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
W.K.Y. Fung et al /Journal of Development Economics 61(2000)111-13 system actually subsidizes the government investment projects and the loss-incur ring state-owned enterprises (vi) Since the state banking system is employed as the main vehicle to transfer resources from the non-state sector to the state sector, the money supply process is endogenously determined by the governments budget requirement 3. The model In our analysis, we will incorporate into our model all of the six institutional features of the Chinese economy mentioned above. The model constructed in this paper has the following three sets of attributes. First, in order to examine the impact of government policy changes on the output growth, we construct an overlapping generations model featuring endogenous growth. Externalities or learning by doing are introduced to the production technologies, which makes sustained growth feasible through a combination of increasing social returns and diminishing private returns to capital. As such, economic growth is driven by the augmentation of the capital stock in the econom Second. to evaluate how allocation of financial resources affects the level of capital investment, production and thus the growth rate of output, our model pecifies an economic system with two sectors: a real sector consisting of the markets for a consumption good, a capital good, and labor services, and a financial ctor consisting of the markets for money, government bonds, and bank deposits and loans. Money is introduced into the model by assuming that there are cash-in-advance constraints on the purchases of the consumption and capital roods These bank loans are"hidden deficits"of the government(McKinnon, 1994). Using a two-dimen- onal moral hazard model, Zuo and Sun(1996) show that there are incentive-based reasons for the low interest rate policy in China. ccording to Feltenstein and Farhadian (1987), in China, changes in the money supply for the period of 1954-1983 can be explained by: (i the government deficit, (ii) procurement payments to the farmers, and(iii) the wage bill of govemment and state enterprises. As Brandt and Zhu(1995)argue when rapid economic growth is generated in the non-state sector, to equalize the benefits of growth, the govemment uses the financial system as the vehicle to transfer resources from the non-state sector to the state sector. As a result, the money supply process is endogenously determined by the government transfer requirement. nat the individuals of the economy are three-period lived overlapping generations, we can simplify their optimization problems and obtain a tractable framework for dynamic general equilibrium analysis. In addition, in contrast to a standard infinitely lived representative agent model an overlapping generations model incorporates the heterogeneity among individuals and allows the govemment's choice between and bond financing of its budget deficit and debt repayment to have real effects on the (1987), and Bencivenga and Smith ver externalities"considered by Romer(1986), Boyd and Prescott These are similar to the
116 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) system actually subsidizes the government investment projects and the loss-incurring state-owned enterprises. 12 Ž . vi Since the state banking system is employed as the main vehicle to transfer resources from the non-state sector to the state sector, the money supply process is endogenously determined by the government’s budget requirement. 13 3. The model In our analysis, we will incorporate into our model all of the six institutional features of the Chinese economy mentioned above. The model constructed in this paper has the following three sets of attributes. First, in order to examine the impact of government policy changes on the output growth, we construct an overlapping generations model featuring endogenous growth. 14 Externalities or learning by doing are introduced to the production technologies, which makes sustained growth feasible through a combination of increasing social returns and diminishing private returns to capital. 15 As such, economic growth is driven by the augmentation of the capital stock in the economy. Second, to evaluate how allocation of financial resources affects the level of capital investment, production and thus the growth rate of output, our model specifies an economic system with two sectors: a real sector consisting of the markets for a consumption good, a capital good, and labor services; and a financial sector consisting of the markets for money, government bonds, and bank deposits and loans. Money is introduced into the model by assuming that there are cash-in-advance constraints on the purchases of the consumption and capital goods. 12 These bank loans are ‘‘hidden deficits’’ of the government McKinnon, 1994 . Using a two-dimen- Ž . sional moral hazard model, Zuo and Sun 1996 show that there are incentive-based reasons for the low Ž . interest rate policy in China. 13 According to Feltenstein and Farhadian 1987 , in China, changes in the money supply for the Ž . period of 1954–1983 can be explained by: i the government deficit, ii procurement payments to the Ž. Ž . farmers, and iii the wage bill of government and state enterprises. As Brandt and Zhu 1995 argue, Ž. Ž . when rapid economic growth is generated in the non-state sector, to equalize the benefits of growth, the government uses the financial system as the vehicle to transfer resources from the non-state sector to the state sector. As a result, the money supply process is endogenously determined by the government’s transfer requirement. 14 By assuming that the individuals of the economy are three-period lived overlapping generations, we can simplify their optimization problems and obtain a tractable framework for dynamic general equilibrium analysis. In addition, in contrast to a standard infinitely lived representative agent model, an overlapping generations model incorporates the heterogeneity among individuals and allows the government’s choice between money and bond financing of its budget deficit and debt repayment to have real effects on the economy. 15 These are similar to the ‘‘spillover externalities’’ considered by Romer 1986 , Boyd and Prescott Ž . Ž. Ž. 1987 , and Bencivenga and Smith 1992
M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 Last, in the model, there are both a state sector and a private sector, with the ng more efficient in production and markets are fully liberalized and thus perfectly competitive. However, the financial sector is monopolized by the government, which sets interest rates on the financial assets and determines the allocation of bank loans. The enterprises in the state ector face soft budget constraints, being subsidized by the government through bank loans with low interest rates, while the private sector faces hard budget constraints,thereby depending on its internal source of finance for capital invest ment. The government finances its budget by collecting tax revenue, issuing government bonds, and printing money. The money supply is endogenously determined in the sense that whenever the other two sources of funds are sufficient to finance the government's budget deficit, money creation is em- ployed to take up the residual 3.1. Agents, preferences, and production technology Consider the following partially reformed socialist economy. In the econom time is discrete and infinite, indexed by t=0, 1, 2,,.. The economy is inhabited by an infinite sequence of overlapping generations of individuals. At the beginning of each period, individuals of measure one are born. Each individual lives for three periods. When young, each individual is endowed with a single unit of labor and inelastically supplies it to a perfectly competitive labor market. Let Wi denote the nominal wage rate prevailing in the labor market in period t. Using the labor income earned, at the end of the first period of their lives, the individuals make their portfolio decisions. At the end of the second period of lives, the middle-aged individuals collect the return from their portfolios. When they are old, the individuals do nothing but consume their wealth The individuals of the same generation are heterogeneous in their ability to organize production processes (i.e, setting up and managing individual firms for commodity production ). There are two types of individuals in each generation:a measure of 8 individuals are endowed with the production-organizing ability, and the rest do not possess such ability. Hereafter, the first type will be referred to as Hereafter, we will refer to the non-state enterprises as the private firms. In our modeling, rivate enterprises and joint-ventures with urban collectives and TVEs will not cause any since both types of enterprises have large autonomy in decision making but receive few supports from the central govemment. sector have been iy d sector wage rates are determined administratively, they can be viewed as This is because since 1979, the growth rates of wages in the ne level as those in the non-state sector which are determined in the labor market. See Brandt (1995)for detailed discussion as to how and why
M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 117 Last, in the model, there are both a state sector and a private sector, 16 with the latter being more efficient in production and learning by doing. In the real sector, markets are fully liberalized and thus perfectly competitive. However, the financial sector is monopolized by the government, which sets interest rates on the financial assets and determines the allocation of bank loans. The enterprises in the state sector face soft budget constraints, being subsidized by the government through bank loans with low interest rates, while the private sector faces hard budget constraints, thereby depending on its internal source of finance for capital investment. The government finances its budget by collecting tax revenue, issuing government bonds, and printing money. The money supply is endogenously determined in the sense that whenever the other two sources of funds are insufficient to finance the government’s budget deficit, money creation is employed to take up the residual. 3.1. Agents, preferences, and production technology Consider the following partially reformed socialist economy. In the economy, time is discrete and infinite, indexed by ts0, 1, 2, 3, . . . . The economy is inhabited by an infinite sequence of overlapping generations of individuals. At the beginning of each period, individuals of measure one are born. Each individual lives for three periods. When young, each individual is endowed with a single unit of labor and inelastically supplies it to a perfectly competitive labor market. Let Wt denote the nominal wage rate prevailing in the labor market in period t. 17 Using the labor income earned, at the end of the first period of their lives, the young individuals make their portfolio decisions. At the end of the second period of their lives, the middle-aged individuals collect the return from their portfolios. When they are old, the individuals do nothing but consume their wealth. The individuals of the same generation are heterogeneous in their ability to organize production processes i.e., setting up and managing individual firms for Ž commodity production . There are two types of individuals in each generation: a . measure of u individuals are endowed with the production-organizing ability, and the rest do not possess such ability. Hereafter, the first type will be referred to as 16 Hereafter, we will refer to the non-state enterprises as the private firms. In our modeling, grouping the private enterprises and joint-ventures with urban collectives and TVEs will not cause any problem since both types of enterprises have large autonomy in decision making but receive few financial supports from the central government. 17 Even though in the state, sector wage rates are determined administratively, they can be viewed as if they are determined by the market. This is because since 1979, the growth rates of wages in the sector have been maintained at the same level as those in the non-state sector, which are determined in the labor market. See Brandt and Zhu 1995 for detailed discussion as to how and why. Ž
W.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 the entrepreneurs(indexed by a superscript e), and the second type will be referred to as the non-entrepreneurs (indexed by a superscript n) The individuals of all generations have identical preferences on consumption or simplicity, it is assumed that individuals value consumption only when they are old. The preferences of an individual of generation t are characterized by the utility function U(C14,Cr+1C计+2)=CH2,i=e,n,Vt≥1 (1) Note that the first superscript indicates which generation the individual belongs to, the second superscript indicates his type, and the subscript indicates which riod the individual lives in. Since the individuals value consumption only when old, they save their labor income made when young by holding money, bank deposits, government bonds, and/or the capital good in the second period of their ives. Further, because consumption must be paid in cash, old individuals finance their consumption by the cash balance carried over from the second period of their ves There are two types of commodities being produced in the economy: a non-storable consumption good and a capital good. The markets for trading the two types of commodities are perfectly competitive. The nominal price of the tal good and consumption good in period t are denoted by Pk and P espectively. The capital good is produced by an investment technology, which converts one unit of the consumption good into one unit of the capital good without using the inputs of labor effort. Thus, the nominal prices of the two goods are always equal, PI=P For simplicity, it is assumed that the capital good depreciates completely after the production processes have been completed By the nature of ownership, there are two types of producers in the consump- tion good industry: the private firms (indexed by a superscript p) owned by the entrepreneurs and the state-owned enterprises(indexed by a superscript s)owned by the government. In the state sector, the number of firms is a measure of one and the number of firms in the private sector is a measure of A Production of the consumption good requires the inputs of capital and labor effort. In order to produce the consumption good in period t+ l, the firms must install the capital good at the end of period t. It is assumed that the capital good must be paid when purchases are made but workers are paid only after the production processes are completed. That is, there exists a cash-in-advance (liquidity) constraint on hiring capital but not on hiring labor 18T1 equired to simplify the problem so that analytical solutions can be obtained. ption, we do not have to worry about how individuals allocate their income or current and savings. a more detailed discussion on how changi affect our results will be presented in Section 5.2
118 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) the entrepreneurs indexed by a superscript e , and the second type will be referred Ž . to as the non-entrepreneurs indexed by a superscript n . Ž . The individuals of all generations have identical preferences on consumption. For simplicity, it is assumed that individuals value consumption only when they are old. 18 The preferences of an individual of generation t are characterized by the utility function: U t,i Ct,i ,Ct,i ,Ct,i sCt,i Ž . , ise,n, ;tG1. 1Ž . t tq1 tq2 tq2 Note that the first superscript indicates which generation the individual belongs to, the second superscript indicates his type, and the subscript indicates which period the individual lives in. Since the individuals value consumption only when old, they save their labor income made when young by holding money, bank deposits, government bonds, andror the capital good in the second period of their lives. Further, because consumption must be paid in cash, old individuals finance their consumption by the cash balance carried over from the second period of their lives. There are two types of commodities being produced in the economy: a non-storable consumption good and a capital good. The markets for trading the two types of commodities are perfectly competitive. The nominal price of the capital good and consumption good in period t are denoted by P k and P , t t respectively. The capital good is produced by an investment technology, which converts one unit of the consumption good into one unit of the capital good without using the inputs of labor effort. Thus, the nominal prices of the two goods are always equal, Pt t ksP . For simplicity, it is assumed that the capital good depreciates completely after the production processes have been completed. By the nature of ownership, there are two types of producers in the consumption good industry: the private firms indexed by a superscript p owned by the Ž . entrepreneurs and the state-owned enterprises indexed by a superscript s owned Ž . by the government. In the state sector, the number of firms is a measure of one, and the number of firms in the private sector is a measure of u. Production of the consumption good requires the inputs of capital and labor effort. In order to produce the consumption good in period tq1, the firms must install the capital good at the end of period t. It is assumed that the capital good must be paid when purchases are made but workers are paid only after the production processes are completed. That is, there exists a cash-in-advance Ž . liquidity constraint on hiring capital but not on hiring labor. 18 This assumption is required to simplify the problem so that analytical solutions can be obtained. With this simplifying assumption, we do not have to worry about how individuals allocate their income for current consumption and savings. A more detailed discussion on how changing this assumption will affect our results will be presented in Section 5.2
M.K.Y. Fung et al/ Journal of Development Economics 61(2000)111-13 he technology for producing the consumption good is characterized by the following production function Q=Q(k,1,H)=4kB”,i=p,,∈(0,1) where A'>0 is the time-invariant productivity parameter and H, is an indicator of the economy-wide technology level in period t. To capture the fact that the state-owned enterprises are less efficient in production than the private firms in China, it is assumed that AP=A and AS=aa, where a E(0, 1). moreover, to capture the fact that the private sector is more efficient in learning by doing(e.g adapting to a fast changing environment and adopting modern technologies and advanced management techniques) in China, we assume that the evolution of H is determined only by the capital stock accumulated in the private sector in period Formally H1=6k That is, the augmentation of the capital good in the private sector generates a positive external effect on the productivity of the whole economy 3. 2. The financial sector and gouernment fiscal arrangement In the economy, there are three types of financial assets: money and bonds. The government monopolizes the allocation of financial resources by etaining the rights for bond-issuing, and by controlling the banking system through a central bank. At the end of period t, the central bank issues B, units of government bonds, and the commercial banks accept deposits from individuals and make loans to the state-owned firms. Once bonds are purchased, they cannot be redeemed until the end of the next period. Similarly, once made, bank deposits cannot be withdrawn until the end of the next period. Since there is a cash-in-advance constraint on the purchases of the consumption good, and since savings in forms of bonds and bank deposits are illiquid for one period, only the young will purchase government bonds and deposit their income into the commercial banks at the end of period t Let Di and di denote respectively the amount of bank deposits held by the entative entrepreneur and non-entrepreneur in period t. Moreover, let D the total amount of bank deposits held by the young individuals and L the total amount of bank loans made by the banking system in period t Given that bank deposits are the only source of loanable funds of the state-banking system, the liquidity constraint faced by the system is D,=OD+(1-O)D2L Given the monopolization of the financial sector by the government, it is the ntral bank that sets the nominal interest rates on bonds (i ), bank deposits (id) and loans (i, ). The nominal interest rate on bonds is usually set at a higher level than that on bank deposits(see Qian, 1994). In this case, the young would like to old bonds instead of bank deposits. Given that B, is less than the desired gregate bond holdings of the young, each young individual is allowed to urchase b, units of the government bonds. In other words, the purchase of
M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 119 The technology for producing the consumption good is characterized by the following production function: Qi sQ k i ,l i ,H sAi k i s l i 1ys H1ys t tt t tt t Ž . , isp,s, sgŽ . Ž. 0,1 , 2 where Ai )0 is the time-invariant productivity parameter and H is an indicator t of the economy-wide technology level in period t. To capture the fact that the state-owned enterprises are less efficient in production than the private firms in p s China, it is assumed that A sA and A sa A, where agŽ . 0,1 . Moreover, to capture the fact that the private sector is more efficient in learning by doing e.g., Ž adapting to a fast changing environment and adopting modern technologies and . t advanced management techniques in China, we assume that the evolution of H is determined only by the capital stock accumulated in the private sector in period t. Formally, H su k p . 3Ž . t t That is, the augmentation of the capital good in the private sector generates a positive external effect on the productivity of the whole economy. 3.2. The financial sector and goÕernment fiscal arrangement In the economy, there are three types of financial assets: money, bank deposits, and bonds. The government monopolizes the allocation of financial resources by retaining the rights for bond-issuing, and by controlling the banking system through a central bank. At the end of period t, the central bank issues B units of government bonds, t and the commercial banks accept deposits from individuals and make loans to the state-owned firms. Once bonds are purchased, they cannot be redeemed until the end of the next period. Similarly, once made, bank deposits cannot be withdrawn until the end of the next period. Since there is a cash-in-advance constraint on the purchases of the consumption good, and since savings in forms of bonds and bank deposits are illiquid for one period, only the young will purchase government bonds and deposit their income into the commercial banks at the end of period t. Let De and Dn denote respectively the amount of bank deposits held by the t t representative entrepreneur and non-entrepreneur in period t. Moreover, let Dt denote the total amount of bank deposits held by the young individuals and Lt denote the total amount of bank loans made by the banking system in period t. Given that bank deposits are the only source of loanable funds of the state-banking e Ž . n system, the liquidity constraint faced by the system is D suD q 1yu D GL . t t tt Given the monopolization of the financial sector by the government, it is the Ž b . Ž d central bank that sets the nominal interest rates on bonds i , bank deposits i ., t t Ž L and loans i .. The nominal interest rate on bonds is usually set at a higher level t than that on bank deposits see Qian, 1994 . In this case, the young would like to Ž . hold bonds instead of bank deposits. Given that Bt is less than the desired aggregate bond holdings of the young, each young individual is allowed to purchase b units of the government bonds. In other words, the purchase of t
M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 government bonds is"quantity-rationed". 9 Entrepreneurs will undertake capital investment using some of their income and hold the rest of it in forms of bonds and deposi It is assumed that only the state-owned enterprises can borrow from the commercial banks and that private firms have no access to the loanable funds. 20 The government subsidizes the state-owned enterprises by lowering their borrow- ing costs. The interest rate on loans, i, is lower than that on bank det In addition, it is assumed that the interest rate on loans, i l, is set too low that there is an excess demand for bank loans. Given the liquidity constraint faced by the state-banking system, D,>,, the central bank chooses D,=L, and imposes credit rationing such that each state-owned enterprise can obtain L, units of bank loans. As the investments undertaken by the state-owned enterprises are financed by bank loans only, the investment level of the state sector is constrained by the quantity of loanable funds available in the banking system, D Since the nominal interest rate charged on bank loans is lower than that on bank deposits, the loan repayments from state-owned enterprises, L, (1+i5),received by the commercial banks are not sufficient to pay off the deposits, D, (1 +in) Given D=Lo the loss of the banking system in period t+ I is given by LGid-iL). In addition to financing this loss, at the end of period t+1, the government must redeem the government bonds issued in the previous period B、1+1) One source of government revenue is the two types of taxes levied on residents labor income tax and corporate profit tax. The nominal tax rates are denoted by T and T, respectively. It is assumed that only the private firms are subject to the corporate profit tax. The state-owned enterprises are not subject to any taxes, but they must submit all of their profits to the government. The tax revenue collected in period t+ I is T+1=rW+1+r∏P+1, where li+i is the profit of each private firm in period t+ 1. Other than collecting taxes, there are two additional ways through which the government can finance its n China, when inflation runs high, each year the govemment will supply a fixed amount of bonds to the public. In recent years, secondary markets have been developed for trading bonds. As modeled re, the individuals are not allowed to trade bonds in secondary markets. It can be shown that this ption will not affect the results derived in the paper In China, firms in the non-state sector are subject to hard budget self-financing for their investment projects. See McKinnon(1994)for a According to Brandt and Zhu(1995), for the period between 1981 3. the interest rate for l-year working capital loans was 0.73% and for l-year fixed investment loans was 1.29%. Taking into consideration the lack of loan repayment enforcement and the possibility of loan forgiveness, the effective real interest rate on loans was even lower
120 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) government bonds is ‘‘quantity-rationed’’. 19 Entrepreneurs will undertake capital investment using some of their income and hold the rest of it in forms of bonds and deposits. It is assumed that only the state-owned enterprises can borrow from the commercial banks and that private firms have no access to the loanable funds. 20 The government subsidizes the state-owned enterprises by lowering their borrowing costs. The interest rate on loans, i L, is lower than that on bank deposits, i d . 21 t t In addition, it is assumed that the interest rate on loans, i L, is set too low that there t is an excess demand for bank loans. Given the liquidity constraint faced by the state-banking system, D GL , the central bank chooses D sL and imposes tt tt credit rationing such that each state-owned enterprise can obtain Lt units of bank loans. As the investments undertaken by the state-owned enterprises are financed by bank loans only, the investment level of the state sector is constrained by the quantity of loanable funds available in the banking system, D .t Since the nominal interest rate charged on bank loans is lower than that on bank Ž L deposits, the loan repayments from state-owned enterprises, Lt t 1qi ., received Ž d by the commercial banks are not sufficient to pay off the deposits, D 1qi .. t t Given Dt t sL , the loss of the banking system in period tq1 is given by Ž d L L i yi .. In addition to financing this loss, at the end of period tq1, the tt t government must redeem the government bonds issued in the previous period, Ž b B 1qi .. t t One source of government revenue is the two types of taxes levied on residents: labor income tax and corporate profit tax. The nominal tax rates are denoted by t l and t c , respectively. It is assumed that only the private firms are subject to the corporate profit tax. The state-owned enterprises are not subject to any taxes, but they must submit all of their profits to the government. The tax revenue collected in period tq1 is: T st l W qt c u Łp , 4Ž . tq1 tq1 tq1 where Łp tq1 is the profit of each private firm in period tq1. Other than collecting taxes, there are two additional ways through which the government can finance its 19 In China, when inflation runs high, each year the government will supply a fixed amount of bonds to the public. In recent years, secondary markets have been developed for trading bonds. As modeled here, the individuals are not allowed to trade bonds in secondary markets. It can be shown that this assumption will not affect the results derived in the paper. 20 In China, firms in the non-state sector are subject to hard budget constraints and must rely on self-financing for their investment projects. See McKinnon 1994 for a detailed discussion. Ž . 21 According to Brandt and Zhu 1995 , for the period between 1981 and 1993, the average real Ž . interest rate for 1-year working capital loans was 0.73% and for 1-year fixed investment loans was 1.29%. Taking into consideration the lack of loan repayment enforcement and the possibility of loan forgiveness, the effective real interest rate on loans was even lower
