NBER WORKING PAPER SERIES

MACROECONOMIC EFFECTS OF CHINA'S FINANCIAL POLICIES

Kaiji ChenTao Zha

Working Paper 25222http://www.nber.org/papers/w25222

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138November 2018

This paper is written for the "Handbook on China's Financial Markets," edited by Marlene Armstad, Guofeng Sun, and Wei Xiong. Zha acknowledges the research support from Shanghai Advanced Institute of Finance at Shanghai Jong Tong University. The research is supported in part by the National Science Foundation Grant SES 1558486 through the NBER and by the National Natural Science Foundation of China Project Numbers 71473168, 71473169, and 71633003. We are grateful to Marlene Amstad, Pat Higgins, Tom Sargent, Guofeng Sun, and Wei Xiong for comments and suggestions and to Yiqing Xiao for excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Atlanta or the Federal Reserve System or the National Bureau of Economic Research.

NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

© 2018 by Kaiji Chen and Tao Zha. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Macroeconomic Effects of China's Financial PoliciesKaiji Chen and Tao ZhaNBER Working Paper No. 25222November 2018JEL No. E5,G1,G28,O2

ABSTRACT

The Chinese economy has undergone three major phases: the 1978-1997 period marked as the SOE-led economy, the 1998-2015 phase as the investment-driven economy, and the new normal economy since 2016. All three economies have been shaped by the government's financial policies, defined as a set of credit policy, monetary policy, and regulatory policy. We analyze the macroeconomic effects of these financial policies throughout the three phases and provide the stylized facts to substantiate our analysis. The stylized facts differ qualitatively across different phases or economies. We argue that the impacts of China’s financial policies work through transmission channels different from those in developed economies and that a regime switch from one economy to another was driven mainly by regime changes in financial policies.

Kaiji ChenEmory University1602 Fishburne Drive Atlanta, GA 30322-2240and Federal Reserve Bank of Atlantakaiji.chen@emory.edu

Tao ZhaEmory University1602 Fishburne DriveAtlanta, GA 30322-2240and Federal Reserve Bank of Atlantaand also NBERtzha@emory.edu

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I. IntroductionSincethebeginningofChina’seconomicreformsin1978,theChineseeconomyhasundergonethreemajorphases.Thefirstphase(1978-1997)marksaneconomyledbygrowthandreformsofstateownedenterprises(SOEs).Theeconomyinthesecondphase(1998-2015)wasdrivenbyinvestmentinlargeandcapital-intensiveenterprises,whichformwhatwecall“theheavysector.”TheheavysectorincludesbothSOEsandprivateownedenterprises(POEs).Inrecentyears(2016-present),wehavewitnessedatransitiontowhattheChinesegovernmentcalls“anewnormaleconomy.”Allthreephaseshavebeenshapedbyparticulargovernmentpolicies.Inthischapter,wefocusonmacroeconomiceffectsoffinancialpoliciesthroughoutthesephasesandprovidestylizedfactstosubstantiateouranalysis.1Wedefine financialpolicies inChinaasasetofcreditpolicy,monetarypolicy,andregulatorypolicy.MonetarypolicyinChinahasalwaysaimedtocontrolthemoneysupplyandaggregatecredit,evenuntiltoday.CreditpolicyinChinaplaysanessentialroleindirectingbanks’creditstodifferentsectorsorfirms.Suchapolicyconsistsofanumberofadministrativetoolssuchasloanquotasandwindowguidancetolimitingcreditstospecificsectorsorindustries.IntheSOE-led economy, credit policy is crucial for achieving balanced growth between heavy and lightsectors and between investment and consumption. For the investment-driven economy,monetarypolicy,coupledwithcreditpolicy,playedacrucialroleinpromotingoveralleconomicgrowth through investment in the heavy sector. Monetary policy was particularly potent incombatingthe2008financialcrisisintheshortrunbutwiththecostofahighdebtburdeninthelongrun(measuredbythedebt-GDPratio).Mostofthestimuluswaschanneledtorealestateandinfrastructure,whichformedalargeportionoftheheavysector.Since themassivemonetary stimulus in2009, theeffectivenessofmonetarypolicyhasbeeneclipsedbytheriseofshadowbankingduetolaxregulatorypolicy.Inrecentyearssince2016,therehavebeenimprovementsincoordinationbetweenmonetaryandregulatorypolicieswithintheframeworkofMacroPrudentialAssessment(MPA).Inparticular,theChinesegovernmenthasplacedanumberofunifyingrulesonassetmanagementacrossdifferentfinancialsectors(i.e.,acrossformalbankingandshadowbanking).TheimpactsofChina’sfinancialpoliciesworkthroughtransmissionchannelsdifferentfromthoseindevelopedeconomies. Bankcreditshavealwaysplayedaspecialrole inpromotingChina'seconomicgrowth.Andthegovernmenthasalwaysgivenpreferentialcreditstocertainfirmsorindustries,althoughthepreferencehasshiftedthroughthethreedifferentphases.IntheSOE-ledeconomy,bankcreditsweredirectedtoSOEsinbothheavyandlightsectors.Asa result, SOEs, especially those in the light sector (e.g. the textile industry), suffered from

1Mosttimeseriesdatausedinthisarticleandmanyotherrelateddatacanbedownloadedfromhttps://www.frbatlanta.org/cqer/research/china-macroeconomy.aspx?panel=1 (the Englishversion)orhttp://cmf.cafr.cn/under数据下载(theChineseversion).

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problemswithexcesscapacityandoverleverage.MostoftheseSOEsweresmallandmedium-sized.Inthelate1990s,reformswerefocusedonSOEsbyreducingovercapacityofsmallandmedium-sizedSOEs.ThismovementiscalledinChinese“Graspthelargeandletgoofthesmall.”ReformsinthebankingsectoralsofocusedonnonperformingloanstoSOEswithovercapacity.Intheinvestment-driveneconomy,preferentialcreditsweregiventotheheavysector.Duringthisphase,mostindustriesintheheavysectorwerefavoredbytheChinesegovernmentaspartofthegovernment’sindustrializationpolicytopromotetheheavysector.Theasymmetriccreditallocationinfavoroftheheavysectorwasexacerbatedduringthestimulusperiod(2009-2010).Themainconsequenceisoverstockintherealestate,overcapacityinindustriessupportingthereal estate, and overleverage in both real and financial sectors. Reforms in this economy,differentfromthoseintheSOE-ledeconomy,focusedondestockingtherealestate,deleveragingovercapacityfirms(e.g.,steel,cement,andglass),anddeleveragingthefinancialsector.While these reforms continue in the new normal economy, China faces new challenges. Inparticular,financialreformshaveunintendedconsequences.Forexample,financialdeleveraginghas reducedbankcredits tononbank financial institutionsand thus shadowbanking loans toPOEs.Atthesametime,thedefaultratesofPOEsandthereforesystemicriskshaveincreased.SOEsinupstreamindustries,however,havecontinuedtoreceivepreferentialcreditsandremainunproductiveandmonopolistic.Implicitguaranteesbylocalgovernmentstosuchzombiefirmsmakedifficultthedeleveragingofcorporatedebts.The rest of the chapter is organized as follows. In Section II, we provide the institutionalbackgroundofChina’sfinancialpolicies.InSectionIII,weanalyzethemacroeconomicimpactsof financial policies on the SOE-led economy, the investment-driven economy, and the newnormaleconomy.SectionIVconcludes.

II. Institutionalbackgroundoffinancialpolicies

ReviewoffinancialpoliciesAsdefinedintheIntroduction,China’sfinancialpoliciesconsistofcreditpolicy,monetarypolicy,andregulatorypolicy.Wereviewtheinteractionsofthesepoliciesinthecontextoftheirimpactsonthemacroeconomy.Creditpolicy.Priorto1978,Chinahadlongpursuedacreditpolicyinfavoroftheheavysector,which led to severelyunbalanceddevelopmentsbetweenheavyand light sectors. In January1980, the central government decided to develop the light sector to avoid a shortage ofconsumptiongoods.Theemphasiswasgiventoproductionofconsumerdurablestogeneratedemandsfortheheavysector.Thelightsectorwasgranted“sixpriorities”,includingthepriorityofreceivingbankloans.Asaresult,bankcreditswerereallocatedtofirmsinthelightsector,mostofwhichwereSOEspriorto1998.

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Figure1.YearoveryeargrowthofM2supplyandbankloans.Thepinkboxmarksthe2009stimulusperiod.ThefirstverticallinedividestheSOE-ledeconomyandtheinvestment-driveneconomy.Thesecondverticallinedividestheinvestment-driveneconomyandthenewnormal

economy.Datasource:Chen,Higgins,Waggoner,andZha(2017).

From1998to2017,thePeople’sBankofChina(PBC)usedanexplicittargetofgrowthratesofM2supplyasaneffectivewaytocontrolaggregatebankloansandpromoteaninvestment-driveneconomy. In this phase, credit policy, through window guidance and loan quotas, was alsocentralized tobe in linewith thegrowthofM2supply.ThePBCutilizedwindowguidance tocontrolthetotalvolumeofbankcreditsandtoredirectloanstothetargetedindustries(e.g.,realestateandinfrastructure).Suchloansweremaderegardlessofprevailinginterestrates.InlinewithM2growth,thePBCplannedtheaggregatecreditsupplyforthecomingyearattheendofeachyearandthennegotiatedwithindividualcommercialbankstoredirectcreditstotargetedindustrieswhennecessaryduringthecomingyear.Monetarypolicy.Before1984,thePBCwastheonlybankinChina.In1984,thePBCbecamethecentralbankandthecentralgovernmentestablishedthebankingsystemcomprisedoffour

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specializedbankstomakeloanstofirmsindifferentindustries:BankofChina,ChinaIndustrialandCommercialBankofChina,ChinaConstructionBank,andAgriculturalBankofChina.Allthesefourbanksweredirectlycontrolledbythegovernment.Theaggregatecreditvolumewaschosentobetheintermediatetargetofmonetarypolicy.Butthistargetwasseldommetbecausetherewas no marketized policy instrument to help achieve the target. Instead the mandatoryadministrativeplanforcreditquotaswasimplementedandlocalgovernmentsplayedanintegralpartinallocatingthesequotastofirmsthroughlocalbranchesofthefourstatebanks.Thelimitedcoordinationamonglocalgovernmentsmadeitimpossibletocontroltheaggregatevolumeofbankcreditsandtheefficiencyoftheirallocations.In1998,targetingtheaggregatecreditvolumeasmonetarypolicywaseventuallyabolished.The ineffectivenessofmonetarypolicy thoughadministrativemeansmade thePBCgraduallyswitchtotargetingM2growth.Before1993,thePBCdirectlycontrolledthebankcreditsupplyanditsallocationsoftenatlocallevels.In1993,forthefirsttime,itannouncedtothepublictheindexofmonetarysupply;in1996,itbeganatransitiontousingthemoneysupplyasatargetformonetarypolicyatthenationallevel.In1998thePBCannouncedthatM2supplywastheonlypolicytarget.Newmarketized instrumentsweresubsequentlyestablishedtohelpachieve the targetedM2growth.InMay1998,openmarketoperationswereinitiatedtoserveasthemaintoolforthePBC to manage the money supply on a regular basis. In addition, the PBC used reserverequirementstoadjustthebanks’liquidity.2Fromthentotheendof2017,Chinaadheredtothisquantity-based monetary policy framework, especially during the entire period of theinvestment-driveneconomy.Monetary policy during the period of the new normal economy has undergone a gradualtransition from the quantity based framework to the interest-rate based framework. Thediscussionof this transitionwas initiated in the Thirteenth Five-Year Plan for “Economic andSocialDevelopment”held in2016. Inadditiontothediscussionofmonetarypolicy, theplanoutlinedanewnormaleconomythatfeaturesfinancialreformsandapromotionofconsumptiongrowthtobesupportedbymonetarypolicy. In2018Q1, forthefirst timesince1998,theM2growthtargetwasnolongeramongthegovernment’skeyeconomicobjects.Figure1showsthetimeseriesofyear-over-yeargrowthratesofM2supplyandaggregatebankcredit.Therectangularbar(withpinkedge)marksthe2009monetarystimulusperiod(2009Q1-Q3)forFigure1aswellasothergraphsintherestofthischapter.3Therearetwoverticallines.The first linemarks thebeginningof1998andthesecond line thebeginningof2016. Theseverticallinesareplottedinothergraphsofthischapter.Clearly,theM2supplyandbankloansdonotco-moveintheSEO-ledeconomy(thegraphtotheleftofthefirstverticallineinFigure2Forexample, inMarch1998,thePBCreducedtherequiredreserveratiofrom13%to8%toincreasetheliquidityinthebankingsystem.3 Chen, Higgins, Waggoner and Zha (2017) identify monetary stimulus as monetary policyswitchingtoamoreaggressiveregimetocombatthefallofGDPgrowthbelowitsofficialtarget.

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1).In1989-1991,thegovernmentused“macroeconomicregulations”toreducethegrowthratesofbothbankcreditsandM2supplyinordertocooldowntheoverheatedeconomygeneratedduring1987-1988.4Asaresult,GDPgrowthin1989-1991wasatthelowestpointintheSOE-ledeconomy(seeSectionIIIforfurtherdiscussions).5TopreventGDPgrowthfromdecliningfurther,thecentralgovernmentreverseditsmacroeconomicpolicybyexpandingbankcreditsthrougharapidincreaseofM2growthin1992aswellasduringthefirsthalfof1993.Thiscreditexpansionfilled the gapbetween insufficienthouseholddeposits and firms’ strongdemands for creditswhenthedepositratewasadministrativelyfixedatalowlevel(Chapter8,Lin2013).Becausethegovernmentdidnotsetatargetonthegrowthofmonetaryaggregates,M2growthovershotin1992-1995 during the process of supporting credit expansions across regions in the country.Consequently,theovershootingofM2supplyledtoanunprecedentedriseofinflation.Theseriesofthesezigzagpolicieswasoneofthemainreasonsforthegovernmenttochangeitsmonetarypolicy in the late1990sby targeting theM2 supply explicitlywithdevelopmentofvariousmarketizedtoolstomakethetargetcredible.AsadirectresultoftargetingM2growthmandatedbythecentralgovernment,theM2supplyandbankloansco-moveintheinvestment-drivenphase(seethegraphbetweenthetwoverticallinesinFigure1),implyingthatmonetarypolicywaseffectiveincontrollingaggregatebankloans.Duringthisphase,twosetsoftoolsweredevelopedtomeettheM2growthtargetandcontrolthegrowthofbank loans.Thefirstset,includingthebenchmarkreserverequirementratioandopenmarketoperations,wasusedtomeet theM2 growth target. The second set, including differential reserve requirements fordifferentcommercialbanks,creditquotas(implicitorexplicit),andwindowguidance,wasusedtokeepgrowthofbankloansinlinewithgrowthofM2supply.Butthiseffectivenesswaseclipsedbytheriseofshadowbankingactivitiesintheaftermathofthe2008financialcrisis(Chen,Ren,andZha,forthcoming).Inthethirdphase(thenewnormaleconomy),thesmalldivergencebetweenM2growthandbank-loangrowth(thegraphtotherightofthesecondverticallineinFigure1)isdrivenmostlybyreductionofbankcreditstonon-banking financial companies (NFCs),which, in turn, reduced their bank deposits through thefinancialdeleveraging.Bank loanstotherealeconomy,however, remainedstableduringthisperiod.Regulatorypolicy.Regulatorypolicyalsowentthroughthethreephases.Inthefirstphaseinwhichthestatebankswerefullyownedandmanagedbythegovernment,administrativetoolswereusedtocontrolbankcreditadvancementswhilethesystemforregulationandsupervisiononNFCswasimmatureandloose.4 In November 1989, the Fifth Plenary Session of the Thirteenth Central Committee of theCommunistPartypassedthe“DecisionoftheCentralCommitteeofCommunistPartyofChinatoFurtherGovern,Reorganize,andDeepenReforms.”Thisdecisionwasastartingpointofthenextthree-yearmacroeconomicregulation.5ThereisnoofficialdatafortheM2supplypriorto1992butthetimeseriesofaggregatebankcreditcanbefoundinChenandZha(2018).

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In the second phase, the loan-to-deposit ratio (LDR) regulation became one of the mostimportantcomponentsofregulatorypolicy;itrequiresacommercialbanktokeeptheratioofitsloans to its deposits under 75%. The LDR regulationwas established in 1994, but itwas notcrediblyenforceduntil the late2000s. The secondmost important componentof regulatorypolicyistherestrictionofadvancementofbankcreditstocertainriskyindustries,whichisoftencalledinChinesethe“safeloanregulation.”In2006,theStateCouncil,concernedwithChina'sreal estate andmany overcapacity industries, issued a notice to accelerate the restructuringprocessoftheseriskyindustries.In2010,thePBCandChineseBankingRegulatoryCommission(CBRC) jointly issuedanothernotice to reinforce the2006notice issuedby theStateCouncil,making itoperational toprohibitcommercialbanks fromoriginatingnewbank loanstotheseindustries.Althoughtheseregulatoryactionspreventednewlyoriginatedtraditionalbankloansfromflowingtotheriskyindustries,laxregulatorypolicyonshadowbankingactivities,combinedwithmonetarypolicytighteningafterthemassive2009monetarystimulus,createdtheshadowbankingboomanddampenedtheeffectivenessofmonetarypolicy inaffectingtheaggregatebankcreditasasumoftraditionalandshadowbankingcredits.Toachievefinancialstability,deleveraginghasbecomeapriorityforthefinancialpoliciesinthethirdphase. InDecember2016,deleveraging corporatedebtswasamajordiscussion for theCentralEconomicWorkConference.InMarch2017,theReportontheWorkoftheGovernment(RWG)madeitaprioritytodeleverageovercapacityfirmsthatsupportedtherealestate.InJuly2017, theNationalFinancialWorkConference reiterated thispriority. InDecember2017, theRWG no longer specified theM2 growth target for 2018,marking a gradual transition fromquantitybasedmonetarypolicytointerest-ratebasedmonetarypolicy.InApril2018,thefirstmeetingoftheCentralFinancialCommissionemphasizedtheimportanceofdeleveragingzombiefirmsassociatedwithlocalgovernmentdebts.Since2016,thecentralgovernmenthasadoptedtheMPASystemtoensurethefinancialstabilityand a cooperation between monetary and regulatory policies. Put in place were variousregulationsonspecificbankingassetsandliabilities(e.g.interbankCDs)andonshadowbankingproducts(e.g.entrustedloansandwealthmanagementproducts).Moreimportantareanumberof unifying rules enactedby the governmentonassetmanagement acrossdifferent financialsectors(i.e.,acrossformalbankingandshadowbanking).6

ThenexusbetweenGDPgrowthandfinancialpoliciesTheSOE-ledeconomy.In1978,economicreformswiththeso-called“opening-uppolicy”wereinitiatedbytheThirdPlenarySessionoftheEleventhCentralCommitteeoftheCommunistParty.In1984,decentralizationtookplace,givingthelocalgovernmentsastrongermanagerialpower.

6In April 2018, PBC and CBRC issued the joint notice “GuidingOpinions on Regulating AssetManagementBusinessofFinancialInstitutions”toforbidthepracticeofguaranteedredemptionofassetmanagementplans.

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In 1987, economic development was the central theme as well as the bottom line of theThirteenthCentralCommitteeoftheCommunistParty.In1992,DengXiaopingadvancedfurthereconomicreformsthroughoutthecountry.In1994,thegovernmentimplementedtaxreformswiththetaxsharingsystem.Theyear1984wasapivotalpointforGDPgrowth.Sincethen,promotinglocalGDPgrowthhasbecomethemajortaskoflocalgovernmentofficialsastheirperformancehasalwaysbeenbasedon local economic grow.7In 1984, the external financing of SOEs switched from direct fiscalappropriationstoindirectbankloans.CreditpolicyaimedatpromotinggrowthofSOEsineachprovince, city, and district. By relaxing credit quotas on state banks, the government usedadministrativetools tocontrolcreditadvancementstoSOEsandhelpedclose,restructure,ormerge small and medium-sized SOEs that experienced large profit losses. Since SOEs wereprevalent in every industry (in both heavy and light sectors), such credit policy influencedinvestmentandconsumptionsimultaneously.Thecentralgovernment'splanforcontrollingtheaggregatecreditvolumewascompromisedbylocalgovernments’actions.LocalgovernmentsoftendirectedlocalbranchesofstatebankstoadvancecreditstoSOEsbeyondtheirquotas(thesoftbudgetconstraints).PressuresexertedbylocalgovernmentsonlocalbranchesofstatebankstoincreasecreditstolocalSOEsresultedinpressuresfromlocalbranchesontheirheadquarterstoloosencreditquotas,whichinturnforcedthePBC toeventually raise theaggregatecredit volumeandmoney supply (this is called the“reverseloanquotatransmission”or倒逼机制(DaoBiJiZhi)inChinese).Apartfrombankinglending,BrandtandZhu(2007)showthatduringthisphase,NFCs,includingtheruralcreditcooperatives,urbancreditcooperatives,andtrustandinvestmentcorporations,emergedtobeimportantsourcesoffinancing.Unlikestatebanks,NFCswereusuallycontrolledorownedbylocalcooperativesandtheirlendinglargelyfelloutsideofthegovernment’screditplan.LendingfromNFCscontributed20-25%tothetotalsourceoffunds.The investment-driveneconomy. In thisphase, thecentralgovernment laidoutmultiplepolicy objectives, including (real) GDP growth, inflation, employment, foreign exchange rate,social stability, and environment. Out of these objectives, only two economic targets are ofprimaryimportance:GDPgrowthandconsumerpriceindex(CPI)inflation.Since1988,theGDPgrowthtargethasbeenspecifiedintheStateCouncil'sReportontheWorkofGovernment(RWG).Thisistheoverridingobjectiveamongallpolicyobjectives.From1999to2017,theM2growthtargetwas also specified in theRWG, alongwith theGDPgrowth target. ThePBC is not anindependent institution inmakingmonetary policy. The State Council andother governmentunitsexertedconsiderableandoftendominantinfluencesontheofficialtargetofM2growth.Chen,RenandZha(Forthcoming)developandestimateaquantity-basedmonetarypolicyrule

7Zhou(2007)callssuchanincentivesystemforlocalgovernmentsthe“promotiontournament.”HearguesthatthepromotiontournamentisthekeysourceofChina’smiraculousgrowth.

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basedonChina’s institutional facts. Under this rule,monetarypolicyendogenously switchesbetweentworegimes,accordingtowhetheractualGDPgrowthisaboveorbelowthetargetedGDPgrowth.InthenormalsituationwhereGDPgrowthisabovethetarget,M2growthrespondspositivelytothegapbetweenactualandtargetedGDPgrowthrates.Bycontrast,inashortfallstatewheretheactualGDPgrowthisbelowthetargetedGDPgrowth,monetarypolicytakesanunusuallyaggressiveresponsetostemtheshortfalltomeettheGDPgrowthtarget.Forthemostpart,quantity-basedmonetarypolicyintheinvestment-driveneconomyfolloweditssystematicresponsetooutputandinflationtargets(thegraphbetweenthetwoverticallinesinFigure2).WecomputecounterfactualpathsofM2growthanditsendogenouscomponentintheperiodoftheSOE-ledeconomy.Thesecounterfactualpaths,showninthegraphtotheleftofthefirstvertical line inFigure2,revealthat incontrasttothe investment-driveneconomy,monetarypolicyintheSOE-ledeconomywouldnothavefolloweditssystematicrulehaditbeenimplementedinthisperiod.TheseresultsconfirmthatwithoutappropriatemarketizedtoolsasintheSOE-ledeconomyitwouldbedifficulttocontroleitherM2ortheaggregatecreditvolume.UnlikeintheSOE-ledeconomyinwhichthegovernmentprovidedcreditstoSOEsacrossbothheavyandlightsectors,mostofpreferentialcreditsinthisphasewerechanneledtotheheavysectorinordertostimulateinvestmentasawaytomeettheoverridingGDPgrowthtarget.Theheavy sector includesbothSOEsand largePOEs thatare capital intensive. Thegovernment'sobjectiveoftargetingGDPgrowthisasymmetric:theGDPgrowthtargethasbeenalowerboundforgrowth.MonetarypolicywascarriedouttosupportGDPgrowthandatthesametimecontrolCPI inflation through effective ways of influencing bank loans (see various monetary policyreports(MPRs).Thisisoneofthemainfeaturesintheinvestment-driveneconomy.Thenewnormaleconomy.Inrecentyears,ChinesecentralgovernmentstrivedtoachieveabalancebetweenGDPgrowthandthefinancialstability.TheCentralEconomicWorkConferenceheldinDecember2014declaredforthefirsttimethattheChineseeconomyenteredthe“newnormalstage.”The2015RWGlistedthedualobjective:maintainingahealthyrateofgrowthwhile moving towards a sustainable level of development. The Central Economic WorkConferenceheld inDecember2015called for ``structural reformson the supply side,”whichincludedeleveragingdebts,reducingovercapacity,anddestockingtherealestate.Thiseffortshowsupasnegativemonetarypolicyshockssince2014(Figure2).Accordingtothemonetarypolicyrulesince1998,GDPgrowthlowerthanthetargetinthisepisodewoulddemandhigher M2 growth (shown as the endogenous component in Figure 2). Considerations ofaccumulateddebtsduetothemonetarystimulusandthefinancialstabilityingeneral,however,induced the government to lower M2 growth at the sacrifice of GDP growth. Theseconsiderations and their effects, which are abstracted from our monetary policy rule, arecaptured as negativemonetary policy shocks (i.e., the difference between the solid and thedashed-xlinestotherightofthesecondverticallineinFigure2).

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Figure2.M2growthanditssystematiccomponent.Datasource:Chen,RenandZha(Forthcoming).

III. MacroeconomicEffectsofFinancialPolicies

Wenowanalyzetheeffectsoffinancialpoliciesonthemacroeconomy.AsFigure3shows,GDPgrowthexperiencedexpansionandslowdowninbothSOE-ledeconomyandinvestment-driveneconomies.AndfinancialpoliciesaffectedbothtrendsandcyclesofChina’smacroeconomy.Inthis section,we first document key patterns of trend and cycle for each economy and thenanalyzetheroleoffinancialpoliciesindrivingthetrendsandcycles.

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Figure3.GDPgrowth(annualdata).Datasource:CEIC.

EffectsoffinancialpoliciesontheSOE-ledeconomy(1978-1997)

In the SOE-led economy, SOEs permeated through the whole economy, including all theindustriesandacrossthelightandheavysectors.MonetarypolicywasthemainfinancialpolicyinallocatingcreditquotastothebankingsystemthatchanneledmostofitsloanstoSOEs.Creditpolicyasanotherfinancialpolicyplayedanindispensableroleforfirmsinbothheavyandlightsectorstoreceivebankcredits.BankloanstovariousSOEsincludelong-termaswellasshort-termloans.TheroleofcreditpolicyintheSOE-ledeconomyissummarizedbyFigure4.StatebanksprovidedcreditstoSOEsinbothheavyandlightsectors.Thisisthemostimportantaspectofcreditpolicyinthiseconomy.Underthecentralgovernment’spro-growthpolicyandlocalgovernment’sGDPgrowthtournament,SOEsinbothsectorsobtainedimplicitgovernmentguaranteesoftheirbankcredits.Withthesefinancialguarantees,statebankswerewillingtoadvancecreditstoSOEsinbothsectorsandacrossallindustries.

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Figure4.RoleofcreditpolicyintheSOE-ledeconomy.

Creditpolicywasessentialtopromotingbothinvestmentandconsumptionforthe1978-1997phase.Sincethedataonconsumptionarefragmentary,wefocusonananalysisofinvestmentwiththeunderstandingthatconsumptionandinvestmentcomovedinthisphase.Figure5showsthatFAIandbankloanstoFAImovedhandinhand.Throughoutthe1978-1997period,theshareofSOEsinFAIremainedhigh(Figure6)andtheshareofSOEsincreditallocationstoinvestmentalsoremainedataveryhighlevel(Figure7).AccordingtoBrandtandZhu(2007),inmostyearsduringthisphase,80-85%oftotalcreditswereextendedtoSOEsthroughstatebanksintheformof either working capital or fixed investment loans. This observation reflected the centralgovernment’s commitment toworkers and job growth in SOEswhile fiscal resources in localgovernmentsdeclined.ThesharesofSOEsinFAIanditsloanvolumeweremuchhigherintheperiodpriorto1998thaninthepost-1997period.HighsharesimplythatSOEs,whichenjoyedpreferentialbankcredits,areadrivingforceoftheaggregateinvestmentfluctuation.

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Figure5.Year-over-yeargrowthratesofFAIandbankloanstoFAI.Datasource:ChenandZha(2018).

Figure6.ShareofSOEsinFAI(compiledfromtheaggregatedata).Datasource:ChenandZha(2018).

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Figure7.ShareofSOEsinbankloanstoinvestment.ThisserieswasdiscontinuedbyChina’sNationalBureauofStatistics.Datasource:ChenandZha(2018).

Despite the lack of sectoral loan data in this phase, credit allocations to the heavy and lightsectors can be inferred from the ratio ofmedium- and long-term (MLT) loans to total loansoutstanding.Thelightsectordemandsmoreworkingcapitalloans(short-term)topaythewagebills than the heavy sector, while the heavy sector demands more MLT loans for capitalinvestmentthanthelightsector.TheratioofMTLloanstototalloansisavailablefrom1994Q1.Figure8showsthattherewasnoseculartrendforthisratiopriorto1998,incontrasttothetrendofasteadyincreasesince1998.8CreditpolicyintheSOE-ledeconomyhadtwonotableeffectsontheChineseeconomy.First,thefluctuationof(real)GDPwasdrivenbythefluctuationsofbothinvestmentandconsumption(thegraphstotheleftofthefirstverticallineinFigure9).Second,thecorrelationbetweeninvestmentand consumption growth rates during 1978-1997 is as high as 0.80 and this correlation isstatisticallysignificant.Table1reportsthiscorrelationalongwithitsp-valuebasedontheHP-filteredlogannualseries.Incontrasttotheinvestment-driveneconomy,aswediscusslater,theinvestment-to-outputratiowasstationaryduringthisepisodebutatthesametimeveryvolatile(Figure10).

8Usingtheannualdatafromthecashflowtablethatdatesbackto1992,ChenandZha(2018)findthattheratioofMLTloanstototaldomesticbankloansremainedstablebetween0.2and0.31duringthephaseoftheSOE-ledeconomy.

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Figure8.Shareofmediumandlongterm(MLT)loansintotalbankloansoutstanding.Data

source:CEICandauthors'calculation.Table1.CorrelationbetweenhouseholdconsumptionandaggregateinvestmentbasedonHP-

filteredlogannualseries.Eachseriesisdeflatedbyitsownpriceindex. 1979-1997 1998-2015

Correlation 0.8062 -0.3500p-value 0.0 0.1545Other important factsof theSOE-ledeconomyare thestationary ratioofgrossoutput in theheavysectortothatinthelightsector(Figure11)andthestationaryratioofgrossfixedassetsintheheavysectortothoseinthelightsector(Figure12).TheseobservationswereanoutcomeofcreditpolicyintheSOE-ledeconomythatwasengineeredtosupportSOEsacrossallsectors,notjust the heavy sector. For instance, a large quantity of bank credits were channeled to theindustriesproducingconsumerdurables.ManybankcreditswereallocatedtoSOEsproducingwatches,bicycles,andsewingmachinesin1978-1982,colortelevisionsandrefrigeratorsin1983-1988,andautomobilesin1992-1997.Thus,weobserveoneprominentfeatureoftheSOE-ledeconomy:investmentandconsumptionco-move.Asaresult,thelaborshareofincomewasalsostablepriorto1998(Figure13).

15

Figure9.Year-over-yeargrowthofaggregateinvestment(measuredbygrossfixedcapitalformation(GFCF))andhouseholdconsumption.Datasource:ChenandZha(2018).

Figure10.Ratiosofinvestment(I)andconsumption(C)toGDP(Y).Investmentis

grossfixedcapitalformation.Datasource:ChenandZha(2018).

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Theobservationthatcreditpolicyfueledthedemandforbothinvestmentandconsumptioninthe1978-1997phaseisalsosupportedbythepatternoffluctuationsforthetwomeasuresofinflation rate, as shown by Figure 14 and by their summary statistics reported in Table 2.AccordingtoTable2,thePPIvolatilitywassimilarinmagnitudetotheCPIvolatilityin1978-1997.

Table2.StandarddeviationsofCPIandPPIinflationrates 1978-1997 1998-2015CPIinflation 0.0618 0.0202PPIinflation 0.0695 0.0397Difference 0.0077 0.0195(p-value) (0.6235) (0.0083)

Therewas,however,oneimportantdifferencebetweentheheavyandlightsectorsintheSOE-ledeconomy.SOEsinthelightsectorweretypicallysmallandmedium-sized(e.g.,firmsinthetextileindustry).AssmallSOEswerelessproductivethanlargeSOEs,reformsonSOEsduringtheperiodoftheSOE-ledeconomyemphasizedthetaskof̀ `graspingthelargeandletgoofthesmall”toreduceexcesscapacityproblemsinsmallandmedium-sizedSOEs.ThesereformsledtoabirthofmanyproductivePOEsinthelightsectorduringthephasegovernedbytheinvestment-driveneconomy.ThetrendsandcyclesintheSOE-ledeconomyaresummarizedasfollows.v Trends:

Ø (T1)Stationaryinvestment-outputratio.Ø (T2)Stationarylaborshareofincome.Ø (T3)HighsharesofSOEsinFAIandinbankloanstoinvestment.Ø (T4)Stableratioofgrossoutput(measuredbytheratioofsalesrevenues)intheheavy

sectortothatinthelightsectorandstationaryratioofthecapitalstock(measuredbygrossfixedassets)intheheavysectortothatinthelightsector.

v Cycles:Ø (C1)Aggregateinvestmentandhouseholdconsumptiontendedtoco-move.Ø (C2)BoomsandbustsofinvestmentanditscreditsweredrivenmainlybySOEs.

(C3)Thevolatilityofproducepriceindex(PPI)inflationhadamagnitudesimilartothevolatilityofCPIinflation.

17

Figure11.Ratioofgrossoutputintheheavysectortothatinthelightsector.Datasource:ChenandZha(2018).

Figure12.Ratioofgrossfixedassetsintheheavysectortothatinthelightsector.Datasource:ChenandZha(2018).

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 20100.5

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3Gross output: Ratio of heavy and light sectors

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 20172

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18

Figure13.ShareoflaborincomeinGDP.Datasource:CEICandChang,Chen,WaggonerandZha

(2016)

ThesetrendandcyclepatternsobservedinthedatafortheSOE-ledeconomycanbeexplainedbythetheoreticalframeworkofChenandZha(2018).Theeconomycontainstwosectors,heavyand light, differentiated by the capital intensity. The crucial model ingredient is that thegovernment‘simplicitguaranteestoSOEs,representedbyitsnetworth,aresymmetricacrossboth light andheavy sectors. SOEs in theheavy sector donot face theborrowing constraintbecausethebanksarenotcommercializedandaspartofthegovernmentarewillingtomakeintertemporal(long-term)investmentloanswithoutconditions.LoanstoSOEsinthelightsectorareofshorttermtofundworkingcapitalforpayinglaborwagesandotherfactorinputs.Suchloansarehardertobefullypledgedthaninvestmentloanstotheheavysector.Thus,thelightsector faces the binding collateral constraint governed by a fraction of their assets. As thegovernmentnetworth increases,thecollateralconstraintofthe lightsector isrelaxed,whichincreases its factordemand.This, inturn, increasesthedemandforcapital investmentoftheheavysectorduetotheimperfectsubstitutabilitybetweenthesetwosectors.Accordingly,theratioofgrossoutputintheheavysectortothatinthelightsectorwasstationary.

Effectsoffinancialpoliciesontheinvestment-driveneconomy(1998-2015)Theperiod1998-2015marksaneconomyqualitativelydifferentfromtheSOE-ledeconomy.Themostconspicuousdifferencewasachangefromthegovernment’sdirectcreditcontrolpolicyto

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explicitlytargetinggrowthofM2supplyasaneffectivewaytocontrolaggregatebankloans.Suchmonetarypolicywasdesignedtoprovideadequateandaccurateliquiditytothebankingsystemto support investment in the heavy sector, which includes both large SOEs and large POEs.Consequently,theshareofSOEsinFAIdeclinedsteadilyin1998-2015untilithoveredbelow20%(Figure6).Sincemonetarypolicywasusedtosupportinvestmentintheheavysector,theshareofSOEsintotalbankloanstoinvestmentdeclinedsteadilyafter1998(Figure7).Themoststrikingfacetoftheinvestment-driveneconomyisthatGDPgrowthwasdrivenmostlyby investment (so-called capital deepening). To illustrate this feature, we calculate growthdecompositionsfromthefollowingproductionfunction:

Y" = TFP"K")N"+,),whereYrepresentsoutput,TFPtotalfactorproductivity,Kcapital,Nlabor(employedworkers),andatheshareofcapitalincomeintotalincome.Thedecompositionofgrowthperworkeris

∆log 1232= ∆logTFP" + α∆log

6232,

wherethesecondtermontheright-handsideoftheequationrepresentsthecontributionfromcapitalintensity(capitalperworker)orinvestment.9Tables3and4reportthegrowthaccountingaccordingtotheabovedecompositionformula.Thecomputationusesthevalueofthecapitalsharesetat0.5asintheliterature.Fortheapproachof Bai, Hsieh, andQian (2006), the data of gross fixed capital formation for ``structures andbuildings''and``machineryandequipment''goesbackonlyto1981.Theinvestmentpricedataforthesetwocategoriesgoesbackonlyto1990.Thevaluesreportedunderthecolumnwiththeheading1978-1997inTable4,markedbythesymbol*,arefortheperiod1990-1997.For2017,theapproachofBai,Hsieh,andQian(2006)requiresgrossinvestmentpriceinflationin2018tobeavailable,whichwedonothaveatthetimeofwritingadraftofthischapter.BothtablesshowthatTFPcontributedmost tothegrowthofGDPperworker in theSOE-ledeconomy,butinvestmentplayedadominantroleindrivingGDPgrowthintheinvestment-driveneconomy.ThisfindingisconsistentwithanindependentstudybyLagakos(2018).Asaresult,weseethattheratioofinvestmenttoGDPhasincreasedsteadilysince1998(Figure15).Theinvestment-driveneconomyexperiencedthreedistinctepisodes:thegoldendecade(1998-2008), the stimulus period (2009), and the post-stimulus period (2010-2015). Along withpreferentialcreditpolicytowardtheheavysector,bothmonetaryandregulatorypoliciesduringthesethreeepisodeshavedistinctivefeatures.Wediscusstheroleoffinancialpoliciesineachofthesethreeepisodesseparately.

9TheU.S.BureauofLaborStatisticslabelsK/N“capitalintensity”.Itisoftendefinedas“theratioofcapitalservicestohoursworkedintheproductionprocess”(seechart2onpage2andpage10ofhttps://www.bls.gov/news.release/pdf/prod3.pdf).WeuseemploymentinsteadofhoursbecauseofthelackoftheChinesedataonhours.

20

Figure14.InflationratesofPPIandCPI.Datasource:CEICandauthors'calculation.

Table3.GrowthaccountingaccordingtoLongandHerrera(2016)Growth(%) 1978-1997 1998-2015 2016 2017GDPperworker 6.67 8.36 6.26 6.55Duetocapitalintensity

2.89 5.71 4.55 4.11

DuetoTFP 3.78 2.65 1.71 2.45Contributionbyinvestment

43.4 68.3 72.7 62.7

Datasource:ChenandZha(2018)

Table4.GrowthaccountingaccordingtoBai,Hsieh,andQian(2006)Growth(%) 1978-1997 1998-2015 2016 2017GDPperworker 7.05* 8.36 6.26 N/ADuetocapitalintensity

2.48* 5.61 4.69 N/A

DuetoTFP 4.57* 2.75 1.57 N/AContributionbyinvestment

35.1* 67.1 74.9 N/A

Datasource:ChenandZha(2018)

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Thegoldendecade.Thegovernment’searlyplanningfortheinvestment-driveneconomywascrucialforthesuccessinthewholeperiod.In1995,ChinaenactedthePeople'sBankofChinalawandotherbankinglawswithdecentralizationofthebankingsystem,whichironicallyledtotheconcentration of large loans to large firms. 10 In March 1996, the Eighth National People'sCongressofChinalaidoutafirstfive-yearstrategicplantodevelopinfrastructure,realestate,basicindustries(metalproducts,automobile,andhigh-techmachinery),andotherheavy-sectorindustries(petroleumandtelecommunication).By1998thegovernmentcompletedtheprocessofprivatizingSOEs(graspthelarge,letgoofthesmall)andbeganaprivatizationofthehousingmarket. Prior to 2003, most houses were transacted below their market values (affordablehousing). In 2003, affordable housing was largely abolished. Instead, the governmentencouragedthetransactionsofhousesatthemarketvalue.Thesehousesarecalled“commodityhouses.”In2000,realestateandautoindustrieswerechosentobethepillarindustriesbythegovernmentfor itsstrategicplan. In2001,China joinedtheWorldTradeOrganization(WTO),whichmarkedan importantadvancement inChina’sopenness to theworldeconomyand itstradeliberalization.In2002,thefourstatebanksbecamecommercializedandthereafterthereemergedmanynewcommercialbanks,includingBankofCommunications---thefifthlargeststatebank.Thebankingsystemwasthemostimportantsourceofexternalfinancinguntilthelate2000swhenariseofshadowbankingeclipsedtheimportanceofthetraditionalbankingrole.Untiltheriseofshadowbanking,monetarypolicyofexplicitlytargetingM2growthhadbeeneffectiveontotalbankcreditaswellastotalsocialfinancing.Onecrucialbankingregulationthatinteractedwiththemonetarypolicytoaffectthetotalbankcreditisaregulationontheceilingoftheloan-to-depositratio(LDR).Inatheoreticalframework,Chen,Ren,andZha(forthcoming)showthatwhenPBCtightensmonetarypolicyviaopenmarketoperations,theprobabilityofdepositwithdrawalsbyprimarydealersincreases,whichmakestheLDRratiomorelikelytobebindingundertheLDRregulation.Consequently,commercialbanks,especiallynon-statebanks,havetoincurextracoststorecoupthedepositshortfalls(knownas“lastminuterushcosts”or冲时点(CongShiDian)inChinese).Theseexpectedregulatorycostsreducetheeffectivereturnofbanklendingandinducebankstoengageinshadowbankingbyreducingformalbanking.AsFigure16shows,localgovernments’implicitguaranteesoncreditstotherealestateanditssupportingheavyindustriesplayedacrucialroleincreditallocationsduringthegoldendecade.When assessing loan applications, banks favored large loans to large firms andwere biasedagainstsmallloanstosmallfirms.Thispracticewasnotonlyduetotheasymmetricinformationproblemfacingsmallfirmswhenbanksassessedloanapplications,butalsobecauselargefirmsintheheavysectorgainedimplicitguaranteesfromlocalgovernments(Jiang,LuoandHuang,2006).Inshort,banksfavoredlendingtolargefirmsorindustriesintheheavysectortargetedby

10SeeBrandtandZhu(2007)foracomprehensivelistofthelawsandregulationsenactedduringthisperiod.

22

the state (e.g. real estateand infrastructure).Compared to small firms, large firmsproducedmoresales,providedmoretaxrevenues,andhelpedboostGDPofthelocaleconomy---themostimportantcriterionforthepoliticalbenefitsoflocalgovernmentofficials.

Figure15.Secularpatternoftheinvestment-to-GDPratio.Thesymbol“I”representsinvestmentmeasuredbyGFCFand“Y”representsoutputmeasuredbyaggregatevalueadded.

Datasource:ChenandZha(2018).Asfinancialpoliciesswitchedfromarelianceoncreditpolicysupportingboth lightandheavysectors in the SOE-led economy to an emphasis on quantity-based monetary policy in theinvestment-driveneconomy,thisneweconomicregimealsochangeditscharacteristics.Becausethegovernment’smonetary/creditpolicyfocusedoninvestmentintheheavysectorduring1998-2015,therelationshipbetweeninvestmentandconsumptionbrokedown.Thatis,thecorrelationbetween growth rates of investment and consumption changed from 0.80 in the SOE-ledeconomytobeingstatisticallyinsignificantintheinvestment-driveneconomy(Table1andFigure9).Andthecorrelationbetweeninvestmentandlaborincomewasalsoclosetozero(0.026withthe p-value 0.919). The promotion of investment at the sacrifice of consumption caused PPIinflationtobemorevolatile thanCPI inflation (Table2andFigure14)andthe laborshareofincometodecline(Figure13).11

11ThedeclineofChina’slaborincomesharesincethelate1990sisarobustfact,asconfirmedbyBaiandQian(2009)andQianandZhu(2012),whohavemadedataadjustmentstotake intoaccountchangesinthestatisticalcoverageoflaborcompensationsovertime.

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Figure16.Monetary/creditpolicyintheinvestment-driveneconomy.Investmentduringthegoldendecadewasfueledby long-termbankcreditsatthesacrificeofshort-termbank credits toworking capital in the light sector (Figure8). Inotherwords, theincrease inbankcreditsunderexpansionarymonetarypolicywaschanneleddisproportionallyintolong-termbankcreditstofinanceinvestment.Accordingly,thecorrelationbetweenshort-termandlong-termbankloansintheinvestment-driveneconomyisnegative(Table5).Contrarytothecommonbelief,theexternalsectorplayedalimitedroleininvestmentgrowthduringthegoldendecade.AfterChinajointedtheWTO,mostexportswereproducedinthelightsector (e.g., the textile, toys, and shoes), as documented inHuang, Ju, andYue (2015). In anumberofnewlyindustrializedeconomiesinAsia(e.g.,SouthKorea,Singapore,andTaiwan),theexport-led economy concentrated on capital-intensive goods. Rapid investment in China'scapital-intensivesector(i.e.,theheavysector)wasnotledbyitsexports.12SOEsalsoplayedalimitedroleduringthegoldendecade.Asdiscussedearlier,theSOEshareininvestmentaswellasininvestmentloansdeclinedsteadily.GiventhesamepreferentialcreditpolicytowardSOEs,thesefactsimplythattheinvestment-to-outputratiowouldhavedeclined.

12 According to Huang, Ju, and Yue (2015), between 1999 and 2007, labor intensive firmsincreasedtheirexportsharesandcapital-intensivefirmsreducedtheirexportshare;atthesametime,thecapitalintensityofexportfirmswasreduced.

24

But instead the investment rate rose steadily. This is because the investment boomwasnotdrivenbySOEsduringthisperiod,butbyrealestateandsupportingheavyindustries(e.g.steeland cement). In particular, large POEs in the real estate industry and other heavy industriesreceivedpreferentialbankcreditstofinancetheirinvestment.13In2002,forinstance,65%ofallfirmswerePOEsinnumberandthePOEshareofgrossindustrialoutputintotalgrossindustrialoutputwas55%.In2004Q1,theFAIgrowthrateinurbanareaswas42.8%(80.7%forPOEsvs.only22.3%forSOEs).14

Thepreferentialcreditpolicytofirmsinheavysectorleadstothefactthatgrossoutputintheheavysectorincreasedmuchfasterthangrossoutputinthelightsector.Bycontrast,growthofgrossoutputinbothsectorswasbalancedintheSOE-ledeconomy.ThisexplainstheincreasingshareofheavysectorGDPintotalGDPsince1998(Figure17).Inparticular,theshareofvalueaddedtotherealestateindustryinGDPincreasedsteadily(exceptfortheglobalfinancialcrisis)in the investment-driven economy (Figure 18). As documented in Chen, Ren, and Zha(forthcoming),mostfirmsintherealestateindustryarenotSOEs.

Table5:Correlationbetweennewlyissuedshort-termandMLTbankloansSample Loangrowth(yoy) Newloanas%ofGDP

1998Q1-2015Q4 -0.37 -0.29The shift of a focus to invest in the heavy sector during the golden decade from a focus topromoteSOEsacrossallsectorsintheSOE-ledeconomyresultedinmorevolatilePPIinflationthanCPIinflation(Table2).Inaddition,growthintherealland(house)pricewasmorevolatilethan inflationbyanorderofmagnitudeandonaveragemuch faster than (real)GDPgrowth(Figure19).Thetrendsandcyclesintheinvestment-driveneconomy,especiallyduringthegoldendecade,aresummarizedasfollows.v Trends:

Ø (T1)Asteadyincrease(decrease)oftheratioofaggregateinvestment(consumption)toGDP.

Ø (T2)Adecliningshareofincome.Ø (T3)AsteadyincreaseintheratioofMLTbankloanstoshort-termbankloans.Ø (T4)Asteadyincreaseintheratioofgrossoutput(andgrossfixedassets)intheheavy

sectortothatinthelightsector.

13 Examples of large and important POEs during the investment-driven phase include华为(communications),联想(informationandtechnology),吉利(automobile),万达and万科(realestate).14SeeLiu(2005).

25

Figure17.GDPintheheavyandlightsectors.Datasource:CEICandauthors'calculation.

Figure18.Theshareofvalueadded(VA)totherealestateindustryintotalvalueadded(GDP).Datasource:CEICandauthors'calculation.

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Figure19.Annualgrowthinthelandprice.Datasource:Wu,Gyourko,andDeng(2012)and

authors'calculation.v Cycles:

Ø (C1)Noco-movementbetweenaggregateinvestmentandconsumption.Ø (C2)Noco-movementbetweenaggregateinvestmentandlaborincome.Ø (C3)Anegativeco-movementbetweenMLTbankloansandshort-termbankloans.

Chang,Chen,WaggonerandZha(2016)developatheoreticalframeworktoexplainthesekeyfactsof the investment-driveneconomy. The crucial differencebetween thismodel and themodelofChenandZha(2018)isthatthegovernment’sfundingthroughmonetary/creditpolicygoestotheheavysectoraspartofashiftofthestrategicemphasistofinancinginvestmentinthe heavy sector. Such a preferential credit reallocation caused resources to be reallocatedtowardtheheavysectorasgovernmentnetworthincreased,whichledtotheupwardtrendofgrossoutput in theheavysector relative to that in the light sector,especially the realestateindustry.Sincetheheavysectorhadahigherinvestmentratethanthelightsector,theratioofaggregate investment to aggregate output kept increasing during the golden decade. Thepreferential credit reallocation alsomade bank loans to the light sector costly. These costs,capturedby theconvex functionofbank loans in the theoreticalmodel,areoneof themainexplanations for the observed negative or insignificant correlation between investment andconsumption.Song,Storesletten,andZilibotti(2011,SSZ)provideacomplementaryexplanationfortherapidgrowthduringthegoldendecade.Theirbenchmarkeconomyassumesoneproductionsectorinwhich less productive SOEs enjoy preferential credits while productive POEs do not. Capital

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accumulationbyPOEsreliesontheirownsavings.Asaresult,whenPOEs’capitalstockincreases,theydemandmorelabor,whichforcesSOEstodownsizeduetothecompetitivelabormarket.The capital reallocation from SOEs to POEs leads to an increase in allocative efficiency andthereforetheaggregateTFP.AsshownbyChenandWen(2017),mostof the increase in theshareofprivateemploymentintotalemploymentoccurredbetween1998and2004(from15%to50%)andthissharekeptincreasingbyanother10%between2004and2011.Therefore,theSSZmodeliscrucialinunderstandingTFPgrowthduringthisperiod,whichaccountsforonethirdofGDPgrowth(Tables3and4).TherestofGDPgrowthisaccountedforbyinvestment.Zilibotti(2017)regardsalltheyearsupto2005asanepisodeof“investment-ledgrowth”andproductivitygrowthasaby-productofinvestmentevenintheabsenceofinnovationsortechnicalchanges.The 2009monetary stimulus. During the phase of the investment-driven economy, theglobalfinancialcrisiseruptedin2008.China'sGDPgrowth(atayear-over-yearrate)plummetedfrom13.6%in2007Q2to6.4%in2009Q1. InNovember2008,theStateCouncilannouncedaplantoinjectthe4trillionRMBliquidityintotheeconomyoverthetwo-yearperiodfrom2009Q1to 2010Q4. The plan listed ten areas with real estate as the number one area for massiveinvestment.Asitturnedout,themonetaryinjectionwasfarlargerthan4trillionwithinthefirstthreequartersof2009(Figure1).Therealestateindustrybenefitedthemost.Therealestatepricebouncedbackimmediatelyafterthe2009stimulus(Figure19)andthevalueaddedtotherealestatenotonlybouncedbackbutalsokeptincreasing(Figure18).Overall,GDPgrowthjumpedfrom6.91%in2008Q4to11.59%in2009Q4(Figure3)andaggregateinvestmentgrewbyover20%duringthisperiod(Figure5).Growthinaggregateconsumptiongrowth,however,barelychangedduringthisperiod.Chen,Higgins,Waggonor,andZha(2017)showthatthemonetarystimulus,representedmainlybyaswitchofmonetarypolicyrulefromthenormalstatetoamoreaggressivestate,canexplain85%oftheincreaseinGDPgrowthduringthestimulusperiod.Intheinvestment-driveneconomy,moreover,investmentplayedevenalargerroleinpropellingeconomic growth during and after themonetary stimulus period. Tables 6 and 7 report thegrowthaccountingbybreakingdowntheperiodoftheinvestment-driveneconomyintothreesub-periods: 1998-2008, 2009-2010, and 2011-2015. Across these three sub-periods, thecontributionfrominvestmentincreasedfrom61.3%to75.8%andthento83.0%(Table6)andfrom60.5%to73.9%andthento81.3%(Table7).

Table6.GrowthaccountingaccordingtoLongandHerrera(2016)Growth(%) 1998-2008 2009-2010 2011-2015GDPperworker 8.72 9.2 7.22Duetocapitalintensity

5.35 6.97 5.99

DuetoTFP 3.38 2.23 1.22Contributionbyinvestment

61.3 75.8 83.0

28

Table7.GrowthaccountingaccordingtoBai,Hsieh,andQian(2006)

Growth(%) 1998-2008 2009-2010 2011-2015GDPperworker 8.72 9.2 7.22Duetocapitalintensity

5.27 6.80 5.87

DuetoTFP 3.45 2.40 1.35Contributionbyinvestment

60.5 73.9 81.3

Investmentwasmainlyfinancedbymassivecreditinjectionsengineeredbylooseningmonetarypolicy (Figure 1). Most of the increase in bank loans under the government’s stimulus waschanneledintofixed-assetinvestment,especiallyintherealestateindustryanditssupportingheavyindustries.SuchamonetarystimulusplayedapivotalroleintherecoveryofGDPgrowth,but the asymmetric credit allocation during the golden decade was exacerbated during thestimulusperiod.TheexacerbationcanbeseeninFigure16,astheshareofMLTloansintotalbankloanssprangupduringthestimulusperiod.TheratiooftotalbankloanstoGDPalsosprangupduringthestimulusperiodandkeptincreasingevenafterthestimuluswasover(Figure21).Chen,Higgins,WaggonorandZha(2017)showthatthe2009monetarystimulusproducedanintertemporaltradeoffbetweenshort-runGDPgrowthandlong-runindebtedness.Inasimilarspirit, Zilibotti (2017) argues that China’s stimulus plan delayed innovations and created atradeoffbetweenfastshort-rungrowthandsustainablelong-rungrowth.Bai,HsiehandSong(2016)arguethatanimportantpartoffinancialstimulationwasthroughanestablishmentoflocalgovernmentfinancingvehicles(LGFVs).Althoughlocalgovernmentswerelegallyprohibitedfromborrowingorrunningbudgetdeficits,theycircumventedthebudgetlawsin 2009 and 2010 by creating off-balance-sheet companies, known as LGFVs, to financeinvestmentininfrastructureandothercommercialprojects.AccordingtoObstfeld(2016),LGFVborrowingasapercentofGDPincreasedfrom16.3%in2008to25.09%in2010(anincreaseof8.79 percentage points), but this increase still paled in comparison to an increase of 31.58percentagepointsinprivatesectorborrowingasapercentofGDPduringthesameperiod.Inthisperiod,SOEsalsoplayedalimitedroleinthesoaringinvestmentrateunderthemonetarystimulus.Figure8showsthattheSOEshareofaggregateFAIincreasedmoderatelyduringthestimulusperiodandresumeditsdecliningtrendwhenthestimuluswasover.Thereasonisthatmostfirmsintherealestateindustry,whichisthelargestrecipientofthebankcreditduringthestimulusperiod,arePOEs.The post-stimulus episode (2010-2015). To combat the rising inflation after the 2009massivestimulus,thegovernmentimplementedtighteningmonetary/creditpolicytoslowdowninvestmentintheheavysectorandplaceeconomicgrowthonasustainablepath.GDPgrowthdeclinedfrom11.59%in2009Q4tolessthan7%in2015Q4.Yet,thecontributionofinvestment

29

to GDP growth continued to increase (Tables 5 and 6); Investment in the heavy sector andupstreamindustriescontinuedtoplayamajorrole(Bai,Liu,andYao,2018).AlthoughthevalueaddedtotheheavysectorandupstreamindustriesdeclinedasthesharesofGDPafterthe2009monetarystimulus,thesesharesstillremainedatanunsustainablyhighlevelandbankcreditscontinuedtobechanneledtonotjustupstreamindustriesbuttheheavysectoringeneral.Whilemonetarypolicytightenedafterthe2009stimulus,regulatorypolicyonshadowbankingremained lax,whichgave rise to theboomof shadowbanking that fueled investment in realestate, infrastructure, and other supporting industries with excess capacity. The lack ofcoordinationbetweenmonetaryandregulatorypoliciesgavenon-statebanksastrongincentivetoavailthemselvesoftheregulatoryarbitragetoengageinshadowbankingactivities,especiallyinentrustedlending.AsshowninFigure20,bothoff-balance-sheetfinancingandcorporatebondfinancingincreasedsignificantlysince2009.Consequently,thegapbetweenbankloansandtotalsocialfinancingwidenedduringandafterthemonetarystimulus(Figure21).From2009to2015,entrustedloansbecamethesecondlargestfinancingsourceofloansafterformal(traditional)bankloans.Entrustedlendingisaloanmadefromonenonfinancialfirmtoanothernonfinancialfirm.Itwasfirstfacilitatedbycommercialbanksoffbalancesheetbutthenbroughtontothebalancesheettotakeadvantageoflaxregulatorypolicy.AccordingtoChen,Ren,andZha(forthcoming),over60%ofentrustedloansduringtheperiodfrom2009to2015were funneled to the real estate and its supporting heavy industries. And for the entrustedlending that went to real estate companies, 75.33% of loan volumes were channeled toenterprisesthatarenotstateowned.As shadow banking activities blossomed, so did investments in shadow banking products onbanks' balance sheets such as account-receivable investment (ARI) and investments inNFCs.NFCs include assetmanagement companies and security companies. These companies issueassetstobanks(suchasassetmanagementplans)andusethefundstofinanceinvestmentsinriskyassetsthatwereoftenshadowbankingproducts.AsshowninFigure22,bankcreditstoNFCshavewaxedandwanedwhenmonetarypolicyhastightenedsince2009. In2010-2015,these credits, aswell as the issuance ofmunicipal corporate bonds, “waxed” in response totightenedmonetary policy.15 The effectiveness of tighteningmonetary policy to reduce theinvestmentrate,therefore,washamperedbyotherfinancialpoliciesthatfailedtocoordinatewithmonetarypolicy.Thefailureofcoordinationbetweenmonetarypolicyandotherfinancialpolicieswas a good lesson for researchers and policymakers to understand the limitation ofmonetarypolicy.

15Chen,Liu,andHe(2018)usetheprovince-leveldatatoshowthatprovincesexperiencinganabnormallyfastgrowthrateofbankloansin2009alsohadfastgrowthofmunicipalcorporatebondissuancesduring2012-2015.

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Figure20.Nonbankfinancingtoinvestment.Off-balance-sheetfinancingisthesumofentrustedloans,trustloans,andbankacceptances.Source:CEICandauthors'calculation.

Xiong(2018)developsatheoreticalgrowthmodelfeaturinglocalgovernmentGDPtournamentstohighlightanotherpotentialsourcefortherisingshadowbankingindustryduringthisperiod:theagencyfrictionsbetweenthecentralandlocalgovernmentsduetotheinabilityofthecentralgovernmenttodistinguishagovernor’sadministrationabilityfrominfrastructureinvestmentinthegovernor’sprovince.Consequently,thegovernorfacesatradeoffbetweendebtandcareer.Toadvancehis/herpersonalcareer,thegovernortakesonmoredebtstofinanceinfrastructureinvestmentwithanadvantageousgrowthrateofregionalproductivity.Butthegovernorhastofacethehighcostofpayingthedebtsnextperiod.Thismodelimpliesthatthegovernor’scareerdevelopment can lead to an overleverage of the local government and a booming shadowbankingindustry.

Newly increased financing (RMB bn)

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Figure21.RatiosoftotalsocialfinancingandbankloanstoGDP.Totalsocialfinancingiscalculatedasthesumofbankloans,entrustedloans,trustedloansandbankacceptances.Data

source:CEICandauthors’calculation.

Inthepost-stimulusperiod,therealestateoverstockproblempersistedinsmall-andmedium-sized cities. To reduce the overstock of real estate, credit policy formortgage financingwasloosened in 2014Q4-2016Q3, which created a boom of mortgage loans and an increasingconcentrationofbankloanstotherealestate(Figure23).Theconcentrationinrecentyearshasfurtherraisedsystemicriskstothefinancialsystem.Insummary,themassivecreditexpansionduringboththestimulusandpost-stimulusepisodeshasledtorapidgrowthofthedebtburdenasapercentofGDPaswellasawideninggapbetweentotal social financing and aggregate bank loans. Both the rapid growth of shadow bankingproductsandtheincreasingconcentrationofbankloansontherealestateindustryhaveraisedsystemicriskstothefinancialsystem.Forshadowbankingproducts,systemicrisksareassociatedwith default risks to real estate companies and LGFVs.16 For bank loans, systemic risks areassociatedwithdefaultriskstothehouseholdsectorifthehousingmarketcollapses.

16 Bai and Zhou (2018) find that the municipal corporate bond yields across provinces arenegativelyinfluencedbythevalueaddedtorealestate(asashareofprovincialGDP).

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Thenewnormaleconomy(2016-present)

Asthedebt-to-GDPratioroserapidlyinthelatterpartoftheinvestment-driveneconomyandhascontinuedtoriseinthenewnormaleconomy,thetensionbetweenrobustGDPgrowthandthe financial stability hasbegun tobuildup.As a result, financial policies in thenewnormaleconomyarefeaturedbystrengthenedregulationsonshadowbankingproductsandabettercoordinationbetweenmonetaryandregulatorypoliciesundertheMPAsystem.Inthisphase,twodeleveragingprocesseshavebegun:financialdeleveragingtoguidebankstoreduceshadowbankingloans(e.g.,bankcreditstoNFCs)andfirmdeleveragingtoreducecorporatedebts(e.g.,ceasingtherolloverofcorporatedebts).AsonecanseefromFigure22,bothNFCcreditsandM2supplyhavedeclinedintandemsince2016.17Themacroeconomicimpactsofthefinancialandrealdeleveragingprocessesinthenewnormaleconomyneedtimetoassess.Earlyevidenceindicatesthatinvestmentinbothrealestateandinfrastructure,thetwoindustriesthatwerethelargestbeneficiariesoftherisingshadowbanking,hasrecentlyloststeam.Variousregulationsonshadowbankingactivitiessince2017hasforcedreal estate developers to deleverage. The housingmarket and construction investment havebeguntocooldown.In2018Q1,thepremiumrateinthelandauctionmarketwasonly10%,farbelowthelevelof30%during2015-2017.Infrastructureinvestmenthasalsosloweddownsincelastyearduetoaseriesofregulationstorectifylocalgovernmentfinancingguarantees.18Theyear-over-yeargrowthrateofinfrastructureinvestmenthasfallensincethesecondquarterof2017to7.3%inthefirsthalfof2018.Oneunintendedconsequenceofdeleveraging is thatPOEs,especially thesmallandmedium-sizedones,havehadevenahardertimetogainaccesstobankfinancing.Duringthedeleveragingprocesses,thetighteningofregulationsontheshadowbankingindustryhasledtodefaultsofunprofitablePOEs,creatingatradeoffbetweencleansingeffectsandsystemicrisksasborrowingcostsforhealthyPOEshavealsoincreased.Themountingdefaultrisks,togetherwithincreasingdepositshortfallsunderthefinancialdeleveraging,havemadebanksmorereluctanttolendtoPOEs,includingthehealthyones.19Since2016,investmentgrowthinthemanufacturingindustryhasbeencontinuouslybelowGDPgrowth. AndasGDPgrowthcontinues to slowdown, thetensionbetweenGDPgrowthandfinancialstabilitychallengesthegovernment’sdeterminationforfurtherdeleveraging.17While the recent cooperation betweenmonetary and regulatory policies improved banks’balance-sheet standing, off-balance-sheet activities and corporate debts continued to be aserious problem. In 2017, trust loans (a major part of off-balance-sheet banking) soared inresponsetotheshrinkingactivitiesofon-balance-sheetinvestments(Figure20).18Forexample,PBC,MinistryofFinance,andfourothergovernmentagenciesissuedaNoticeonFurtherRegulatingLocalGovernment'sDebtFinancingBehaviorinMay2017forthepurposeofrectifyinglocalgovernment’sfinancingguarantees.19Asimilarsituationoccurredinthecorporatebondmarket,asimpliedbytheincreasingcreditspread.

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Figure22.GrowthratesofbankcreditstoNFCsandM2supply.Datasource:CEICandauthors'

calculation.

AdeeperconcernisthelimitedimpactofdeleveragingonSOEsinupstreamindustries,whichhave continued to receive preferential credits and remain unproductive and monopolistic.Implicitguaranteesbylocalgovernmentstosuchzombiefirmsmakedifficultthedeleveragingofcorporatedebts.Figure24showsthatinrecentyears,theshareofnewlyissuedbankloanstoSOEshasincreasedrapidly,whiletheshareofbankloanstoPOEshasdeclined.TodealwiththisasymmetrybetweenthetreatmentsofSOEsandPOEs,thegovernmentintroducedreformsin2016toreducetheproductionofupstreamindustriesintheheavysectorthroughadministrativemeans.TheproductionreductionresultedinanincreaseofPPIintheupstreamfirmswhiletheseunproductiveandmonopolisticfirmscontinuedtoreceivepreferentialcredits.TheincreaseofPPIinturnraisedthecoststodownstreamindustries,mostofwhichbelongtothelightsector.Itwouldinevitablyexacerbatethecreditandresourcemisallocations,puttingfurtherdownwardpressuresoneconomicgrowth.As investmentgrowthinthelightsectorhasslowedinrecentyears,GDPgrowthhasalsoslowedwhiletheinvestment-to-GDPratiohasremainedpersistentlyhigh,over42%asshowninFigure14.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

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Figure23.Loanconcentration:theshareofbankloanstotherealestateintotalbankloans.

Datasource:CEICandauthors'calculation.

IV. Conclusion

Theprecedingsectionsprovideanoverviewofhowregimeshiftsinthegovernment’sfinancialpoliciesinfluencedthewayspreferentialcreditswereallocatedtoSOEsandtheheavysector.Theanalysishighlightstheroleofthegovernmentinthestructuralchangesoftheeconomy.TheregimeswitchingfromtheSOE-ledeconomytotheinvestment-driveneconomyandthentothenewnormaleconomyhasbeenaproductofchangesinthegovernment’sactivefinancialpolicies.Policytoolssince2016havebeenadaptedtoassistatransitiontothenewnormaleconomy.Atthebeginningof2016, thegovernment incorporated theMPASystem toensureaneffectivecoordination between monetary and other financial policies. Other unifying rules on assetmanagementacrossdifferentfinancialsectors(formalbankingandshadowbanking)havebeendeveloped.Monetarypolicyhasbeguntoexperiencearegimechangeaswell:atransitionfromthe quantity based framework to an interest-rate based framework. 20 In addition to theconventional policy tools, the government has applied many unconventional tools such as

20SeeMaandGuan(2018)foradetailedassessmentofthetransmissionmechanismandtheeffectivenessofthereformsontheinterestrateliberalizationandLiu,Spiegel,andZhang(2018)foratheoreticalanalysis.

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StandardLendingFacility(SLF),Medium-termLendingFacility(MLF),andPledgedSupplementaryLending(PSL)toassistthistransition.

Figure24.TheshareofnewlyissuedbankloanstoSOEsandPOEsintotalnewlyissuedbank

loans.Datasource:CEICandauthors'calculation.Suchatransition,however,willnotbesmoothunderChina’sinstitutionalconstraints.TheGDPgrowth target still remains the foremost goal of monetary policy. According to the centralgovernment'sThirteenthFive-YearPlan(2016-2020),theGDPgrowthtargetasalowerboundwill continue for the next five years. High GDP growth vigorously pursued by the centralgovernmentastheoverridingpolicygoalputsasevereconstraintonhowthePBCtoconductitsmonetarypolicyandonhowtightregulatorypolicyshouldbe.AslongastheGDPgrowthtargetisinforce,monetaryandcreditpolicies,withimplicitgovernmentguaranteestoSOEsintheSOE-ledeconomyand to theheavy sector in the investment-driveneconomy,will remain tobeauseful guidance for how to allocate bank credits to different firms, industries, or sectors.Therefore,weconcludethattheheavyhandofgovernmentininfluencinghowcommercialbanksallocatetheirloanswillcontinue,makingM2growthaneffectivetoolformonetarypolicynotonlyinthepastbutalsointhenearfuture.

36

Thenewnormaleconomyismarkedbyotherchallengesaswell. Financialmarketsareinthedevelopment stage and still suffer from market frictions such as deposit rate ceilings andilliquidity in bond markets. Coordination between monetary and regulatory policies shouldcontinuetoimprove.Theeffectsonthemacroeconomyofaregimeswitchinmonetarypolicytoan interest ratebased frameworkareunknownanddifficult tomeasureat thispoint. Nor isknown about how effective is the monetary transmission from the policy rate to interbankinterestratesandeventuallytobanklendingrates.Insum,Chinawillfacenewchallengestoitsreformsonfinancialpoliciesanditspolicyimpactsonthenewnormaleconomy.

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