Wednesday, December 29, 2004

A reporter friend asked me to give a brief outline of the RMB, or the Chinese yuan. Below are my quick response.

The RMB played a peripheral role during the 50s through the 70s mainly as a way to control the supply and demand of non-essential luxury goods. All of the essential goods like food and building material were allocated through the plan, and, as you pointed out, through the coupon system. Cash income in those days was used by residents to buy luxury items like bicycles and radios. After the great leap forward, cash circulation was severely curtailed so that industrial capacity could scale back and focus on the essential. As I mentioned in my chapter, cash was also used by firms to fill unexpected gaps in the annual budget. In theory, all the working capital and investment costs were supplied by the state through the state plan, but firms sometimes needed a bank loan to fulfill unexpected costs.

What happened in the late 70s and early 80s was that the household responsibility system gave peasants much more cash than before, and Deng also raised the urban wage scale substantially. This provided a great boost in cash in the economy,which allowed much more non-state spending and investment. One can say that the large boost in cash in the early 80s was the seed of private sector development in China. Since the state can't control cash once it is circulating, people can take this cash to invest in new firms...etc. These new firms then competed with the SOEs, which created SOE losses but also a vibrant private sector in the 90s.

The amazing thing is that the state continued to print more and more cash over time to pay for SOE losses. While dumping money on loss-making SOEs is bad, increasing cash circulation and financial assets allowed the rest of the economy to finance new investment. This use of money is not the most economically efficient, but new research shows that just by having more money in a non-inflationary environment is in itself enough to generate growth.

The other unique thing that China did was that it maintained a successful capital control regime throughout the reform. The key to this success was that the Chinese government kept foreign exchange spending low and thus foreign debt low. In some Latin American countries, elites competed with each other to borrow as much foreign currency as possible, causing a complete collapse of the fixed exchange rate. So, unlike some developing countries in Latin America and Africa, China was able to maintain capital control with relatively low cost and did not face the financial volatility faced by Latin America. Granted, there were a few close calls (1988 and 1994), but China weathered them.

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