Shifting the Focus of Fiscal Policy

A proactive fiscal policy has jump-started China’s economic growth, but the time has come to cool down sectors with excessive investments

By LAN XINZHEN

Jin Renqing, Minister of Finance

Local government officials in China are worried a lot these days. The reason? Beijing’s expected moves to transform its fiscal policy this year. Officials fear that they may not receive the same sort of financial support from the central authorities as in previous years.

At the Central Economic Working Conference (CEWC) held in Beijing on December 5, the Central Government gave a hint of the changes on the way when it said, “China will implement prudent fiscal and monetary policies next year.” Its proactive policy of the last seven years is set to make way for a prudent one.

According to the CEWC, a prudent fiscal policy will make it necessary to rein in inflationary trends while also discouraging deflation. It said investment demand would have to be curtailed while consumption demand would be encouraged. Industries with excess investments would be reined in and weaknesses in economic and social development overcome.

“Prudent fiscal policy focuses on controlling deficit, adjusting structure, promoting reform, increasing revenue and reducing expenditure,” says Minister of Finance Jin Renqing.

According to Jin, “controlling the fiscal deficit” implies scaling down the deficit as appropriate and restricting the issue of long-term treasury bonds for construction projects.

“Adjusting the structure” refers to the need to adjust financial expenditures and the target financed by the treasury-bond funds, in compliance with sound public finance management. More government funds will go to support national development strategies and to key sectors of agriculture, forestry, water conservation, ecological protection and land reclamation, development of the western region, revitalization of old industrial bases in the northeast as well as infrastructure, public health, education, scientific progress and social security.

The minister explained that fiscal reform will be aimed at changing the model of economic growth that is based primarily on treasury bond investments. Jin said such investments should be scaled down and more resources should be diverted toward structural and institutional reform and innovation and the creation of a relatively relaxed financial and taxation environment.

“Increasing revenue and reducing expenditure’’ is meant to further strengthen tax implementation-not by increasing taxes and reducing the tax burden-but to boost revenues while, at the same time,

optimizing the use of funds.

Why the Shift?

The Asian financial crisis of 1997 prompted China to adopt a proactive fiscal policy. From 1998 it began issuing more long-term treasury bonds and increased investments using funds raised from issues of treasury bonds. Between 1998 and 2004, China issued long-term construction treasury bonds worth 910 billion yuan ($109.9 billion), which created 3.5 trillion yuan ($422.71 billion) in investments and raised the gross domestic product (GDP) by 1.5-2 percentage points every year.

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However, such proactive fiscal policy is essentially expansionary, leading to growing fiscal deficits.

The fiscal deficit hit 319.8 billion yuan ($38.62 billion) for two years in succession in 2002 and 2003. The ratio of the deficit to GDP reached 2.9 percent, coming close to the internationally accepted safe limit of 3 percent.

In early 2004, China experienced over-investment in some sectors and in the second half of the year, there were signs of inflation. According to the National Bureau of Statistics, in September, the consumer price index rose 5.2 percent compared with the same period in 2003. This exceeded the 5-percent safe limit and put pressure on macro-economic development. In response to this situation, the government released a series of macro-control measures such as tight money policies, restraints on investments in key sectors and higher interest rates on bank deposits.

If a proactive fiscal policy is continued, it will not help control the excessive investments in fixed assets and inflationary tendencies. It will, in fact, sharpen the gap between consumption and investment and defeat the efficacy of macro-control measures.

“Therefore, proactive fiscal policy must be shifted,” asserts Finance Minister Jin.

However, not all sectors are overheated and there are many that need more investments such as agriculture, education, public health and social security. Moreover, short-term inflationary pressures have eased. Hence, a sudden shift from a proactive fiscal policy is not warranted. This explains the government’s move toward a prudent fiscal policy-one that is neither expansionary nor restrictive-is aimed at balancing revenues and expenditures.

“Prudent fiscal policy conforms to the present Chinese economic development and meets the demands of macro-economic control,” said Jia Kang, Director of the Fiscal Science Institute of the Ministry of Finance.

An increase in fiscal revenues will facilitate the move toward such a policy. According to statistics released by the State Administration of Taxation, in the first three quarters of 2004, tax revenues stood at 1.93 trillion yuan ($233.1 billion), 26.3 percent or 401.4 billion yuan ($48.48 billion) more than the same period in 2003. It is estimated that for the whole of 2004, the increase is expected to stand at 500 billion yuan ($60.39 billion).

According to Finance Minister Jin, after the implementation of a prudent fiscal policy, the financial deficits of the central finance could still be 300 billion yuan ($36.23 billion). The ratio of the deficit to GDP is predicted to drop to about 2 percent this year. With the government making conscious efforts to reduce the issue of long-term treasury bonds, such bond issue in 2003 was 10 billion yuan ($1.21 billion) less than in 2002 and last year it was 30 billion yuan ($3.62 billion) less than in 2003. The figures for this year are expected to at least match those of last year.

Cooling the System

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To curb the over-investment in some industrial sectors, the government adopted macro-control measures in 2004, tightening loans to such sectors as real estate, iron and steel and cement. With a prudent fiscal policy, these sectors will face more challenges.

According to the CEWC, this year, treasury bond funds will go mainly toward completing the on-going long-term construction projects, rural infrastructure and agricultural development, technological upgrading and transformation, the development of the western region and reforestation. The focus will shift to public services from economic construction.

Statistics show that a large part of the excessive investments in some sectors came from bank loans and fiscal support. For some real estate projects, bank loans even accounted for more than 70 percent of the total investment. For the expansion of some state-owned factories in cement and steel, all the capital came from local governments which, in turn, looked to the Central Government.

Changes in the use of treasury bond funds this year will reduce bank loans and financial support from local governments into the overheated sectors.

“To reduce treasury investment to production projects and lead banks to reduce loans to overheated industries like urban construction and real estate will help curb market demand of capital goods and investment products, reduce non-performing loans of banks and provide conditions to reduce money supply and restrain inflation,” said Vice Minister of Finance Lou Jiwei.

Impact on the Economy

How will the pace of economic development be affected by the move toward a prudent fiscal policy?

Yi Xianrong, Director of the Finance Development Division of the Institute of Finance and Banking under the Chinese Academy of Social Sciences (CASS), holds that a prudent fiscal policy will not affect economic development.

According to Yi, the shift from a proactive fiscal policy to a prudent one is not a “sharp turn” but a “smooth turn,” referring to a prudent readjustment of fiscal expenditures to treasury investments.

“Prudent fiscal policy only changes the target of financial support, but attention will be paid to key projects with long-term construction treasury funds and on-going projects in order to keep stability of policies. However, new construction projects will be restrained to resolutely prevent low-level redundant development and excessive superior construction,” said Yi. “The change is just to restrain the unbalanced investment structure and to make Chinese economic development more healthy.”

Fu Yuan, Professor of the Institute of Economics at CASS, believes that with a prudent fiscal policy, GDP will inevitably decline, but that is exactly the objective of such a policy.

According to Fu, aggregate demand and supply at present are generally balanced and the biggest challenge for the economy is to make structural changes, instead of controlling overall supply and demand.

“Significance of prudent fiscal policy is, by moderately controlling and reducing financial deficits and treasury bond and readjust treasury expenditure, to lessen unfavorable influence in the arrangement of treasury funds and further cool down the overheated industries,” said Fu.