Journal of Comparative Economics 28, 293–320 (2000)
doi:10.1006/jcec.2000.1655, available online at http://www.idealibrary.com on
The Impact of Credit Control and Interest Rate
Regulation on the Transforming Chinese Economy:
An Analysis of Long-Run Effects 1
Michael Ka-Yiu Fung,* ,2 Wai-Ming Ho,† and Lijing Zhu‡
*Department of Decision Sciences & Managerial Economics, The Chinese University
of Hong Kong, Shatin, N.T., Hong Kong, China; †York University, Toronto, Ontario,
Canada M3J 1P3; and ‡National University of Singapore, Singapore
E-mail: michael@baf.msmail.cuhk.edu.hk
Received May 12, 1999; revised February 25, 2000
Fung, Michael Ka-Yiu, Ho, Wai-Ming, and Zhu, Lijing—The Impact of Credit Control
and Interest Rate Regulation on the Transforming Chinese Economy: An Analysis of
Long-Run Effects
After identifying the two major institutional features of the Chinese economy, i.e., the
coexistence of state-owned enterprises and private firms and tight governmental control
over the financial sector, we incorporate these features into an endogenous growth model
to investigate the long-run impacts of credit control and interest rate policies on the
macroeconomic performance of the transforming Chinese economy. We find that (i)
raising the interest rate on government bonds reduces the inflation rate without tempering
the output growth rate, (ii) reducing the bank loans available to the state-owned enterprises
may lower both the inflation rate and the output growth rate, (iii) increasing the nominal
interest rate on bank deposits will exert a stagflationary effect on the economy, i.e.,
increasing the inflation rate but reducing the output growth rate, and (iv) changing the
nominal interest rate on bank loans will have little real effect. J. Comp. Econ., June 2000,
28(2), pp. 293–320. Department of Decision Sciences & Managerial Economics, The
Chinese University of Hong Kong, Shatin, N.T., Hong Kong; York University, Toronto,
Ontario, Canada M3J 1P3; and National University of Singapore, Singapore.
© 2000 Academic Press
Key Words: credit control; interest rate regulation; financial repression; endogenous
growth; inflation control.
Journal of Economic Literature Classification Numbers: E52, E60, O40, P20.
1
The authors thank Professor John P. Bonin and two anonymous referees for helpful comments on
an earlier draft. All remaining errors are solely our own responsibility.
2
To whom correspondence should be addressed.
293
0147-5967/00 $35.00
Copyright © 2000 by Academic Press
All rights of reproduction in any form reserved.
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FUNG, HO, AND ZHU
1. INTRODUCTION
In the past 20 years, while undergoing a fundamental transformation, China’s
real GDP grew at an average annual rate close to 10%. 3 However, the reform
process has not been a smooth one. Rapid economic growth was accompanied by
several cyclical fluctuations. 4 At times, double-digit inflation forced the Chinese
government to slow the pace of reforms. Maintaining macroeconomic stability
while retaining impressive growth performance has become the principal concern
for the Chinese government.
In this paper, we address two important questions concerning macroeconomic
management in China. First, given the existing economic structure, is it possible
for the Chinese government, using the policy instruments at its disposal, to
control inflation without tempering the long-term economic growth performance? Second, if so, which instruments should be used to accomplish the goal?
We attempt to analyze the effects of changes in government policies on the key
macroeconomic aggregates of the economy and to identify the transmission
mechanisms through which changes in policies affect the aggregates. Given that
the long-term implications of macroeconomic control measures are our major
concern, we confine our investigation to the long-run effects of policy changes.
Although 20 years of reforms have changed the economic structure in China,
the system is still not comparable to an advanced market economy. Hence, the
theoretical models developed to evaluate the macroeconomic policies of Western
countries are not immediately applicable to China. 5 To address the issue of
macroeconomic management in China, we modify the existing analytical framework to construct a sufficiently close approximation of the partially reformed
economic structure. 6
In China, two sectors, i.e., the state sector and non-state sector, coexist. 7 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
3
For discussions on why the Chinese economic reforms are successful, see McMillan and
Naughton (1991), Qian and Xu (1993), and Naughton (1994, 1995).
4
Since 1979, Chinese economic growth has exhibited a pronounced cyclical pattern, and inflation
was observed to be strongly cyclical, occurring in 1980, 1984, 1988, and 1993.
5
Extensive research on the effects of fiscal and monetary policies exists. For example, Barro
(1981) and Aiyagari et al. (1992) study the impact of temporary and permanent government spending
changes on output, interest rates, and employment. Good summaries of the literature on monetary
policy are Mishkin (1995) and Taylor (1995).
6
There have been attempts to construct analytical models for the transforming Chinese economy.
For example, Bennett and Dixon (1995, 1996) study the implications of various policies on the
steady-state equilibrium of the Chinese economy by analyzing the comparative statics. In contrast,
our study investigates the effects of monetary policies using an endogenous growth model.
7
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.
Since the late 1980’s, this sector has been the major contributor to the impressive economic growth
performance (Byrd and Lin, 1990; Weitzman and Xu, 1994).
CREDIT/INTEREST RATE CONTROL IN CHINA
295
sector, it is extremely inefficient. 8 While firms in the non-state sector face hard
budget constraints and rely mainly on internal sources of finance, 9 firms in the
state sector face soft budget constraints and receive policy loans from the state
banking system. Furthermore, the real sector of the economy is liberalized
considerably, with markets for consumption goods, capital goods, and labor
services becoming increasingly competitive. However, the reforms in the financial sector are rather limited. The government still plays a dominant role in
allocating the financial resources of the economy and absorbs most of the
household savings by deciding the quantity and type of bonds available to the
public and by regulating interest rates on financial assets.
On the macroeconomic side, the structure of national savings has changed
drastically over time. State-owned enterprises no longer generate much savings,
and the government has difficulty in collecting taxes from the newly developed
non-state sector; hence, government savings has declined. 10 On the other hand,
due to the rapid expansion of the non-state sector, household savings has been
increasing substantially. 11 Given these changes, the state banking system is
crucial to resource allocation as it channels savings from the household sector to
investors (see Barandiaran, 1996, 1997). Moreover, the state banking system
plays a quasi-fiscal role. By charging interest rates well below the market
clearing level on bank loans, the banking system subsidizes investment projects
and the loss-incurring state-owned enterprises. 12 Since the state banking system
is the main vehicle for transferring resources from the non-state sector to the state
sector, the money supply process is determined endogenously by the government’s transfer requirement. 13
In our analysis, we incorporate these features in a model with the following
three attributes. First, in order to examine the impact of government policy
8
Between 1979 and 1993, the real growth rate of gross output in the non-state sector averaged
18.7%, which is about two times higher than that observed in the state sector. Moreover, total factor
productivity growth in the non-state sector for the same period was also significantly higher than that
estimated for the state sector (Brandt and Zhu, 1995).
9
According to a survey conducted by the Chinese Academy of Social Sciences on Private
Enterprises and Entrepreneurs in 1995, private businesses are faced with a scarcity of financial
resources and institutional support. As indicated by the survey, the three major sources of initial
capital for private enterprises were personal saving, loans from friends or relatives, and personal loans
from other people.
10
Due to the ineffective tax-collecting apparatus, central government expenditure as a proportion
of GDP has fallen from about 34% in 1978 to about 17.5% in 1993 (World Bank, 1995).
11
Since 1984, the rate of household accumulation of monetary assets has surpassed 8% of GDP
annually.
12
These bank loans are considered to be policy loans and are hidden deficits of the government
(McKinnon, 1994).
13
Feltenstein and Farhadian (1987) show that changes in money supply for the period from 1954
to 1983 can be explained by government deficits, procurement payments to farmers, and the wage bill
of government and state-owned enterprises. See Brandt and Zhu (1995) for further discussion of this
point.
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FUNG, HO, AND ZHU
changes on output growth, we construct an overlapping generations model
featuring endogenous growth. Externalities, or learning by doing, are introduced
to the production technologies, which make sustained growth feasible through a
combination of increasing social returns and diminishing private returns to
capital. 14
Second, to evaluate how changes in the allocation of financial resources affect
capital investment, production, and the growth rate of output, we consider two
sectors, i.e., a real sector, consisting of markets for a consumption good, a capital
good, and labor services, and a financial sector, consisting of markets for money,
government bonds, and bank deposits and loans. Money is introduced by assuming that there are cash-in-advance constraints on the purchases of consumption
and capital goods. In the real sector, markets are assumed to be perfectly
competitive. 15 However, the financial sector is monopolized by the government,
which sets interest rates on financial assets and determines the allocation of bank
loans.
Third, by ownership classification, we have a state sector and a private
sector. 16 The state-owned enterprises can be either less efficient than or equally
efficient as the private firms in production, but they are assumed to be less
efficient than the private firms in learning by doing. Furthermore, the enterprises
in the state sector face soft budget constraints as they receive bank loans with low
interest rates, while private firms face hard budget constraints and rely on internal
sources of financing. The government finances its expenditure by collecting tax
revenue, issuing government bonds, and printing money. The money supply is
determined endogenously in the sense that when the other two sources of
revenues are insufficient to cover the budget deficit, money creation takes up the
residual.
Since fiscal policy is not a feasible option for macroeconomic control in
China, 17 monetary policy has become the main policy tool in recent years. When
the Chinese economy was overheated, e.g., in 1988 and especially 1993, a
combination of credit control and interest rate adjustment was employed to exert
macroeconomic control (Allsopp, 1995). This combination did reduce the inflation rate but at the expense of economic growth in the short run. 18
14
These are similar to the spillover externalities considered by Romer (1986) and Bencivenga and
Smith (1991, 1993).
15
This is an auxiliary assumption that is made for analytically tractability.
16
Hereafter, we will refer to non-state enterprises as private firms. In our model, the private
enterprises and joint ventures are grouped with urban collectives and township and village enterprises
(TVEs). This causes no problem since both types of enterprises have significant autonomy in decision
making and receive little financial support from the central government.
17
In addition to being ineffective, the tax system is not flexible enough to allow fine-tuning in
China (Allsopp, 1995).
18
World Bank (1995) shows the close relationship between the inflation rate measured by changes
in the retail price index and the People’s Bank of China’s (PBC) lending policy. PBC Research Group
CREDIT/INTEREST RATE CONTROL IN CHINA
297
How do each of the monetary instruments affect the macroeconomic performance of the Chinese economy in the long run? Using an analytical framework,
we show the following. First, raising the interest rate on government bonds will
reduce the inflation rate without tempering the growth rate of output. Second,
reducing the amount of bank loans available to state-owned enterprises may
lower both the inflation rate and the growth rate of output. Third, raising the
nominal interest rate on bank deposits will exert a stagflationary effect on the
economy by increasing the inflation rate and reducing the growth rate of output.
Fourth, changing the nominal interest rate on bank loans will have little real
effect.
The dual structure of our model makes the impact of macroeconomic policy in
China different from that in the advanced market economies. In particular, policy
actions affect not only the behavior of households and firms but also the
allocation of resources between the state and non-state sectors. As such, they
affect aggregates through two transmission mechanisms. First, they influence
individuals’ decisions by changing the rate of return on a financial asset or the
individuals’ disposable income, or both. Any change in the rate of return on a
financial asset will induce individuals to adjust their portfolios. Also, any change
in disposable income will affect the aggregate demand for the consumption good
and thus alter the price level. The price adjustment, in turn, will change the
marginal rate of return on investment and, therefore, induce individuals to adjust
their portfolios. These portfolio adjustments will alter the amount of resources
flowing into the two sectors and, thus, affect the levels of capital investment in
the two sectors. Given that there are differences in productivity and learning by
doing between the two sectors, economy-wide production and productivity will
be affected and will generate different effects on the growth rate of output, labor
income, and profit conditions for firms in the two sectors.
Second, policy actions affect money supply and inflation by changing the
government budget deficit situation. Given that the proceeds of the state banking
system are a component of the government budget, policy actions exert an impact
on the government budget by affecting bank proceeds. In addition, by altering the
economy-wide production and productivity, policy actions affect tax revenues
and profit remission. Since money creation takes up the residual of the government budget deficit, the growth rate of the money supply and the inflation rate are
affected by policy actions.
In constructing our model, we assume that markets in the real sector are
perfectly competitive and state-owned enterprises are profit-maximizing for
analytical tractability. However, the crucial assumption is that efficiency in
production and learning by doing is different between the state and private
sectors. As long as this assumption is retained, different assumptions for
(1994) discuss how the interest rate policy of the PBC affects China’s macroeconomic performance.
298
FUNG, HO, AND ZHU
the market structure of the real sector and the objective function of the
state-owned enterprises should have no substantial impact on the results
derived.
The rest of the paper is organized as follows. Section 2 provides some
institutional background for readers who are not familiar with Chinese economic
reforms. The model is specified in Section 3. Section 4 characterizes the agents’
optimization problems, determines the general equilibrium, and solves for the
balanced growth path. The major results are presented in Section 5. Section 6
concludes the paper by discussing the policy implications and the limitations of
our analysis. The derivations of our analytical results are provided in the
appendixes.
2. CREDIT CONTROL AND INTEREST RATE REGULATION
Under the supervision of the People’s Bank of China (PBC), China’s
central bank, the banking system remains largely state-controlled. About 80%
of total bank assets are controlled by the four specialized state-owned banks
(the Industrial and Commercial Bank of China, the Agricultural Bank of
China, the People’s Construction Bank of China, and the Bank of China).
This concentrated structure makes the state banking system a quasi-fiscal
institution. As the only low-risk vehicle available for savings in the economy,
it offers an extremely low real rate of return on bank deposits. In addition,
about 80% of the bank loans were extended to the state sector in the early
1990’s (Montes-Negret, 1995). By charging interest rates well below market
clearing levels on the bank loans, the banking system actually subsidizes
government investment projects and the loss-incurring state-owned enterprises.
The dual function of financial intermediation and quasi-fiscal financing
involves the use of two policy instruments, i.e., credit control and interest rate
regulation. 19 Credit control was exercised through credit quota plans from the
1950’s to 1997. As part of the central plan, state banks directed credits to
specific sectors and users. Credit allocation decisions were made according to
policy goals for major macroeconomic aggregates, i.e., targets for annual
output growth, investment, and inflation, and according to sectoral and local
investment needs. In the early part of this period, policymakers, not bank
managers, decided the size of bank loans and to whom bank loans should be
made based on criteria like employment and social stability. In the late 1980’s
and early 1990’s, the administration and extensiveness of credit controls
changed. First, the formulation and implementation of the credit plan were
19
Yu (1997) provides an empirical study on how monetary policy affects economic fluctuations in
the Chinese economy and finds a stable long-run relationship between financial variables and
economic activities.
CREDIT/INTEREST RATE CONTROL IN CHINA
299
subject to local governments’ intervention. Second, the coverage of the credit
plan was reduced due to the growth of the non-bank financial institutions,
which included the urban credit cooperatives, rural credit cooperatives, and
trust and investment companies. However, the state banking system remains
the major source of loanable funds in China; as recent experience has shown,
credit control was the major instrument of monetary policy when inflation
became a severe problem.
Starting from January 1, 1998, the central bank no longer imposes loan quotas
on the four specialized state-owned commercial banks. In theory, these banks
decide to whom they will lend as long as their balance sheets meet the requirements laid down by the PBC. However, given that these large banks are state
owned, the PBC can intervene in credit allocation to achieve political and
economic goals. In 1998, the PBC issued a guideline to state banks indicating
that they should guarantee reasonable funds to key state owned enterprises,
including loss-making enterprises (Hanli Consultancy Ltd., 1998). In 1999, Dai
Xianglong, the Governor of the PBC, proposed a lending guideline to expand
credit to the infrastructure program so as to attain an annual economic growth
rate of 7% (Hanli Consultancy Ltd., 1999). Credit controls have changed over
time from strict targets early in the period to exhortations and suasion of
state-owned banks.
Interest rate regulation is the second major policy instrument for macroeconomic control in the economy, and the PBC manages and supervises
interest rate policy. In consultation with other government ministries, the
PBC determines the levels of different interest rates, the floating limits for
deposits, loans, financial securities, and private lending (see Yi, 1994).
Similar to credit-allocation decisions, interest-rate decisions are based on
targets for major economic aggregates, such as the output growth rate and the
inflation rate. As a policy tool to lower the inflation rate, interest rates were
increased substantially in 1988, 1989, and 1993 to 1994 when inflation
became a major concern of the central government (see PBC Research Group,
1994). Not surprisingly, the impact of changes in interest rates has been most
pronounced on household savings rather than on the demand for credit, given
the soft nature of bank loans extended to the state-owned enterprises (World
Bank, 1995). Given that both local governments and the central government
compel the banking system to provide credit for their priority investment
projects, bank credits monetize government budget deficits, which have been
the major source of the loss of control over the money supply and the rapid
increase in the general price level in China. When inflation becomes a severe
problem in this partially reformed system, the government makes a serious
attempt to reduce the growth rate of money supply by tightening up bank
credits and raising interest rates on government bonds and bank deposits to
soak up excess liquidity from the public.
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FUNG, HO, AND ZHU
3. THE MODEL
3.1. Agents, Preferences, and Production Technology
Consider the following economy in which time is a discrete and infinite
variable, indexed by t ⫽ 0, 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
supplies it to a perfectly competitive labor market inelastically. Let W t denote the
nominal wage rate prevailing in the labor market in period t. 20 Using the labor
income earned at the end of the first period of their lives, young individuals make
their portfolio decisions. At the end of the second period of their lives, middleaged individuals collect returns from their portfolios. When they are old, individuals consume only.
Individuals of the same generation differ 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 ␪
individuals are endowed with the production-organizing ability, and the rest do
not possess this ability. Hereafter, the first type will be referred to as entrepreneurs, indexed by a superscript e, and the second type as non-entrepreneurs,
indexed by a superscript n.
The individuals of all generations have identical preferences concerning consumption. For simplicity, individuals are assumed to value consumption only
when they are old. 21 The preferences of an individual of generation t are
characterized by the utility function
t,i
t,i
t,i
U t,i 共C t,i
t , C t⫹1 , C t⫹2 兲 ⫽ C t⫹2 ,
i ⫽ e, n, ᭙ t ⱖ 1.
(1)
Note that the first superscript indicates which generation the individual
belongs to, the second superscript indicates his type, and the subscript
indicates in which period the individual lives. Since the individuals value
consumption only when they are old, they save all the labor income made in
the first period by holding money, bank deposits, government bonds, or
capital goods in the second period of their lives. Furthermore, consumption
must be paid by the cash balance carried over from the previous period of
their lives.
20
Even though wage rates are determined administratively in the state sector, they can be viewed
as if they are determined by the market. Since 1979, the growth rates of wages in the state sector have
been maintained at the same level as those in the non-state sector, which are determined in the labor
market (Brandt and Zhu, 1995).
21
With this simplifying assumption, we do not have to worry about how individuals allocate their
income between current consumption and savings. The appendix discusses how changing this
assumption affects our results.
CREDIT/INTEREST RATE CONTROL IN CHINA
301
By the nature of firm ownership, there are two types of producers in the
consumption good industry, i.e., private firms, indexed by a superscript p and
owned by the entrepreneurs, and state-owned enterprises, indexed by a superscript s and owned by the government. In the state sector, firms are of measure
one, whereas firms in the private sector are of measure ␪.
There are two types of commodities produced in the economy, i.e., a nonstorable consumption good and a capital good. The markets for the two types of
commodities are perfectly competitive. The nominal prices of the capital good
and the consumption good in period t are denoted by P tk and P t , respectively. The
capital good is produced by an investment technology that converts one unit of
consumption good into one unit of capital good without using labor. Thus, the
nominal prices of the two goods are always equal; P tk ⫽ P t . For simplicity, we
assume that the capital good depreciates completely after the production processes have been completed.
Production of the consumption good requires capital and labor. To produce the
consumption good in period t ⫹ 1, firms must install the capital good at the end
of period t. We assume that the capital good must be paid for when purchased but
that workers are paid only after the production processes are completed. Consequently, a cash-in-advance or liquidity constraint applies to purchasing capital
but not to hiring labor.
The technology for producing the consumption good is characterized by the
production function
␴
Q it ⫽ Q共k it , l it , H t 兲 ⫽ A i k it l it
1⫺ ␴
␴
H 1⫺
,
t
i ⫽ p, s, ␴ 僆 共0, 1兲,
(2)
where A ⬎ 0 is the time-invariant productivity parameter and H t is an indicator
of the economy-wide technology level in period t. We assume that A p ⫽ A and
A s ⫽ ␣ A, where ␣ 僆 (0, 1] to capture the fact that, in China, the state-owned
enterprises can be either less efficient than or equally efficient as the private firms
in production. Moreover, we assume that the evolution of H t is determined only
by the capital stock accumulated in the private sector in period t to capture the
fact that the private firms are more efficient than the state-owned enterprises in
learning by doing, e.g., in adapting to a fast-changing environment by adopting
modern technologies and advanced management techniques. Formally,
i
H t ⫽ ␪ k pt .
(3)
Consequently, only the augmentation of the capital good in the private sector can
generate a positive external effect on the productivity for the economy.
3.2. The Financial Sector and Fiscal Arrangements
There are four types of financial assets in the economy, i.e., money, bank
deposits, bank loans, and government bonds. The government monopolizes the
allocation of financial resources by retaining the rights over money printing and
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FUNG, HO, AND ZHU
bond issuing and by controlling the banking system. At the end of period t, the
banking system issues B t units of government bonds while the commercial banks
accept deposits from individuals and make loans to state-owned enterprises.
Once bonds are purchased, they cannot be redeemed until the end of the next
period. Similarly, bank deposits cannot be withdrawn until the end of the next
period. 22 Since there is a cash-in-advance constraint on the purchases of the
consumption good and savings in the forms of bonds and bank deposits will be
illiquid for one period, only young individuals will purchase government bonds
and deposit their labor income in the commercial banks at the end of period t.
Let D te and D tn denote the amount of bank deposits held by the representative
entrepreneur and non-entrepreneur in period t, respectively. Moreover, let D t ⫽
␪ D te ⫹ (1 ⫺ ␪ ) D tn denote the total amount of bank deposits held by young
individuals, and L t be the total amount of bank loans made by the banking system
in period t. The fraction of total deposits that the state banking system can lend
to its borrowers, ⑀ t , is determined by the central bank with 0 ⬍ ⑀ t ⱕ 1. Given
that bank deposits are the only source of loanable funds for the state banking
system, the system-wide liquidity constraint is ⑀ t D t ⱖ L t . After the loans are
allocated, the excess funds of the banking system, D t ⫺ L t , are held by the
central bank in the form of money.
Due to the monopolization of the financial sector by the government, the
banking system sets nominal interest rates on bonds (i tb), bank deposits (i td), and
loans (i tL). The nominal interest rate on bonds is set at a higher level than that on
bank deposits, i.e., i tb ⬎ i td. 23 In this case, young individuals would like to hold
bonds instead of bank deposits. Given that B t is less than the desired aggregate
bond holdings of young individuals, each young individual is allowed to purchase b t units of government bonds. In other words, the purchase of government
bonds is quantity-rationed. 24 Entrepreneurs will undertake capital investment
using some of their labor income and will hold the rest of it in the forms of bonds
and deposits.
Only state-owned enterprises can obtain loans from the commercial banks, and
private firms have no access to loans. The government subsidizes the state-owned
enterprises by lowering their borrowing costs. The interest rate on loans, i tL, is
lower than that on bank deposits, i td. 25 In addition, we assume that the interest rate
22
Given the specifications of the model, individuals have no incentive to withdraw their deposits
earlier even if the term is flexible. Hence, the assumption that the deposits are fixed-term does not
affect our results but allows us to maintain tractability of the flow of funds and the volume of deposits.
23
According to various issues of The Yearbook of Financial Statistics, the interest rates on bonds
were higher than on bank deposits in the period 1991 to 1997.
24
In China, when inflation runs high, the government supplies a fixed amount of bonds to the
public. In recent years, secondary markets have developed for trading bonds. Our model assumes that
individuals are not allowed to trade bonds in secondary markets. As discussed in the appendixes,
relaxing this assumption will not affect our results.
25
This is consistent with what McKinnon (1994) reported for the period from 1980 to 1991.
CREDIT/INTEREST RATE CONTROL IN CHINA
303
on loans i tL is set low enough to generate excess demand for bank loans. Given
that the state banking system faces a liquidity constraint, it chooses ⑀ t D t ⫽ L t
and imposes credit rationing so that each state-owned enterprise can obtain L t
units of bank loans. 26 As the investment undertaken by state-owned enterprises is
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, ⑀ t D t .
Since the nominal interest rate charged on bank loans is lower than that on
bank deposits, the interest payments from the state-owned enterprises to the
commercial banks, L t i tL, are not sufficient to cover the commercial banks’ interest
payments on deposits, D t i td. The loss of the banking system in period t ⫹ 1 is
then given by D t (i td ⫺ ⑀ t i tL). 27 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 t (1 ⫹ i tb).
One source of government revenues is taxes levied on individuals, i.e., a labor
income tax and a corporate profit tax, with nominal tax rates denoted by ␶ l and
␶ c, respectively. We assume that only private firms are subject to the corporate
profit tax. The state-owned enterprises are not subject to any taxes although they
must remit their profits to the government. The tax revenue collected in period
t ⫹ 1 is given by
p
T t⫹1 ⫽ ␶ lW t⫹1 ⫹ ␶ c␪ ⌸ t⫹1
,
(4)
where ⌸ is the profit of each private firm in period t ⫹ 1. The government’s
budget constraint in period t ⫹ 1 is given by
p
t⫹1
s
⌸ t⫹1
⫹ T t⫹1 ⫹ B t⫹1 ⫹ M t⫹1 ⫺ M t ⫽ D t 共i dt ⫺ ⑀ t i Lt 兲 ⫹ B t 共1 ⫹ i bt 兲,
(5)
s
where ⌸ t⫹1
is the total profit of the state sector, and M t is the end-of-period
money stock in period t. 28 If the revenues collected from the profits of the
state-owned sector and taxes are not sufficient to cover both the losses in the
banking system and the redemption of the government bonds, the government
will finance its deficit by issuing new government bonds, B t⫹1 , and printing more
money, M t⫹1 ⫺ M t . Note that once the quantity of government bonds, B t⫹1 , is
set by the government, the quantity of newly printed money, M t⫹1 ⫺ M t , will be
According to Brandt and Zhu (1995), for the period between 1981 and 1993, the average real interest
rate for one-year working capital loans was 0.73%, and for one-year fixed investment loans it was
1.29%. Taking into consideration the lack of loan repayment enforcement and the possibility of loan
forgiveness, the effective real interest rates on loans were even lower.
26
In the allocation of loanable funds, local branches of the PBC are subject to the influence of local
governments (World Bank, 1995).
27
In reality, state-owned banks can earn profits through the provision of financial services.
s
28
Note that ⌸ t⫹1
is positive even though the production of the state sector is inefficient because
positive profit is created by the government’s loan subsidization. McKinnon (1994) refers to this
phenomenon as the hidden deficit.
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FUNG, HO, AND ZHU
determined endogenously by the size of the residual of the government budget
deficit. 29
4. OPTIMIZATION, EQUILIBRIUM, AND BALANCED GROWTH
4.1. Optimization Problems
Consider the entrepreneurs’ optimization problem. At the end of period t,
taking as given the nominal price of the capital good, P t , the nominal wage rate,
W t⫹1 , the nominal price of the consumption good, P t⫹1 , the interest rates i td and
i tb, the bond subscription b t , and the tax rates ␶ l and ␶ c, the representative
p
p
entrepreneur of generation t chooses k t⫹1
, l t⫹1
, and D te to solve the optimization
problem
p
p
p
max 共1 ⫺ ␶ c兲关P t⫹1 Q共k t⫹1
, l t⫹1
, H t⫹1 兲 ⫺ W t⫹1 l t⫹1
兴 ⫹ D et 关1 ⫹ i di 兴
(6)
p
p
k t⫹1
,l t⫹1
,D te
subject to
p
p
p␴ p1⫺␴ 1⫺ ␴
Q共k t⫹1
, l t⫹1
, H t⫹1 兲 ⫽ Ak t⫹1
l t⫹1 H t⫹1 ,
and
p
共1 ⫺ ␶ l兲W t ⱖ b t ⫹ D et ⫹ P kt k t⫹1
.
(7)
The liquidity constraint, Eq. (7), indicates that the representative entrepreneur has
no access to external funds and must finance the project internally. Hence, the
production decision and the portfolio decision of each entrepreneur are determined jointly. Since the nominal rate of return on money is zero, no young
individual will hold money and the liquidity constraint is always binding. Thus,
p
.
D te ⫽ (1 ⫺ ␶ l)W t ⫺ b t ⫺ P tkk t⫹1
At the end of period t ⫹ 1, the representative entrepreneur of generation t
p
p
p
p
receives (1 ⫺ ␶ c)⌸ t⫹1
as a dividend payment, where ⌸ t⫹1
⫽ P t⫹1 Q(k t⫹1
, l t⫹1
,
p
H t⫹1 ) ⫺ W t⫹1 l t⫹1 is the before-tax profit of the representative private firm. Thus,
the representative entrepreneur has a cash balance of
e
p
m t⫹1
⫽ 共1 ⫺ ␶ c兲⌸ t⫹1
⫹ b t 共1 ⫹ i bt 兲 ⫹ D et 共1 ⫹ i di 兲.
(8)
t,e
In period t ⫹ 2, he can consume C units of the consumption good, where C t⫹2
e
⫽ (m t⫹1/P t⫹2 ).
Without the choice of private capital investment, the optimization problem for
t,e
t⫹2
29
Brandt and Zhu (1995) identify quantitatively the underlying link between the cyclical growth
pattern of the Chinese economy and the behavior of the state-owned enterprises as the government’s
use of the financial system to transfer resources from the non-state sector to the state sector so as to
equalize the benefits of economic reforms. In the process, the money supply is determined endogenously by the transfer requirement, which is a function of the government’s commitment to protect
the state sector.
CREDIT/INTEREST RATE CONTROL IN CHINA
305
the nonentrepreneurs is degenerate. Because no young individual will hold any
money, at the end of period t, the representative non-entrepreneur holds b t units
of bonds and has a deposit balance of D tn ⫽ (1 ⫺ ␶ l)W t ⫺ b t . Accordingly, at
the end of period t ⫹ 1, the individual has a cash balance of
n
m t⫹1
⫽ 关共1 ⫺ ␶ l兲W t ⫺ b t 兴共1 ⫹ i dt 兲 ⫹ b t 共1 ⫹ i bt 兲.
(9)
t,n
Similarly, in period t ⫹ 2, he can consume C t⫹2
units of the consumption good,
t,n
n
where C t⫹2 ⫽ (m t⫹1/P t⫹2 ).
The objective of the representative state-owned enterprise is to maximize its
profit subject to the technological constraint and the liquidity constraint, taking
as given the market wage rate and prices of goods. The optimization problem of
a representative state-owned enterprise in period t ⫹ 1 is 30
s
s
s
max P t⫹1 Q共 ␣ , k t⫹1
, l t⫹1
, H t⫹1 兲 ⫺ L t 共1 ⫹ i Lt 兲 ⫺ W t⫹1 l t⫹1
(10)
s
s
k t⫹1
,l t⫹1
subject to
s
s
s␴ s1⫺␴ 1⫺ ␴
Q共k t⫹1
, l t⫹1
, H t⫹1 兲 ⫽ ␣ Ak t⫹1
l t⫹1 H t⫹1 ,
and
s
L t ⫽ P kt k t⫹1
.
(11)
The strict equality in (11) implies that the cash-in-advance constraint is always
binding, given the existence of credit rationing.
4.2. Market Equilibrium and the Balanced Growth Path
In equilibrium, three conditions must be satisfied in each period. First, taking
as given the market prices and government policies, each agent solves his
optimization problem. Second, the government’s budget constraint is balanced.
Third, all markets clear. The market-clearing conditions for the economy in
period t are
the labor market:
l st ⫹ ␪ l pt ⫽ 1,
(12)
␪ C t⫺2,e
⫹ 共1 ⫺ ␪ 兲C t⫺2,n
⫹ I t ⫽ ␪ Q pt ⫹ Q st ,
t
t
(13)
the consumption-good market:
30
Modeling state-owned enterprises as profit-maximizing entities simplifies the derivation of the
analytical results. If we assume that each manager of a state-owned enterprise chooses labor to
maximize his share of profit, the corresponding first-order condition would be exactly the same.
306
FUNG, HO, AND ZHU
the capital-good market:
p
s
␪ k t⫹1
⫹ k t⫹1
⫽ I t,
(14)
⑀ t D t ⫽ ⑀ t 关 ␪ D et ⫹ 共1 ⫺ ␪ 兲 D nt 兴 ⫽ L t ,
(15)
共D t ⫺ L t 兲 ⫹ ␪ m et ⫹ 共1 ⫺ ␪ 兲m nt ⫽ M t ,
(16)
b t ⫽ B t,
(17)
the loan market:
the money market:
the bond market:
where I t is the aggregate investment of the economy in period t.
In order to analyze the balanced growth path, we define the following variables. Let g t⫹1 denote the growth rate of output in period t ⫹ 1; i.e., g t⫹1 ⬅
(Q t⫹1 ⫺ Q t )/Q t . Let ␲ t⫹1 be the inflation rate in period t ⫹ 1, i.e., ␲ t⫹1 ⬅
(P t⫹1 ⫺ P t )/P t , and let ␮ t⫹1 be the growth rate of money supply in period t ⫹
1, i.e., ␮ t⫹1 ⬅ (M t⫹1 ⫺ M t )/M t . Furthermore, let ␤ t denote the fraction of each
young individual’s disposable income held in the form of government bonds in
period t; i.e., ␤ t ⬅ b t /[(1 ⫺ ␶ l)W t ]. Given that the purchase of government
bonds is quantity-rationed, ␤ t is a decision variable of the government. Last, let
␾ t denote the propensity to invest in the private sector in period t, i.e., the
fraction of each young entrepreneur’s disposable income net of government bond
p
subscription put into private investment ␾ t ⬅ (P tkk t⫹1
/[(1 ⫺ ␶ l)W t ⫺ b t )]. In
fact, this propensity to invest determines the expansion of the private sector.
If the exogenous variables are held constant, the economy exhibits steady-state
growth and the balanced growth path is deterministic. Along the balanced growth
path, the levels of output, consumption, savings, and investment are all growing
at a rate of g, and the money supply, government bonds, and wage rate are all
growing at a rate of ␮. For given values of ␶ l, ␶ c, i L, i d, i b, ⑀, and ␤, the balanced
growth path requires that the growth rate of money supply, ␮, the growth rate of
output, g, the inflation rate, ␲, and the propensity to invest in the private sector,
␾, are all constant over time.
On the balanced growth path, the equilibrium values of g, ␲ , ␮ , and ␾ can be
derived from the following equations 31:
共1 ⫹ g兲共1 ⫹ ␲ 兲 ⫽ 共1 ⫹ ␮ 兲,
冋
共1 ⫺ ␶ c兲 ␴ A ␪ 1⫺ ␴ ␪ ⫹ ␣ 共1/ ␴ 兲 ⑀
31
冉
1
⫺␪
␾
冊册
(18)
␴ ⫺1
See the appendixes for the derivation of these equations.
共1 ⫹ ␲ 兲 ⫽ 1 ⫹ i d,
(19)
CREDIT/INTEREST RATE CONTROL IN CHINA
307
共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲共1 ⫹ i d兲关 ␪␾ 共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ 兲 ⫹ ␣ 共1/ ␴ 兲 ⑀ 兴
␴ 共1 ⫺ ␶ c 兲
⫽ 0,
1⫺␴
(20)
⫺ 共1 ⫺ ␶ l兲关共1 ⫺ ␤ 兲共1 ⫹ i d兲 ⫹ ␤ 共1 ⫹ i b兲兴 ⫽ 0.
(21)
⫺ 共1 ⫹ ␮ 兲
共1 ⫹ ␮ 兲 2
冋
1
⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲共 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兲
1⫺␴
册
5. THE ANALYSIS
In this section, we study how changes in the government’s monetary policies
affect the key macroeconomic aggregates. By differentiating totally the system of
simultaneous equations (18) to (21), we derive the long-run effects of changes in
⑀, i b, i d, and i L on the values of ␮, g, ␲, and ␾. 32 In the following four
subsections, we present the major results and offer the intuition behind them.
5.1. Effects of a Reduction in the Availability of Bank Loans
PROPOSITION 1.
d␮
⬎ 0,
d⑀
1.
d␲
⬎ 0,
d⑀
d␾
d⑀
再
dg
d⑀
⬎ 0,
⫽ 0,
⬍ 0,
再
⬎ 0 if ␣ 僆 共0, ␣ *兲,
⬎ 0, if ␣ ⫽ ␣ *,
᭙ 0 ⬍ ⑀ ⱕ 1,
⫽ ? if ␣ 僆 共 ␣ *, 1兲,
where ␣* satisfies the condition
2 ␣ * 1/ ␴
冋
1
⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲关 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ *兴
1⫺␴
册
⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲关 ␣ * 1/ ␴ ⑀ ⫹ 共1 ⫺ ␣ * 1/ ␴ ⑀ 兲 ␪␾ *兴 ⫽ 0,
and ␾* is the equilibrium value of ␾ corresponding to ␣*.
2. If ␣ ⫽ 1,
d␮
⫽ 0,
d⑀
d␲
⬎ 0,
d⑀
d␾
⬍ 0,
d⑀
32
and
dg
⬍ 0 ᭙ ⑀ 僆 共0, 1兲.
d⑀
The derivations of our comparative statics analysis are provided in the appendixes.
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FUNG, HO, AND ZHU
There are two direct effects associated with a policy of reducing the availability of bank loans, i.e., reducing ⑀. First, the quantity of money in circulation
is decreased, and second, the level of capital investment in the state sector is
reduced. The first effect lowers the price level and the second effect decreases
production scale and, therefore, the labor demand from the state sector so as to
generate a downward pressure on the wage rate.
The two direct effects will induce further indirect effects on the economy.
First, consider the effect on the propensity to invest in the private sector. A lower
wage rate encourages the private sector to increase its labor input. Hence, the
marginal product of capital in the private sector rises, inducing young entrepreneurs to increase their capital investment and causing the propensity to invest in
the private sector to increase. However, the decrease in the quantity of money in
circulation lowers the price level and also the rate of return on capital. These
changes cause the propensity to invest in the private sector to decrease. As a
result, the overall effect is ambiguous. If productive efficiency in the state sector
is sufficiently lower than that in the private sector, the amount of labor reallocation from the state sector to the private sector induced by the policy action will
be small, and the private sector will experience only small increases in both the
marginal product of capital and the propensity to invest. In this case, tightening
up the availability of bank loans will reduce the propensity to invest in the private
sector. However, if productive efficiency in the state sector is sufficiently close
to that in the private sector, the reduction in bank loans available to the state
sector will cause a large labor reallocation, resulting in a large increase in the
marginal product of capital and, therefore, a large increase in the propensity to
invest in the private sector. In this case, the policy action will increase the
propensity to invest in the private sector.
Next, consider the effect on the growth rate of output. The policy action exerts
its impact through three channels. First, because the private sector is relatively
more efficient in production than the state sector, the reallocation of labor from
the state sector to the private sector raises the growth rate of output. Second, the
private sector is relatively more efficient in learning by doing, implying that
changes in private investment have positive external effects on economy-wide
productivity and the growth rate of output. Third, the decrease in the wage rate
leads to a reduction in the young individuals’ labor income, causing investment
in both sectors to decrease and thus reducing economy-wide productivity and the
growth rate of output. Hence, the overall effect is again ambiguous. If productive
efficiency in the state sector is sufficiently lower than that in the private sector,
the effect on the growth rate of output will be negative. If it is sufficiently close
to that in the private sector, the effect will be ambiguous. However, if productive
efficiency in the state sector is the same as that in the private sector, the effect
will be positive; the growth rate of output will be higher on the new balanced
growth path.
Finally, consider the effect on the growth rate of money supply and inflation.
CREDIT/INTEREST RATE CONTROL IN CHINA
309
A lower scale of production in the state sector and less labor-income tax revenue
increase the government budget deficit, which leads the government to increase
the growth rate of money supply to finance a higher deficit. However, a higher
scale of production in the private sector increases the government revenue from
corporate profit taxes and reduces the government budget deficit, which allows
the government to reduce the growth rate of money supply. Again, the overall
effect is ambiguous. If productive efficiency in the state sector is lower than in
the private sector, the government budget deficit will be lower, implying a lower
growth rate of money supply. Given a lower growth rate of money supply and a
smaller fraction of money stock in circulation, the inflation rate is lower on the
new balanced growth path. If the state sector is as efficient as the private sector,
a lower scale of production in the state sector will cause a large decrease in the
profits remitted. In this case, the two opposing effects on the government budget
deficit will offset each other exactly and the government will not need to adjust
the growth rate of money supply. As the growth rate of output is higher and the
money growth rate remains unchanged, the inflation rate is lower on the new
balanced growth path.
5.2. Effects of a Change in the Nominal Interest Rate on Government Bonds
PROPOSITION 2. We have
d␮
⬎ 0,
di b
d␲
⬍ 0,
di b
d␾
⬎ 0,
di b
and
dg
⬎ 0.
di b
An increase in the nominal interest rate on government bonds increases the
income level of old individuals. With higher interest income levels, old individuals increase their demand for the consumption good, causing the price level to
rise. In response to the expected price increase, young entrepreneurs allocate
more of their disposable income to private capital investment and less to bank
deposits. This portfolio adjustment raises the propensity to invest in the private
sector on the balanced growth path. A higher level of capital investment in the
private sector raises not only the scale of production but also the level of
economy-wide productivity. In turn, the demand for labor and the wage rate
increase, thus exerting further positive effects on the level of capital investment
in both sectors and on economy-wide scale of production. Given more investment in the private sector, the output growth rate is higher on the new balanced
growth path.
When the economy-wide productivity rises, government revenues from taxes
and profit remission increase; however, the policy action increases the burden of
interest payment. The overall effect is to increase the government budget deficit,
and the government must rely more on money creation for deficit financing.
Consequently, the growth rate of the money supply is higher on the new balanced
310
FUNG, HO, AND ZHU
growth path. Since the increase in the growth rate of output is larger than the
increase in the growth rate of money supply, the inflation rate is lower.
5.3. Effects of a Change in the Nominal Interest Rate on Bank Deposits
PROPOSITION 3. We have
d␮
⫽ ?,
di d
d␲
⬎ 0,
di d
d␾
⬍ 0,
di d
d␮
⬎ 0,
di d
when
and
dg
⬍ 0.
di d
It can be shown that
⑀ ⫽ 1.
An increase in the nominal interest rate on bank deposits will generate two
effects. The first is an increase in old individuals’ disposable income, and thus a
higher level of aggregate consumption. The second one is to induce young
entrepreneurs to allocate more of their disposable income to bank deposits and
less to private capital investment. The increase in aggregate consumption causes
the price level and the rate of return on capital to rise, inducing a higher level of
private capital investment. However, the decrease in the level of private capital
investment not only reduces the scale of production in the private sector but also
lowers economy-wide productivity. The reduction in economy-wide productivity
lowers the demand for labor. This leads to a reduction in the level of labor
income and further decreases the level of capital investment in the two sectors
and the economy-wide scale of production. The overall effect is that the propensity to invest in the private sector is lower on the new balanced growth path,
implying a lower growth rate of output.
This policy action generates three offsetting effects on both the government
budget and the growth rate of money supply. First, it increases the interest
payment liability of the government. Second, it reduces the revenues collected
from taxes and profit remission. Third, it increases the amount of bank loans
available to the state sector and thus increases the scale of production in the state
sector, resulting in a higher profit remission. Hence, the overall effects on the
government budget deficit and the growth rate of money supply are ambiguous.
In spite of the ambiguous effect on the growth rate of money supply, the inflation
rate is always higher, given that the growth rate of output is lower, on the new
balanced growth path. If the state banking system channels all bank deposits to
the state sector for capital investment, the overall effect increases the government
budget deficit, which implies a higher growth rate of money supply and inflation
on the new balanced growth path.
CREDIT/INTEREST RATE CONTROL IN CHINA
311
5.4. Discussion
Why are the effects of an increase in the interest rate on government bonds
different from those of an increase in the interest rate on bank deposits? If the
government raises the interest rate on bank deposits, individuals will allocate
more of their disposable income to bank deposits. As a result, financial resources
will be diverted away from the private sector, which is more efficient in both
production and learning by doing. However, individuals do not have the option
to increase their holdings of government bonds when the government raises the
interest rate on government bonds because the quantity of government bonds
supplied to the public is fixed by the government. Thus, the increase in the
interest rate on government bonds will not reduce the amount of financial
resources allocated to the private sector. Having different implications for resource allocation, the two policy actions exert different effects on the economy.
Furthermore, changes in the nominal interest rate on bank loans have no real
effect on the economy. Even though i L is a control variable of the government,
it does not play any allocative role in the economy. 33 Once ␤, i d, and ⑀ are set,
the deposits in the banking system are determined and, in turn, the bank loans
available to the state sector for capital investment are decided. Thus, a change in
i L has no implications for resource allocation. The only effect of this policy is to
change the amount of profit generated in the state sector and, hence, the loan
repayment to the banking system. 34 A higher interest rate on bank loans would
raise the loan repayment to the banking system and lower the profit of the state
sector by the same amount, leaving the government budget deficit unchanged.
6. CONCLUSION
Despite the fundamental structural changes that have occurred in the past
twenty years, the Chinese economy differs from the advanced market economies
in two significant ways. First, it has a dual structure consisting of a state and a
non-state sector. Second, the financial sector is still monopolized by the government and the state banking system serves as a quasi-fiscal institution. Given the
gradual reform approach, these two distinctive features may linger for the next
couple of decades. From a policy-making perspective, the effects of the various
macroeconomic control measures available to the Chinese government are important. Using the analytical framework specified to capture the two major
institutional features, we investigate the long-run effects of tightening bank credit
and raising interest rates on government bonds, bank deposits, and bank loans on
33
Note that i L does not appear in the system of simultaneous Eqs. (18) to (21), which characterizes
the balanced growth path.
34
The zero interest rate elasticity of the state sector’s demand for loanable funds is due to the soft
budget constraint: “The effectiveness of interest rates as a monetary policy instrument remains
constrained by the soft budget constraints of SOEs” (World Bank, 1995, p. 41).
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FUNG, HO, AND ZHU
the expansion of the non-state sector, on the growth rates of output and money
supply, and on inflation.
We identify two transmission mechanisms through which policy actions affect
macroeconomic aggregates. First, they can influence either the rate of return on
a financial asset or individuals’ disposable income so that individuals are induced
to adjust their portfolios. These portfolio adjustments will alter the amount of
resources flowing into the two sectors and thus affect capital investment,
economy-wide scale of production and productivity, the growth rate of output,
labor income, and the profit conditions in the two sectors. Second, they can exert
an impact on the government budget either by influencing individuals’ portfolio
decisions and thus affecting bank proceeds or by altering economy-wide scale of
production and productivity and thus affecting the level of tax revenues and profit
remission. Consequently, the growth rate of the money supply and the inflation
rate are affected by these policy actions.
As this is a first attempt to understand macroeconomic policy issues in China,
there are some limitations associated with our analysis. In constructing the
model, certain important factors, which may exert non-negligible impacts on the
effectiveness of macroeconomic control in China, have not been considered.
First, the foreign trade sector in the economy has been expanding at an extraordinary pace. No longer isolated from the outside world, the Chinese economy is
now much more susceptible to external shocks. Inflation in other countries may
be transmitted through the channel of foreign trade. A surge in foreign investment will increase aggregate demand and thus exert upward pressure on the
domestic general price level. As the economy becomes increasingly open,
changes in exchange rates will exert influence on the key macroeconomic
aggregates.
Second, the emergence of a rapidly growing stock market has changed
substantially the way state-owned enterprises finance their capital needs. A listed
state-owned enterprise can finance capital investment by borrowing from banks
or issuing shares to the public; its effective cost of funds is a weighted average
of the interest rate on bank loans and the rate of return to their shareholders.
Given that the rate of return from holding a stock is equal to the interest rate on
bank deposits in equilibrium, the investment decisions of the state sector are
affected by the changes in the interest rates on bank loans and deposits. Hence,
changes in either the loan interest rate or the deposit interest rate may affect the
long-run macroeconomic aggregates in a model with a stock market. An increase
in the interest rate on bank loans leads to a rise in the effective cost of funds so
that the state-owned firms reduce their demand for capital investment, causing
labor to be reallocated from the state sector to the private sector. Since the private
sector is more efficient in both production and learning by doing, an increase in
the interest rate on bank loans should promote economic growth. An increase in
the interest rate on bank deposits also increases the effective cost of funds facing
CREDIT/INTEREST RATE CONTROL IN CHINA
313
state-owned firms and discourages capital investment in the state sector, which
tends to mitigate the negative effect on the output growth rate.
Finally, although the government did not intentionally relax its control over the
financial sector, an informal credit market has emerged in China. The interaction
between the state banking system and the informal credit market has been studied
by Fung et al. (1999). By assuming the co-existence of a state banking system
and an informal credit market, the model captures the following two features.
First, although private firms have difficulty in obtaining bank loans, they can now
seek external financing in the informal credit market. Second, the central bank
has been attempting to affect the equilibrium interest rate on private loans in the
informal credit market by channeling funds from the state banking system to the
informal credit market. Our results show that the presence of an informal credit
market does not alter the predictions of this paper that the interest rate on bank
loans to the state sector does not play any allocative role and that an increase in
the interest rate on bank deposits lowers private investment and therefore reduces
the growth rate of output. 35
APPENDIX A: RELAXING SOME SIMPLIFYING ASSUMPTIONS
In constructing our model, some simplifying assumptions have been made. In
this appendix, we examine the effect of relaxing two of these assumptions on our
results.
A.1. Utility Function
We assume that individuals consume only when they are old. Suppose now
that the individuals are assumed to consume in all three periods. For the
non-entrepreneurs, there are two effects when the rate of return on a financial
asset is altered, i.e., an intertemporal substitution effect and an income effect. For
the entrepreneurs, there is an additional effect, i.e., a portfolio substitution effect.
Consider the effects of an increase in the interest rate on bank deposits. This
change will induce individuals to make intertemporal substitution by saving more
and consuming less. For the entrepreneurs, another type of substitution results
from saving more in bank deposits and less in capital investment. However, the
higher interest income will induce individuals to increase their current consumption and decrease their saving. Thus, the net effect on private capital investment
is negative, while the effect on consumption is ambiguous. If the effect of
intertemporal substitution is sufficiently large, there will be a fall in aggregate
demand, which will exert a negative effect on the price of the consumption good.
A lower price will induce young entrepreneurs to reduce their capital investment.
35
In the model with an informal credit market, an increase in i d reduces private investment not only
directly, by increasing the opportunity cost of investment faced by the entrepreneur, but also
indirectly, by reducing the quantity of funds flowing into the informal credit market.
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FUNG, HO, AND ZHU
In this case, the effects on the propensity to invest in the private sector, the
growth rate of output, and the inflation rate are similar to those we have discussed
in the text. However, if the effect of intertemporal substitution is small, the
effects on the propensity to invest in the private sector, the growth rate of output,
and the inflation rate are ambiguous. In summary, to derive the results in our
paper, the elasticity of intertemporal substitution must be sufficiently large.
A.2. Secondary Markets for Government Bonds
In the absence of a secondary bond market, the entrepreneurs can adjust their
portfolios by changing only the levels of capital investment and bank deposits.
Whenever possible, they will equate the marginal rate of return on capital
investment to the interest rate on bank deposits.
Consider two possible cases. First, suppose that the entrepreneurs’ internal
finance constraint is not binding. In this case, the marginal rate of return on their
capital investment equals the interest rate on bank deposits. As the interest rate
on bank deposits is lower than the interest rate on government bonds, the
emergence of a secondary bond market will induce all young individuals to
reduce their bank deposits and to increase their bond holdings. Given a fixed
supply of government bonds, competition among potential buyers bids up the
price of bonds in the secondary market. As a result, the effective rate of return
on bonds purchased from the secondary market falls until it is equal to the interest
rate on bank deposits. The purchase of each bond reduces the buyer’s bank
deposits by an amount equal to (1 ⫹ i b)/(1 ⫹ i d), while the sale of each bond
will increase the seller’s bank deposits by the same amount. Consequently, the
original holder of each government bond can make a profit of (i b ⫺ i d)/(1 ⫹ i d)
units of money in the current period by selling the bond in the secondary market.
However, the emergence of a secondary bond market will have no real effect on
resource allocation.
Next, consider the case in which entrepreneurs are subject to a binding internal
finance constraint. In this case, each entrepreneur’s marginal rate of return on
capital investment is higher than the nominal interest rate on bank deposits. Each
entrepreneur invests in ((1 ⫺ ␶ )W t ⫺ b t )/P t units of capital and does not hold
any bank deposits. Because of the internal finance constraint, each entrepreneur
has an incentive to sell his bond holding in the secondary market so that his
internal funds are equal to (1 ⫺ ␶ l)W t ⫹ b t (i b ⫺ i d)/(1 ⫹ i d). Obviously, the
emergence of a secondary bond market allows each entrepreneur to attain an
investment level that is greater than ((1 ⫺ ␶ )W t ⫺ b t )/P t . To determine the
optimal level of investment, the entrepreneur equates the marginal rate of return
on capital investment to the interest rate on bank deposits, which is also equal to
the effective rate of return on a bond purchased from the secondary market in
equilibrium. If the optimal level of investment is less than [(1 ⫺ ␶ l)W t ⫹ b t (i b
⫺ i d)/(1 ⫹ i d)]/P t , the entrepreneur saves the excess funds either by holding
CREDIT/INTEREST RATE CONTROL IN CHINA
315
bank deposits or by acquiring bonds from the secondary bond market. If the
optimal level of investment is greater than [(1 ⫺ ␶ l)W t ⫹ b t (i b ⫺ i d)/(1 ⫹
i d)]/P t , the entrepreneur can afford to have only [(1 ⫺ ␶ l)W t ⫹ b t (i b ⫺ i d)/(1 ⫹
i d)]/P t units of investment so that he does not hold any bank deposits and
government bonds. Hence, the emergence of a secondary market will exert real
effects on resource allocation. In sum, whether the emergence of a secondary
market will have a real effect on resource allocation depends on whether or not
the entrepreneurs face binding internal finance constraints and whether the
interest rate on the bonds is higher or lower than the rate of return on private
capital investment.
Now we are ready to discuss the effect of the emergence of a secondary market
on our results. If the entrepreneurs do not face binding internal finance constraints, an increase in the interest rate on bank deposits will induce the entrepreneurs to increase their bank deposits and decrease capital investment; however, an increase in the interest rate on government bonds will not have a direct
effect on resource allocation but the indirect effect will induce the entrepreneurs
to increase their capital investment. If the entrepreneurs face binding internal
finance constraints and each entrepreneur’s capital investment is equal to [(1 ⫺
␶ l)W t ⫹ b t (i b ⫺ i d)/(1 ⫹ i d)]/P t , an increase in the interest rate on bank
deposits will effectively reduce the profit from selling bonds to the secondary
market, and therefore it will reduce the capital investment of the entrepreneurs.
Under the same condition, an increase in the interest rate on government bonds
will effectively increase the profit from selling bonds to the secondary market,
and therefore will allow the entrepreneurs to increase their capital investment.
Thus, in the presence of a secondary bond market, the results will be very similar
to those derived in the text.
APPENDIX B: DERIVATION OF EQUATIONS (18) TO (21)
The representative entrepreneur’s optimization problem is characterized by
p␴ p1⫺␴ 1⫺ ␴
p
max 共1 ⫺ ␶ c兲关P t⫹1 Ak t⫹1
l t⫹1 H t⫹1 ⫺ W t⫹1 l t⫹1
兴
p
p
k t⫹1
,l t⫹1
p
兴关1 ⫹ i dt 兴.
⫹ 关共1 ⫺ ␶ l兲W t ⫺ b t ⫺ P kt k t⫹1
The first-order conditions are
p
p␴⫺1 p1⫺␴ 1⫺ ␴
k t⫹1
: 共1 ⫺ ␶ c兲 ␴ P t⫹1 Ak t⫹1
l t⫹1 H t⫹1 ⫺ 共1 ⫹ i dt 兲 P kt ⫽ 0,
(A1)
p
p␴ p⫺␴ 1⫺␴
l t⫹1
: 共1 ⫺ ␴ 兲 P t⫹1 Ak t⫹1
l t⫹1 H t⫹1 ⫺ W t⫹1 ⫽ 0.
(A2)
p
/[(1 ⫺ ␶ l)W t ⫺ b t ], we have
Given that ␾ t ⬅ P tkk t⫹1
p
D et ⫽ 共1 ⫺ ␶ l兲W t ⫺ b t ⫺ P kt k t⫹1
⫽ 关共1 ⫺ ␶ l兲W t ⫺ b t 兴共1 ⫺ ␾ t 兲.
(A3)
316
FUNG, HO, AND ZHU
The optimization problem of the representative state-owned enterprise is
max P t⫹1 ␣ A
s
l t⫹1
冉 冊
Lt
P kt
␴
s
1⫺ ␴
s
l t⫹1
H t⫹1
⫺ L t 共1 ⫹ i Lt 兲 ⫺ W t⫹1 l t⫹1
.
s
The first-order condition for l t⫹1
is given by
s
l t⫹1
: 共1 ⫺ ␴ 兲 P t⫹1 ␣ A
冉 冊
Lt
P Kt
␴
s⫺␴ 1⫺␴
l t⫹1
H t⫹1 ⫺ W t⫹1 ⫽ 0.
(A4)
s
p
and l t⫹1
yields
Solving Eqs. (12), (15), and (A2)–(A4) for l t⫹1
冋
p
⫽ ␪ ⫹ ␣ 共1/ ␴ 兲 ⑀ t
l t⫹1
冉
1
⫺␪
␾t
冊册
⫺1
s
and l t⫹1
⫽ ␣ 共1/ ␴ 兲 ⑀ t
冉
冊
1
p
⫺ ␪ l t⫹1
.
␾t
(A5)
Substituting Eqs. (3) and (A5) into Eqs. (A1) and (A2), we obtain
冋
共1 ⫺ ␶ c兲 ␴ A ␪ 1⫺ ␴ ␪ ⫹ ␣ 共1/ ␴ 兲 ⑀ t
冉
1
⫺␪
␾t
冋
冊册 冉 冊
冉 冊册 冉 冊
␴ ⫺1
共1 ⫺ ␴ 兲 A ␪ 1⫺ ␴ ␾ t 共1 ⫺ ␶ l兲共1 ⫺ ␤ t 兲 ␪ ⫹ ␣ 共1/ ␴ 兲 ⑀ t
P t⫹1
⫽ 1 ⫹ i d,
Pt
1
⫺␪
␾t
␴
(A6)
W t⫹1
P t⫹1
⫽
.
Pt
Wt
(A7)
By combining Eqs. (A6) and (A7), we have
共1 ⫺ ␶ l兲共1 ⫺ ␤ t 兲共1 ⫹ i d兲关 ␪␾ t 共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ t 兲 ⫹ ␣ 共1/ ␴ 兲 ⑀ t 兴
冉 冊
W t⫹1 ␴ 共1 ⫺ ␶ c兲
⫺
⫽ 0.
Wt
1⫺␴
(A8)
Substituting Eqs. (4), (8), (9), (15)–(17), (A3), (A5), and (A8) into the government’s budget constraint (5) yields
冉 冊冉 冊冋
W t⫹2
W t⫹1
W t⫹1
Wt
1
⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ t⫹2 兲共 ⑀ t⫹2 ⫹ 共1 ⫺ ⑀ t⫹2 兲 ␪␾ t⫹2 兲
1⫺␴
册
⫺ 共1 ⫺ ␶ l兲关共1 ⫺ ␤ t 兲共1 ⫹ i d兲 ⫹ ␤ t 共1 ⫹ i b兲兴 ⫽ 0.
(A9)
On the balanced growth path, we have
W t⫹1 P t⫹1 Q t⫹1 M t⫹1
⫽
⫽
.
Wt
Pt Qt
Mt
Consequently, the relationship between the growth rate of the economy, g, and the
growth rate of the money supply, ␮, is given by (1 ⫹ g)(1 ⫹ ␲) ⫽ (1 ⫹ ␮), and
(W t⫹1/W t) ⫽ 1 ⫹ ␮. Hence, Eqs. (A6), (A8), and (A9) can be rewritten as
CREDIT/INTEREST RATE CONTROL IN CHINA
冋
共1 ⫺ ␶ c兲 ␴ A ␪ 1⫺ ␴ ␪ ⫹ ␣ 共1/ ␴ 兲 ⑀
冉
1
⫺␪
␾
冊册
317
␴ ⫺1
共1 ⫹ ␲ 兲 ⫽ 1 ⫹ i d,
(19)
共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲共1 ⫹ i d兲关 ␪␾ 共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ 兲 ⫹ ␣ 共1/ ␴ 兲 ⑀ 兴
␴ 共1 ⫺ ␶ c兲
⫽ 0,
1⫺␴
(20)
⫺ 共1 ⫺ ␶ l兲关共1 ⫺ ␤ 兲共1 ⫹ i d兲 ⫹ ␤ 共1 ⫹ i b兲兴 ⫽ 0.
(21)
⫺ 共1 ⫹ ␮ 兲
共1 ⫹ ␮ 兲 2
冋
1
⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲共 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兲
1⫺␴
册
APPENDIX C: COMPARATIVE STATIC ANALYSIS
By differentiating totally Eqs. (20) and (21), we derive the effects of changes
in i d, i b, and ⑀ on ␮ and ␾, respectively. Then, we use Eqs. (18) and (19) to derive
the effects on g and ␲. Define
共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲共1 ⫺ ⑀ 兲 ␪␾
,
共1/1 ⫺ ␴ 兲 ⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲共 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兲
共1 ⫺ ␣ 1/ ␴ ⑀ 兲 ␪␾
A2 ⬅
.
共1 ⫺ ␣ 1/ ␴ ⑀ 兲 ␪␾ ⫹ ␣ 1/ ␴ ⑀
A1 ⬅
A 1 兩 ⑀ ⫽1 ⫽ 0,
0 ⱕ ␮ ⱕ 1 f 2 A 2 ⫺ A 1 ⬎ 0, ᭙ 0 ⱕ ⑀ ⱕ 1.
C.1. Effects of Changes in ⑀
冉
1 ⫺ ␣ 1/ ␴
⑀
d␮
A 1A 2
⫽
共1 ⫹ ␮ 兲 d ⑀
2 A 2 ⫺ A 1 1 ⫺ ␣ 1/ ␴ ⑀
冊冉
冊
⑀ 共1 ⫺ ␪␾ 兲
ⱖ 0,
共1 ⫺ ⑀ 兲 ␪␾
冋
⑀ d␾
⑀ 共1 ⫺ ␪␾ 兲
2 ␣ 1/ ␴ A 2
A1
⫽⫺
⫺
1/ ␴
␾ d⑀
共2 A 2 ⫺ A 1 兲 ␪␾ 共1 ⫺ ␣ ⑀ 兲 1 ⫺ ⑀
⫽⫺
⫺
冋
册
⑀ 共1 ⫺ ␪␾ 兲
2 ␣ 1/ ␴
1/ ␴
2 A 2 ⫺ A 1 共1 ⫺ ␣ ⑀ 兲 ␪␾ ⫹ ␣ 1/ ␴ ⑀
册
共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲
,
共1/1 ⫺ ␴ 兲 ⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲关 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兴
冋
⑀
d ␲ 共1 ⫺ ␴ 兲 ␣ 共1/ ␴ 兲 ⑀ 共1 ⫺ ␪␾ 兲 A 2
A 1 关 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兴
⫽
2⫺
共1 ⫹ ␲ 兲 d ⑀
共1 ⫺ ⑀ 兲 ␪␾
1 ⫺ ␣ 共1/ ␴ 兲 ⑀
册
318
FUNG, HO, AND ZHU
⫽
共1 ⫺ ␴ 兲 ␣ 共1/ ␴ 兲 ⑀ 共1 ⫺ ␪␾ 兲 A 2
1 ⫺ ␣ 共1/ ␴ 兲 ⑀
共1 ⫹ ␮ 兲 2 共1 ⫺ ␤ 兲关 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兴
⫻ 2⫺
,
共1 ⫺ ␤ 兲共1 ⫹ i d兲 ⫹ ␤ 共1 ⫹ i b兲
冋
册
0ⱕ␮ⱕ1 f
⑀
d␲
⬎ 0,
共1 ⫹ ␲ 兲 d ⑀
⑀
⑀
⑀
dg
d␮
d␲
⫽
⫺
.
共1 ⫹ g兲 d ⑀ 共1 ⫹ ␮ 兲 d ⑀
共1 ⫹ ␲ 兲 d ⑀
⑀ d␾
␴␣ 共1/ ␴ 兲 ⑀ 共1 ⫺ ␪␾ 兲 A 2
⫽ 关共1 ⫺ ␴ 兲 ⫹ ␴ A 2 兴
⫹
.
␾ d⑀
共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ 兲 ␪␾
冉 冊
sign
A3 ⬅
d␾
⫽ ⫺sign A 3 ,
d⑀
2 ␣ 1/ ␣
共1 ⫺ ␣ 1/ ␴ ⑀ 兲 ␪␾ ⫹ ␣ 1/ ␴ ⑀
共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲
⫺
,
共1/1 ⫺ ␴ 兲 ⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲关 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兴
A 3 兩 ␣ ⫽0 ⬍ 0,
A 3 兩 ␣ ⫽ ␣ * ⫽ 0,
and
A 3 兩 ␣ ⫽1 ⬎ 0.
dA 3 2 ␣ 1/ ␴ 关共 ␪␾ / ␴␣ 兲 ⫺ ␪ 共1 ⫺ ␣ 1/ ␴ ⑀ 兲共d ␾ /d ␣ 兲兴
⫽
d␣
关共1 ⫺ ␣ 1/ ␣ ⑀ 兲 ␪␾ ⫹ ␣ 1/ ␴ ⑀ 兴 2
关共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲兴 2 共1 ⫺ ⑀ 兲 ␪ 共d ␾ /d ␣ 兲
⫺
⬎ 0,
关共1/1 ⫺ ␴ 兲 ⫺ 共1 ⫺ ␶ l兲共1 ⫺ ␤ 兲关 ⑀ ⫹ 共1 ⫺ ⑀ 兲 ␪␾ 兴兴 2
where
d␾
2 A 2␾
⫽⫺
d␣
共2 A 2 ⫺ A 1 兲 ␴␣
d␾
f
d⑀
再
冋
册
共1 ⫺ ␪␾ 兲 ␣ 1/ ␴ ⑀
⬍ 0.
␪␾ 共1 ⫺ ␣ 1/ ␴⑀ 兲
⬎ 0 if ␣ 僆 共0, ␣ *兲,
dg
⫽ 0 if ␣ ⫽ ␣ *,
f
d⑀
⬍ 0 if ␣ 僆 共 ␣ *, 1兴,
再
⬎ 0 if ␣ 僆 共0, ␣ *兲,
⬎ 0 if ␣ ⫽ ␣ *,
⫽ ? if ␣ 僆 共 ␣ *, 1兴.
C.2. A Special Case: ␣ ⫽ 1 and 0 ⬍ ⑀ ⬍ 1
d␮
⫽ 0,
d⑀
⑀ d␾
共1 ⫺ ␪␾ 兲 ⑀
⫽⫺
⬍ 0,
␾ d⑀
共1 ⫺ ⑀ 兲 ␪␾
CREDIT/INTEREST RATE CONTROL IN CHINA
319
⑀
d ␲ 共1 ⫺ ␴ 兲共1 ⫺ ␪␾ 兲 ⑀
⫽
⬎ 0,
共1 ⫹ ␲ 兲 d ⑀
共1 ⫺ ⑀ 兲 ␪␾
⑀
dg
共1 ⫺ ␴ 兲共1 ⫺ ␪␾ 兲 ⑀
⫽⫺
⬍ 0.
共1 ⫹ g兲 d ⑀
共1 ⫺ ⑀ 兲 ␪␾
C.3. Effects of Changes in i b
共1 ⫹ i b兲
共1 ⫹ ␮ 兲
共1 ⫹ i b兲
␾
共1 ⫹ i b兲
共1 ⫹ ␲ 兲
共1 ⫹ i b兲
共1 ⫹ g兲
冋
册
␤ 共1 ⫹ i b兲
d␮
A2
⬎ 0,
b⫽
di
2 A 2 ⫺ A 1 共1 ⫺ ␤ 兲共1 ⫹ i d兲 ⫹ ␤ 共1 ⫹ i b兲
1 共1 ⫹ i b兲 d ␮
d␾
⬎ 0,
b⫽
di
A 2 共1 ⫹ ␮ 兲 di b
d␲
共1 ⫺ ␴ 兲 ␣ 共1/ ␴ 兲 ⑀ 共1 ⫹ i b兲 d ␮
⬍ 0,
b⫽ ⫺
di
␪␾ 共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ 兲 共1 ⫹ ␮ 兲 di b
共1 ⫺ ␴ 兲 ␣ 共1/ ␴ 兲 ⑀
共1 ⫹ i b兲 d ␮
dg
⫽
1
⫹
⬎ 0.
di b
␪␾ 共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ 兲 共1 ⫹ ␮ 兲 di b
冉
冋
冊
冉
冊
册冉
冊
C.4. Effects of Changes in i d
共1 ⫹ i d兲
共1 ⫹ ␮ 兲
共1 ⫹ i d兲
␾
共1 ⫹ i d兲
共1 ⫹ ␲ 兲
共1 ⫹ i d兲
共1 ⫹ g兲
冋
册
d␮
共1 ⫺ ␤ 兲共1 ⫹ i d兲
A2
A1
⫺
,
d⫽
di
2 A 2 ⫺ A 1 ␤ 共1 ⫹ i b兲 ⫹ 共1 ⫺ ␤ 兲共1 ⫹ i d兲 A 2
d␾
1
共1 ⫺ ␤ 兲共1 ⫹ i d兲
2⫺
⬍ 0,
d⫽ ⫺
di
2 A2 ⫺ A1
␤ 共1 ⫹ i b兲 ⫹ 共1 ⫺ ␤ 兲共1 ⫹ i d兲
d␲
共1 ⫺ ␴ 兲 ␣ 共1/ ␴ 兲 ⑀
共1 ⫹ i d兲 d ␾
⬎ 0,
d⫽ 1 ⫺
di
␾
di d
␪␾ 共1 ⫺ ␣ 共1/ ␴兲 ⑀ 兲 ⫹ ␣ 共1/ ␴兲 ⑀
dg ␪␾ 共1 ⫺ ␣ 共1/ ␴ 兲 ⑀ 兲 ⫹ 共1 ⫺ ␴ 兲 ␣ 共1/ ␴ 兲 ⑀ 共1 ⫹ i d兲 d ␾
⫽
⬍ 0.
di d
␾
di d
␪␾ 共1 ⫺ ␣ 共1/ ␴兲 ⑀ 兲 ⫹ ␣ 共1/ ␴兲 ⑀
冋
冋
册冉
冉
冊
册
冊
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