## Modernizing China’s Growth Paradigm ## Source details **Canonical URL:** [Modernizing China’s Growth Paradigm](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2006/_pdp03.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2006/_pdp03.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2006/_pdp03.pdf.json) --- ### I. Introduction - Incremental, experimental reform approach and dual-track strategy have been central to China’s development model, yielding high and relatively stable growth. - Main argument: the traditional incremental paradigm may now be untenable given shifts toward a complex market-oriented economy and greater global integration; bolder and more concerted reforms are needed to sustain growth and resilience. - Present favorable domestic and external circumstances create a window for tackling deep-rooted problems with limited disruption. ### II. Some Context - Two key transitions: - From a command economy to a private-sector-led one; private sector’s share in GDP now estimated to be "one-half to two-thirds". - From a relatively closed economy before the 1980s to one very open to trade and more integrated into global financial markets. - Challenges from these transitions: - Employment and income uncertainty from market orientation; restructuring of state enterprises has contributed to rising unemployment. - Rising average incomes mask increasing disparities, especially rural–urban, generating political and social tensions. - Greater dependence on external demand increases vulnerability to external shocks. - Despite challenges, China has grown rapidly over the last two decades without sharp crises. ### III. China’s Path to High Growth - Exchange rate policy: - Renminbi fixed against the U.S. dollar since 1995; revalued by "2.1 percent" on July 21, 2005 and in principle set with reference to a basket, but "in practice" remains effectively pegged to the dollar. - Resisting real appreciation pressures has encouraged speculative inflows and a surge in international reserve accumulation since 2001. - Capital flow management: - Extensive capital controls, tax benefits, and incentives promoted inward FDI; portfolio debt inflows discouraged. - Controls have limited foreign bank entry and protected the state-owned banking system; limited debt and equity markets leave state banks as the main official intermediaries. - Household behavior and savings: - Transition uncertainties, limited borrowing instruments, and lack of international portfolio diversification contributed to high household savings. - Financial repression means savings are channeled into state bank deposits; implicit government deposit insurance encourages this. - Investment-driven demand: - Policy choices have skewed domestic demand toward investment rather than private consumption. - Investment recently has accounted for "more than half of nominal GDP growth" and may now amount to "nearly 40 percent of GDP". - Risks and implications: - Cheap credit and optimistic sectoral expectations have fueled an investment boom concentrated in sectors doing well now. - Potential for a resurgence of nonperforming loans if the economy or key sectors falter. - A fixed exchange rate constrains monetary policy tools (e.g., interest rates), complicating banking reform and financial market development. - Policy implication: - Greater exchange rate flexibility would provide instrument independence for monetary policy, help correct external imbalances, and support banking reform and capital account liberalization, thereby promoting broader financial market development and shifting demand toward private consumption. ### IV. Approaches to Reform - Constraints facing policymakers: weak legal framework, poor governance, dubious economic data quality, and significant autonomy of provincial and lower-level governments. - Incremental/experimental reform approach: - Small steps and geographically confined experiments (e.g., phased tax reforms; cautious move toward exchange rate flexibility). - Advantages: reduces costs of policy errors in a second-best world; enables learning and politically manageable compensation for losers. - Limitations of incrementalism as China develops: - Some reforms (exchange rate flexibility, capital account liberalization) cannot be confined regionally or sectorally. - Increased factor mobility means small moves can be exploited by arbitrageurs (e.g., speculative inflows anticipating further revaluation). - Interconnectedness of reforms: banking reform is linked to state-enterprise reform and social safety net development; exchange rate flexibility supports financial sector reforms. - Conclusion: simultaneous, sizable, coordinated reforms across national and local domains may be required to prevent arbitrage and achieve intended reform outcomes. ### V. Timing and Priorities - Risks of continuing incrementalism: - Partial liberalization of banks with implicit deposit insurance can create moral hazard and a resurgence of nonperforming loans. - Gradualism can perpetuate inefficiencies and create legacy problems that are costly to fix. - Practical considerations: - Capital controls are increasingly porous, with evasion facilitated by expanding trade; a fixed exchange rate with an opening capital account is dangerous. - Exchange rate flexibility without a clear alternative nominal anchor risks instability. - Recommended monetary framework: - Anchor monetary policy with an explicit long-run low inflation objective to tie down inflation expectations and stabilize inflation and employment (cited view: Goodfriend and Prasad, 2006). - Flexible exchange rate and instrument independence for the People’s Bank of China (PBC) are essential for this framework and for macroeconomic and financial stability. - A firm public commitment to a low inflation objective could galvanize complementary reforms. - Priority: Financial sector reform to make state banks efficient commercial intermediaries, recognizing it is a core priority for sustained growth and stability. ### Financial sector development and reform - Develop broader financial markets to give firms alternative sources of funds and provide households with alternative investment opportunities. - Competition from other segments of the financial sector would help spur the banking system’s reform efforts. - Continued interest rate liberalization is important for the banking system to function efficiently. - Caution: an all-out sprint towards full liberalization without adequate regulatory and supervisory mechanisms in place could create perverse incentives that could decrease financial system stability. ### Fiscal policy and social safety nets - Fiscal policy can strengthen the social safety net to reduce the political and social costs of market-oriented reforms. - Reorient government spending toward essential social expenditures, including health care and education, to reduce uncertainty and help give households the confidence to increase consumption levels (Blanchard and Giavazzi, 2005). - The low levels of explicit government deficits and public debt provide some room for maneuver in these areas. - Ensure that other reforms, including to the banking sector, proceed apace to avoid further buildup of contingent liabilities that could constrain fiscal policy. ### Political economy and sequencing of reforms - Constituencies that favor the current system because it generates rents can effectively block reforms. - The current period of high growth and low inflation provides an opportunity to broaden the dual-track approach to reform, allowing more of the economy to be opened to market forces while weaning the rest from implicit or explicit state support. - Further opening of the economy to external influences could help create coalitions in support of reform. ### Final remarks and strategic implications - China has achieved notable economic progress in the last three decades, but much work remains to build resilience to large shocks, ensure sustainability of growth, and translate growth into welfare gains. - Periods of high growth can mask deep underlying problems; favorable domestic and external circumstances may provide a narrow window of opportunity for tackling deep-rooted problems without much economic disruption. - Sustained capital inflows and appreciation pressures on the exchange rate may make it easier to manage the move towards greater exchange rate flexibility. - The current state of low inflation provides a good environment to consider setting a long-run low inflation objective as a nominal anchor. - The favorable fiscal position provides room for rethinking social expenditure priorities, particularly in education and health care. - Policymakers face a difficult balancing act: reforms should proceed at a reasonably rapid pace and a broad set of reforms should move in tandem—a "twin Goldilocks-ian outcome." - To mitigate unknowable risks, develop flexible and potent policy instruments and streamlined economic decision-making structures that allow nimble responses to unanticipated developments. - Recommendation: move beyond cautious, incremental experiments and take bigger, coordinated steps on the road to reform. *Source: PDP/06/3, "Modernizing China’s Growth Paradigm" by Eswar S. Prasad and Raghuram G. Rajan (March 2006).* ### Section 1 ### Modernizing China’s Growth Paradigm ### I. Introduction - Incremental, experimental reform approach and dual-track strategy have been central to China’s development model, yielding high and relatively stable growth. - Main argument: the traditional incremental paradigm may now be untenable given shifts toward a complex market-oriented economy and greater global integration; bolder and more concerted reforms are needed to sustain growth and resilience. - Present favorable domestic and external circumstances create a window for tackling deep-rooted problems with limited disruption. ### II. Some Context - Two key transitions: - From a command economy to a private-sector-led one; private sector’s share in GDP now estimated to be "one-half to two-thirds". - From a relatively closed economy before the 1980s to one very open to trade and more integrated into global financial markets. - Challenges from these transitions: - Employment and income uncertainty from market orientation; restructuring of state enterprises has contributed to rising unemployment. - Rising average incomes mask increasing disparities, especially rural–urban, generating political and social tensions. - Greater dependence on external demand increases vulnerability to external shocks. - Despite challenges, China has grown rapidly over the last two decades without sharp crises. ### III. China’s Path to High Growth - Exchange rate policy: - Renminbi fixed against the U.S. dollar since 1995; revalued by "2.1 percent" on July 21, 2005 and in principle set with reference to a basket, but "in practice" remains effectively pegged to the dollar. - Resisting real appreciation pressures has encouraged speculative inflows and a surge in international reserve accumulation since 2001. - Capital flow management: - Extensive capital controls, tax benefits, and incentives promoted inward FDI; portfolio debt inflows discouraged. - Controls have limited foreign bank entry and protected the state-owned banking system; limited debt and equity markets leave state banks as the main official intermediaries. - Household behavior and savings: - Transition uncertainties, limited borrowing instruments, and lack of international portfolio diversification contributed to high household savings. - Financial repression means savings are channeled into state bank deposits; implicit government deposit insurance encourages this. - Investment-driven demand: - Policy choices have skewed domestic demand toward investment rather than private consumption. - Investment recently has accounted for "more than half of nominal GDP growth" and may now amount to "nearly 40 percent of GDP". - Risks and implications: - Cheap credit and optimistic sectoral expectations have fueled an investment boom concentrated in sectors doing well now. - Potential for a resurgence of nonperforming loans if the economy or key sectors falter. - A fixed exchange rate constrains monetary policy tools (e.g., interest rates), complicating banking reform and financial market development. - Policy implication: - Greater exchange rate flexibility would provide instrument independence for monetary policy, help correct external imbalances, and support banking reform and capital account liberalization, thereby promoting broader financial market development and shifting demand toward private consumption. ### IV. Approaches to Reform - Constraints facing policymakers: weak legal framework, poor governance, dubious economic data quality, and significant autonomy of provincial and lower-level governments. - Incremental/experimental reform approach: - Small steps and geographically confined experiments (e.g., phased tax reforms; cautious move toward exchange rate flexibility). - Advantages: reduces costs of policy errors in a second-best world; enables learning and politically manageable compensation for losers. - Limitations of incrementalism as China develops: - Some reforms (exchange rate flexibility, capital account liberalization) cannot be confined regionally or sectorally. - Increased factor mobility means small moves can be exploited by arbitrageurs (e.g., speculative inflows anticipating further revaluation). - Interconnectedness of reforms: banking reform is linked to state-enterprise reform and social safety net development; exchange rate flexibility supports financial sector reforms. - Conclusion: simultaneous, sizable, coordinated reforms across national and local domains may be required to prevent arbitrage and achieve intended reform outcomes. ### V. Timing and Priorities - Risks of continuing incrementalism: - Partial liberalization of banks with implicit deposit insurance can create moral hazard and a resurgence of nonperforming loans. - Gradualism can perpetuate inefficiencies and create legacy problems that are costly to fix. - Practical considerations: - Capital controls are increasingly porous, with evasion facilitated by expanding trade; a fixed exchange rate with an opening capital account is dangerous. - Exchange rate flexibility without a clear alternative nominal anchor risks instability. - Recommended monetary framework: - Anchor monetary policy with an explicit long-run low inflation objective to tie down inflation expectations and stabilize inflation and employment (cited view: Goodfriend and Prasad, 2006). - Flexible exchange rate and instrument independence for the People’s Bank of China (PBC) are essential for this framework and for macroeconomic and financial stability. - A firm public commitment to a low inflation objective could galvanize complementary reforms. - Priority: Financial sector reform to make state banks efficient commercial intermediaries, recognizing it is a core priority for sustained growth and stability. *Source: PDP/06/3, "Modernizing China’s Growth Paradigm" by Eswar S. Prasad and Raghuram G. Rajan (March 2006).* ### Section 2 ### _pdp03 - Section 2 ### Financial sector development and reform - Develop broader financial markets to give firms alternative sources of funds and provide households with alternative investment opportunities. - Competition from other segments of the financial sector would help spur the banking system’s reform efforts. - Continued interest rate liberalization is important for the banking system to function efficiently. - Caution: an all-out sprint towards full liberalization without adequate regulatory and supervisory mechanisms in place could create perverse incentives that could decrease financial system stability. ### Fiscal policy and social safety nets - Fiscal policy can strengthen the social safety net to reduce the political and social costs of market-oriented reforms. - Reorient government spending toward essential social expenditures, including health care and education, to reduce uncertainty and help give households the confidence to increase consumption levels (Blanchard and Giavazzi, 2005). - The low levels of explicit government deficits and public debt provide some room for maneuver in these areas. - Ensure that other reforms, including to the banking sector, proceed apace to avoid further buildup of contingent liabilities that could constrain fiscal policy. ### Political economy and sequencing of reforms - Constituencies that favor the current system because it generates rents can effectively block reforms. - The current period of high growth and low inflation provides an opportunity to broaden the dual-track approach to reform, allowing more of the economy to be opened to market forces while weaning the rest from implicit or explicit state support. - Further opening of the economy to external influences could help create coalitions in support of reform. ### Final remarks and strategic implications - China has achieved notable economic progress in the last three decades, but much work remains to build resilience to large shocks, ensure sustainability of growth, and translate growth into welfare gains. - Periods of high growth can mask deep underlying problems; favorable domestic and external circumstances may provide a narrow window of opportunity for tackling deep-rooted problems without much economic disruption. - Sustained capital inflows and appreciation pressures on the exchange rate may make it easier to manage the move towards greater exchange rate flexibility. - The current state of low inflation provides a good environment to consider setting a long-run low inflation objective as a nominal anchor. - The favorable fiscal position provides room for rethinking social expenditure priorities, particularly in education and health care. - Policymakers face a difficult balancing act: reforms should proceed at a reasonably rapid pace and a broad set of reforms should move in tandem—a "twin Goldilocks-ian outcome." - To mitigate unknowable risks, develop flexible and potent policy instruments and streamlined economic decision-making structures that allow nimble responses to unanticipated developments. - Recommendation: move beyond cautious, incremental experiments and take bigger, coordinated steps on the road to reform. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2006/_pdp03.pdf* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2006/_pdp03.pdf_