds. Financing deficit through money creation constitutes taxing the money holders through inflation; and bond financing is to shift the fiscal burden from the current generation to the future generations. Conventional wisdom suggests that financing budget deficit by money creation will generate high inflation and thus social instability. 4 It is for this reason that 2 In China, the process of decentralization and marketization in the financial sector has been rather limited. Although the banking system has been restructured, and now consists of a central bank and a group of specialized banks, it remains state-controlled. The central bank can tightly control the allocation of bank loans whenever it is necessary. In addition, only government agencies and state-owned enterprises are permitted to raise funds by issuing bonds. 3 The estimated total budget deficit was 6% of GDP in 1988 and 1989, and 8% of GDP in 1990 and 1991 See Wong et al., 1996 . Ž . 4 Standard textbooks suggest that, by using the traditional IS-LM model, monetization always leads to more inflation. This conclusion is first questioned by Sargent and Wallace 1981 . They provide Ž . conditions under which the conclusion is exactly reversed, and term it ‘‘unpleasant monetarist arithmetic’’. Subsequent authors have debated on the theoretical and empirical validity of these conditions. See for example, Darby 1984 , Scarth 1987 , Papadia and Rossi 1990 , Dotsey 1996 , Ž. Ž. Ž. Ž. and Bhattacharya et al. 1998 . Ž
114 M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 governments in the developed market economies mainly rely on issuing govern- ment bonds instead of printing more money to finance their deficits. 5 The relevant question here is: if the Chinese government uses more bonds and lus less money creation to finance its deficit, will this measure necessarily lower the rate of inflation given that inflation is already a severe problem in the conomy? To provide a pertinent answer to the question posed, we follow the methodology adopted by Byrd(1989), Bennett and Dixon(1995; 1996),Brandt and Zhu(1995), to build a macrotheoretic model based on the existing analytical framework in such a way that it sufficiently characterizes the partially reformed structure observed in the Chinese economy. 6 Using the framework, we show that if the Chinese government uses more bonds to finance its deficit, it may generate a stagflationary effect. Specifically, if the initial fraction of government deficit and debt repayment financed by bonds sufficiently small and if the tax rate on labor income is sufficiently low,an increase in the fraction of government budget deficit and debt repayment financed by government bonds will decrease the growth rate of output and increase the inflation rate. As such, our analysis does provide a possible explanation for the flationary phenomenon experienced in China during the 1993-1996 period The rest of the paper is organized as follows. The institutional features of the Chinese economy is summarized in Section 2. In Section 3, the model is specified Section 4 characterizes the agents' optimization problems, the general equilibrium, and the balanced growth path of the model economy. Section 5 provides the major results and intuitions. Some concluding remarks are offered in Section 6. The derivations of our analytical results are in Appendix A 2. The institutional features of the Chinese economy The following are the six characteristics that have been identified by economists who study the Chinese economy Recently, several analytical models of endogenous growth have been constructed to investigate the macroeconomic implications of government deficits, which are shown to be crucially dependent on how the govemment expenditure is financed. Turnovsky(1992)studies the impact of different methods of government expenditure financing in a Ramsey-Cass economy. Ploeg and Alogoskoufis(1994) ompare the effects on growth and inflation of tax-financed, debt-financed, and money-financed increases in govemment consumption by using an overlapping generations model. Palivos and Y (1995)derive different effects on the growth rate of tax-financed and money-financed increases in 9 6 In Sections 2 and 3, we provide detailed description of the institutional features observed in China emment spending in an endogenous growth model and the specification of the model constructed, respecti 'In China, given the ineffective tax collection, the effective tax rate on labor income is rather low. In addition, according to Watanabe(1997), the government bonds issued are only 4.5% of GNP in 1993and57%in1995
114 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) governments in the developed market economies mainly rely on issuing government bonds instead of printing more money to finance their deficits. 5 The relevant question here is: if the Chinese government uses more bonds and thus less money creation to finance its deficit, will this measure necessarily lower the rate of inflation given that inflation is already a severe problem in the economy? To provide a pertinent answer to the question posed, we follow the methodology adopted by Byrd 1989 , Bennett and Dixon 1995; 1996 , Brandt Ž. Ž . and Zhu 1995 , to build a macrotheoretic model based on the existing analytical Ž . framework in such a way that it sufficiently characterizes the partially reformed structure observed in the Chinese economy. 6 Using the framework, we show that if the Chinese government uses more bonds to finance its deficit, it may generate a stagflationary effect. Specifically, if the initial fraction of government deficit and debt repayment financed by bonds is sufficiently small and if the tax rate on labor income is sufficiently low, 7 an increase in the fraction of government budget deficit and debt repayment financed by government bonds will decrease the growth rate of output and increase the inflation rate. As such, our analysis does provide a possible explanation for the stagflationary phenomenon experienced in China during the 1993–1996 period. The rest of the paper is organized as follows. The institutional features of the Chinese economy is summarized in Section 2. In Section 3, the model is specified. Section 4 characterizes the agents’ optimization problems, the general equilibrium, and the balanced growth path of the model economy. Section 5 provides the major results and intuitions. Some concluding remarks are offered in Section 6. The derivations of our analytical results are in Appendix A. 2. The institutional features of the Chinese economy The following are the six characteristics that have been identified by economists who study the Chinese economy. 5 Recently, several analytical models of endogenous growth have been constructed to investigate the macroeconomic implications of government deficits, which are shown to be crucially dependent on how the government expenditure is financed. Turnovsky 1992 studies the impact of different methods Ž . of government expenditure financing in a Ramsey–Cass economy. Ploeg and Alogoskoufis 1994 Ž . compare the effects on growth and inflation of tax-financed, debt-financed, and money-financed increases in government consumption by using an overlapping generations model. Palivos and Yip Ž . 1995 derive different effects on the growth rate of tax-financed and money-financed increases in government spending in an endogenous growth model. 6 In Sections 2 and 3, we provide detailed description of the institutional features observed in China and the specification of the model constructed, respectively. 7 In China, given the ineffective tax collection, the effective tax rate on labor income is rather low. In addition, according to Watanabe 1997 , the government bonds issued are only 4.5% of GNP in Ž . 1993 and 5.7% in 1995
W.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 (i) By the nature of ownership, there exist two sectors in the economy: a state sector and a non-state sector. The state sector is relatively large, measured either by the number of employees or the amount of resources it commands. However, when compared with the non-state sector, as a whole, it is extremely inefficient (i) While the non-state sector faces hard budget constraints and relies mainly n its internal source of financing. the state sector faces soft budget constraints and enjoys the advantage of being subsidized by the government for its production as well as capital investment. 1i)The real sector of the economy is considerably liberalized, with the markets for consumption goods, capital goods, and labor services becoming increasingly competitive. However, the reform in the financial sector is rather limited. The government still plays a key role in allocating the financial resources of the economy by absorbing most of the household savings, setting the quantity f bonds available to the public, regulating interest rates on the financial asset and determining which agencies can issue bonds and how bank loans are allocated (iv)Because the state-owned enterprises can no longer generate sufficient savings for the state and the government has great difficulty in collecting taxes from the newly developed non-state sector, government savings have declined. On the other hand, due to the rapid expansion of the non-state sector, private savings have been increasing considerably. Given the drastic change in the structure of national savings, the state banking system has become more important in resource allocation, channeling most savings from the household sector to investors (v) The state banking system is a quasi-fiscal institution. As the only low risk financial intermediary available, it offers extremely low real returns on bank detest anes th saim loses a de f to t hen deres itrs. Fu rther, by charging In China, the non-state sector includes private enterprises, joint-ventures, urban collectives and ownship and village enterprises(TVEs), which are owned by local governments and communities ince the late 1980s, the non-state sector has been the major contributor to the impressive economic growth performance experienced in China. For discussions on the special features of the sector and its impressive growth performance, see Byrd and Lin(1990)and Weitzman and Xu(1994). According to Jefferson and Rawski (1994), the growth rates of average TFP(Total Factor Productivity)for the collective sector were about 5% in the period of 1980-1988 and 4.7% during the period of 1988-1992. The growth rates of average TFP for the state sector were lower than that for the their estimation ccording to a survey conducted by the Chinese Academy of Social Sciences in a Research Project on Private Enterprises and Entrepreneurs in 1995, private businesses are faced with the scarcity of resources and institutional supports. Insufficient capital poses a major difficulties for private busi- esses. The survey indicated that the three major sources of initial business capital for the pi nterprises were personal saving, loans from friends or relatives, and personal loans from other people Only 11.8% of them reported that their primary source of capital came from the banking system(See Project Group for Research on Private Entrepreneurs in Contemporary China, 1996) See McKinnon(1994), Qian(1994), and Naughton(1995)
M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 115 Ž .i By the nature of ownership, there exist two sectors in the economy: a state sector and a non-state sector. 8 The state sector is relatively large, measured either by the number of employees or the amount of resources it commands. However, when compared with the non-state sector, as a whole, it is extremely inefficient. 9 Ž . ii While the non-state sector faces hard budget constraints and relies mainly on its internal source of financing, the state sector faces soft budget constraints and enjoys the advantage of being subsidized by the government for its production as well as capital investment. 10 Ž . iii The real sector of the economy is considerably liberalized, with the markets for consumption goods, capital goods, and labor services becoming increasingly competitive. However, the reform in the financial sector is rather limited. The government still plays a key role in allocating the financial resources of the economy by absorbing most of the household savings, setting the quantity of bonds available to the public, regulating interest rates on the financial assets, and determining which agencies can issue bonds and how bank loans are allocated. Ž . iv Because the state-owned enterprises can no longer generate sufficient savings for the state and the government has great difficulty in collecting taxes from the newly developed non-state sector, government savings have declined. On the other hand, due to the rapid expansion of the non-state sector, private savings have been increasing considerably. Given the drastic change in the structure of national savings, the state banking system has become more important in resource allocation, channeling most savings from the household sector to investors. 11 Ž . v The state banking system is a quasi-fiscal institution. As the only low risk financial intermediary available, it offers extremely low real returns on bank deposits and thus imposes a de facto tax on depositors. Further, by charging interest rates on bank loans at well below the market clearing level, the banking 8 In China, the non-state sector includes private enterprises, joint-ventures, urban collectives and township and village enterprises TVEs , which are owned by local governments and communities. Ž . Since the late 1980s, the non-state sector has been the major contributor to the impressive economic growth performance experienced in China. For discussions on the special features of the sector and its impressive growth performance, see Byrd and Lin 1990 and Weitzman and Xu 1994 . Ž. Ž. 9 According to Jefferson and Rawski 1994 , the growth rates of average TFP Total Factor Ž. Ž Productivity for the collective sector were about 5% in the period of 1980–1988 and 4.7% during the . period of 1988–1992. The growth rates of average TFP for the state sector were lower than that for the collective sector Jefferson et al., 1992 . McGuckin and Nguyen 1993 reached a similar conclusion in Ž . Ž. their estimation. 10 According to a survey conducted by the Chinese Academy of Social Sciences in a Research Project on Private Enterprises and Entrepreneurs in 1995, private businesses are faced with the scarcity of resources and institutional supports. Insufficient capital poses a major difficulties for private businesses. The survey indicated that the three major sources of initial business capital for the private enterprises were personal saving, loans from friends or relatives, and personal loans from other people. Only 11.8% of them reported that their primary source of capital came from the banking system See Ž Project Group for Research on Private Entrepreneurs in Contemporary China, 1996 .. 11 See McKinnon 1994 , Qian 1994 , and Naughton 1995 . Ž. Ž. Ž