How China Applies the Principle of Modern Monetary Theory in Its Economic Structure - Tianyu Chen '24
In 2010, the People’s Republic of China (PRC) became the world’s second largest economy. In the past seven decades, China experienced a huge economic boost and eliminated extreme poverty. This paper attempts to examine its economic resurgence and identify the crucial economic policies that resulted in its success. It will argue that China uses Modern Monetary Theory (MMT) in its economic framework to achieve its fiscal goal. Since 2014, in order to alleviate the investor’s concern, China hides its national debt behind the local government debt, but in fact, the central bank pays for all of it, injecting the money into the private sector without causing any inflation. China’s economic achievements prove the applicability of the Modern Monetary Theory framework. In the future, it could and should keep accumulating its government debt and fund the domestic economy to deal with unemployment.
Modern Monetary Theory (MMT) is an unorthodox macroeconomic framework that offers both a descriptive model of fiat currency operation and a prescriptive approach to domestic economic funding. On the descriptive side, MMT points out that policy makers overemphasize the significance of the government debt. A government that does not execute a currency peg policy can have full monetary sovereignty to operate as a currency issuer instead of a currency user, so that it can always clear the national debt by printing money. There should be no worries about the government’s solvency, as the deficit on the central bank’s balance sheets is just numbers. Moreover, government spending should not be limited by the national debt, as long as it does not cause inflation. On the prescriptive side, MMT suggests that the government should invest in the society: it should offer more job opportunities, increase the domestic demand and stimulate the economy through enlarging the scale of government spending, since the government can always pay. Therefore, the previous (TAB)S model (“Tax, Borrow, and then Spend”) of government 1 spending should be replaced by the S(TAB) model (“first Spend, then Tax and Borrow”) to better support the domestic economy.
The Evolving Monetary Policy from 1949 to 1999
Since the PRC was established, the Chinese central bank has played the role of funding the government project by money creation, which laid a solid background for the MMT framework. It was widely acknowledged that China changed its major monetary policy three times in the past 70 years.1 There was a planned economic regime from 1949-1977, a fiscal dominance regime from 1977 to 1993, and a monetary dominance regime from 1994 till now2.
In 1949, under the guideline of communism, Mao’s government created a highly centralized system, and distributed the resources through a strict planned economy regime. All the enterprises were state-monopolized and there were no individual property rights defined. The local government collected all the fiscal revenue and gave it to the central government, the only agent to direct the government fund and devise the future provision. By that time, the central bank served as both a central bank and a commercial bank, issuing the currency and clearing the payments for state-owned enterprises (SOEs).3 This “all inclusive mono-bank system” has a similar characteristic to MMT–it issued money according to the contemporary monetary policy, and was subordinated to the economic plan made by the central government.4 The strict monetary system (keeping majority of money in credit instead of cash), eliminated other money bearing tools like interest rate. Hence, the central bank holds full power over the money supply, as it only offers loans to SOEs with real goods5, which eliminates the potential inflation. However, this MMT framework is nothing if not aimed to create a better life for people. Without a free market, people lacked incentive to produce goods and services. An economic reform became urgent to incentivize people and save the lagging economy.
In 1978, led by Deng Xiaoping, China shifted to a decentralized, market-oriented economic system.6 It expanded the fiscal power of the local government and SOEs, allowing them to decide its future plan and individualize the policies in response to the market, rather than solely follow the instruction from the central government.7 The open-door policy allows the foreign capital to flow in, bringing new demand and technology to promote economic growth.8 Most importantly, the central bank was split into two: its responsibility of the central bank was specialized, and its commercial bank business was taken over by the state-owned commercial banks such as Agricultural Bank of China (which it still does today).9
However, after the economic boost slowed down, China faced the problem of inflation. On the one hand, the central bank overuses its monetary sovereignty to heat up the economy. In 1984, the net issuance of RenMinbi (RMB) was 26.2 billion yuan, which was larger than its total amount throughout the whole planned economic regime.10 In the 1980s, all the government projects were centered at local industrialization and agriculture for export, instead of small consumer goods.11 As a result, China did not develop enough light industry to meet the domestic demand. The central bank must keep printing money to prevent the decline in the industrial products12, but the price of electronic utilities (TV, radio) is still not affordable for normal people.
On the other hand, commercial banks issued a lot of bad loans without regulations, whereas they also borrowed unlimitedly from the central banks, as in Table 1. (Table 1. Growth rate of Loans in Percent in China, 1982-1988. People’s Bank of China.)13
In the past days of the planned economy, offering loans to SOEs was regarded as a major way to redistribute public funds.14 This special view of loans with Chinese characteristics heavily impacted the assessment of SOEs’ liability from the state-owned bank–the main financial institution in China. Both supported by the government, the commercial bank was always willing to lend to the SOEs with little collateral, while the central bank also kept funding the commercial banks with little collateral.15 As shown in Figure 1, China encountered two inflation peaks from 1984 to 1994. The central bank overlooked the potential inflation brought by the increased spending, which should be the most crucial indicator in the MMT model. The government projects in 80s transferred money into the society, but failed to raise the productivity of light industry in response to the domestic demand, which created the classic economic scenario of inflation: “more money chasing fewer goods”. (Figure 1. China Inflation Rate in Percent, 1986-2023. National Bureau of Statistics of China.)16
Following the inflation, the Chinese government set up the structural reform of SOEs. Since then, China pegged its currency to the U.S dollars at a ratio of 8.28:1 until 2005. To some extent, it weakened the monetary sovereignty of China as a country, but it also stopped the central bank from unlimited spending. It was not equivalent to fully giving up its monetary sovereignty. Rather than directly transform the U.S dollar into RMB, the central bank of China leaves space to maneuver the money supply besides accumulating massive foreign reserves, which will be further discussed in the next section. In fact, Premier Zhu Rongji’s government report in 1999 clearly suggested that the Chinese government had full control over the issuance of RMB: “When many neighboring countries devalued their currencies by a large margin (during the Asian financial crisis), we weighed the pros and cons and decided not to depreciate the Renminbi. …The state increased the national debt by 100 billion yuan last year…yet the volume of currency issued during the year was still some 50 billion yuan less than the target figure set at the beginning of the year… Both retail prices and consumer prices dropped compared with those in the previous year. Under normal circumstances, increasing the deficit to spend more on development would bring about inflation. However, under current special conditions, there is little possibility of such a danger.”17 According to MMT, in “normal circumstances”, the society operates at maximum production capacity. Under these conditions, any increased spending can trigger inflation because there are no additional goods available in the market to match the surplus currency in circulation. However, if prices remain stable despite increased spending, it means that there is enough fiscal space for the government to encourage people to produce more. Zhu applied this theory to absorb the non-performing loans, and propose infrastructure development from agriculture to transportation, water conservation to public facilities by government financing. His re-employment project, financed by the government, worked together with enterprise and unemployment insurance funds to reimburse the living costs for people who were laid off in the textile sector from 1997 to 1998.18 Zhu was correct; high government expenditures did not lead to inflation over this period, as shown in Figure 1. Under his leadership, China pivoted to the diversified industry from the SOEs, aiming to better supply the domestic demand. Shown in Figure 2., since then, China has strided on the path of growing national deficit to support the economy. (Figure 2. General Government Gross Debt to GDP in Percentage, 1996-2023. IMF.)19
The Monetary Policy in 21th century China
Since China pegging the RMB to U.S dollars in 1994, China seems to diverge from the principles of MMT by relinquishing some aspects of its monetary sovereignty. However, evidence shows that pegging to dollars does not weaken China’s liabilities. It still controls its money issuance and keeps accumulating the national debt to stimulate the economy. In the other words, China still sees itself as a currency issuer. Its central bank creates a buffer before transforming the foreign reserve to the domestic currency, which is different from the orthodox theory.
The orthodox monetary model, or the Mundell–Fleming model, usually simulates a small economy with restricted capital flow. It argues that if a country pegs its currency with one or more other countries, its foreign reserves would directly transform into the combination of Money in Circulation (M0) and the bank reserve balance, which can harm its indepence of the monetary policy. If the government allows the foreign capital flow, currency arbitrage can easily happen when the interest rate fluctuates, which is called the “Mundell Trilemma”.20
However, shown in Figure 3. and 4. (see below), there is no perceived relationship between the foreign exchange reserves to the Money in Circulation (M0) in China. Hence, it is widely argued that the Chinese central bank applies the compensation thesis instead, transforming the fluctuation in foreign reserves onto its balance sheet to keep its monetary sovereignty and control the interest rate.21 Table 2, the balance sheet of People’s Bank of China (PBoC), reveals how Chinese government financing works. It has more monetary power to manage its total assets, which constitutes the basis of MMT. (Figure 3. China’s Foreign exchange reserve in Billion, 1981-2023. People Bank of China.)22 (Figure 4. M0 in China in US Dollar Million, 1981-2023. People’s Bank of China.)23
(Table 2. Balance sheet of People’s Bank of China (PBoC), 1999, 2007 and 2010.)24
Different from what the Mundell–Fleming model suggests, the compensation thesis believes that the central bank can maintain the independence of a pegged currency from the foreign currency market from the foreign market by maneuvering its balance sheet, which offers the central bank the flexibility to achieve its monetary policy target.25 China has accumulated massive foreign reserves to practice this compensation thesis. People’s Bank of China (PBoC) lends out a substantial amount to local governments, banks and other financial institutions and increasingly issues bonds. PBoC’s assets not only consist of foreign reserves; it holds at least 3 tools to increase its assets: decrease the claims on commercial banks, increase the government deposits in the central bank, and issue bonds, but the PBoC could freely choose whether to do so.26 For instance, the legal requirement of the ratio of required reserve (RRR) in China forces commercial banks to borrow from the central bank, or other commercial banks by the end of the quarter to keep rolling, as an interest-rate managing tool since the 1980s.27 The claim from PBoC to these local commercial banks is set up to fund their day-to-day business. “Some of these advances [claims] are linked to the bailout of non-performing loans made by state-owned banks in the 1990s and are unlikely to be retrieved.”28 Likewise, the central bank transforms the deprecation in foreign reserves onto the balance sheet, implying that the foreign reserve isn’t crucial to the currency, but a tool for risk management.29 In brief, China does not lose its monetary sovereignty, but seeks to fund the society in a more implicit way. (Figure 5. China Government Spending, 1991-2023. People’s Bank of China.)30
How so? On the fiscal side, China has increased its government spending since 1991. In 2009, there was about 12 trillion RMB of household savings in China, which raised economists’ concern of excessive liquidity. The orthodox theory views money in circulation and deposit as liquidity. Having excessive liquidity usually signals too much money supply and potential inflation.31 However, this did not happen in 2009 in China. Due to the 2008 financial crisis, Chinese people preferred to increase their liquidity, while their government offered them local government projects as a safe investment option. The Chinese government allows its citizens to inject capital to the local government projects including infrastructure and university construction, as a conservative investment combination. Even though these projects have a high default rate, people hold trust in the government to finally step in and clear the bad loans. Until now, “bad loans by banks have not had bad consequences.”32 The allowance of private investment in the government project creates the interest-bearing RMB, which would only benefit the people.
The Current MMT Approach in China
In recent years, the Chinese local government has transitioned from the traditional (TAB)S model (“Tax, Borrow, and then Spend”) to the S(TAB) model (“first Spend, then Tax and Borrow”), resulting in a substantial increase in government debt. Moreover, China obscures its national debt behind the local government debt to alleviate the investors’ concern, while both of it would finally be paid by the central bank. Following the principles of MMT, this should not raise alarm as long as 1) China can perpetually print RMB to alleviate its debt burden, 2) currency issuance does not trigger inflation, and 3) there is still fiscal space in China to be realized, such as decreasing the unemployment rate.
In 1994, China centralized its fiscal system. It allowed the central government to mandate the local government to reach the GDP growth target, which seemed to transform the fiscal burden to the latter. Article 28 of the 1994 Budget Law claimed that, “local budgets…shall not contain deficits. Except for where provided by law or State Council regulation, local governments shall not issue local government bonds.”33 The local government found the funds from the central government funds were either delayed or insufficient, since all the provinces joined the so-called “competitive development”, trying to attract as much capital and good jobs as possible34. Hence, the local officials created local government financial vehicles (LGFVs) to finance the government project and reach the target growth,35 which was a prototype for the subsequent accumulation of high local government debt.
Twenty years after, in 2014, China amended the budget law to grant the local government power to issue bonds36, and prohibited LGFVs on paper, which essentially changed the fiscal dynamic. In 2016, China’s Ministry of Finance updated the local debt policy through The Measures for the Budget Management of General Debt of Local Governments. It notes that, “general debt revenue and expenditure are mainly repaid with general public budget revenue; special debt revenue and expenditure are mainly repaid through special revenue generated from government fund revenue and project income.”37 For both the provincial government and the city and county-level government, their “debt income and arranged expenditures transferred from higher-level governments should be included in the budget adjustment plan.”38 In the other words, the Chinese central bank is in charge of all of these deficits by incorporating them into the “general budget”, and it will finally clear these debts as a whole through local government bonds.
These local bonds are created for supporting the infrastructure program, but they are not paid by the local tax revenue, but by the central bank. After the amendment of the budget law, the local government not only utilizes LGFVs, but also issues bonds to meet that goal, with no further consideration for default. In the 2022 government report, the central government issued 2.8 trillion yuan to fund the local government and issued a total 3.65 trillion yuan of special-purpose bonds for local governments.39 As Table 3. shown below, more local governments were allowed to carry outstanding debt in 2022 than in 2017. For example, Guizhou province has 60 billion RMB monthly debt payment in 2022, which is several times more than its own tax revenue.40
The local bonds are not always going to support the infrastructure construction as the Chinese government claims, but also become a way to hide China’s implicit national debt. For instance, Zhejiang, with “a dynamic, technology-driven economy”, increased its debt from 31% to 61% of provincial GDP in 5 years, while it is a well-developed area which “presumably did not need infrastructure investment to generate growth.” One could reasonably argue that Zhejiang subsidizes the deficit in other areas based on its own economic advantages.
Nonetheless, there is no evidence that China is under the serious burden of a high government debt. That’s because the state-owned commercial banks, who do not care about the default, always buy these bonds back. According to the China Ministry of Finance, by 2023 November, commercial banks hold 82.17% of total local government bonds, amounting to 33,231.753 billion yuan.42 The central bank behind the state-owned commercial banks will buy the bonds when needed and be responsible for the future payment, while default does not have any impact on these commercial banks. All the evidence shows that China fully controls its national debt, and is still able to increase its government spending to pump in more money to fund the private sector, which in fact, is a successful MMT approach to grow its domestic economy.
Unfortunately, the increase of government spending does not lower the overall unemployment rate in China, which floated at 4% from 2002 to 2018, and has not yet dropped below 5% after covid.43 Liu has argued that the problem of “excessive saving” in 2009 is “rather, depressed domestic consumption.”44 The MMT model has been proven to be successful in China, which allows more investment to the society to improve welfare for its citizens. The next-step goal for the Chinese government should be creating more job opportunities for its vast population and bolster local demand. China has already initiated efforts toward this goal: look at the Belt and Road Initiative. The Chinese government invests in infrastructure construction in foreign countries and engages Chinese companies for these projects. Chinese workers employed overseas subsequently send their earnings back to China, thereby boosting local demand and stimulating the economy.45 As of 2024, there has been no significant inflation in the RMB, indicating that China can continue to increase its debt to maximize production capacity and address its unemployment challenges in the coming years.
Conclusion
During the gradual reformation of the decentralized government system in the past 70 years, the Chinese government applied Modern Monetary Theory in its economic policy. The analysis shows that its central bank has enough money-issuing power to accomplish its econmoic goal. China maintains its own monetary sovereignty, and stimulates the economy by running the government deficit. In response to investors’ concern, China hides its increasing government deficit on the balance sheet behind the local government debt, but that deficit does not harm the economy. As this MMT approach does not create inflation in RMB, China should work on improving its people’s welfare, and keep spending on government-funded projects until achieving the goal of full employment.
Bibliography
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Li, Keqiang. “Report on the Work of The Government.” The Fifth Session of the 13th National People’s Congress of the People’s Republic of China. Delivered on March 5, 2022. Li, Lili, Hanyu Tan, and Hongmei Zhang. “Government finance and money creation in China: An MMT perspective.” The Chinese Economy 53.4 (2020): 329-341. Liu, Xinhua, and L. Randall Wray. “Excessive liquidity and bank lending in China: A modern money perspective.” International Journal of Political Economy 39.3 (2010): 45-63. Lu, Di. “China’s local government credit dilemma.” November 03, 2023, East Asian Forum. Accessed March 26, 2024. https://doi.org/10.59425/eabc.1699005655 16 Marten, Finn. Ehnts, Dirk H. “Chinese monetary policy–from theory to practice.” In: Halberstadt, J., Jakob, C., Schuricht, M. “Jenseits des Elfenbeinturms”, Josef Eul Verlag GmbH, Lohmar (2013): 137-160. Mills, Rick. “China will be poster child for developing countries MMT.” Intelligence China (2022). Mining.com. Accessed March 26, 2024. https://www.mining.com/web/china-will-be-poster-child-for-developing-countries-mmt/ Ministry of Finance of the People’s Republic of China. “Local Government Bond Market Report for November 2023 (Difang Zhengfu Zhaiquan Shichang Baogao).” Government Debt Research and Evaluation Center, 2024. Accessed April 3rd, 2024. http://kjhx.mof.gov.cn/yjbg/202401/t20240112_3925768.htm Ministry of Finance of the People's Republic of China. “The Person in Charge of the Ministry of Finance Answered Reporters’ Questions on the Issuance of Budget Management Measures for Local Government General Debt and Special Debt (Cai Zheng Bu You guan Fu Ze Ren Jiu Yinfa DiFang Zhengfu Yiban Zhaiwu He Zhuanxiang Zhaiwu Yusuan Guanli Banfa Da Jizhe Wen).” The People’s Republic of China, 2016. Accessed April 24th, 2024. https://www.gov.cn/zhengce/2016-12/01/content_5140834.htm Ministry of Finance of the People's Republic of China. “Measures for the Budget Management of General Debt of Local Governments (DiFang Zhengfu Yiban Zhaiwu Yusuan Guanli Banfa).” The People’s Republic of China. 2016. Accessed April 24th, 2024. https://www.gov.cn/gongbao/content/2017/content_5208218.htm Sheel, Alok. “Modern Monetary Theory, Deglobalisation and the Dollar.” Economic & Political Weekly, March 6, 2021, NA. Gale Academic OneFile. Accessed March 26, 2024. https://link.gale.com/apps/doc/A656879530/AONE?u=nysl_se_millbrk&sid=bookmark-AO NE&xid=b5c765ef. Shih, Victor. Elkobi, Jonathan. “Local Government Debt Dynamics in China: An Exploration Through the Lens of Local Government Debt and LGFV Debt.” 21st century China Center (2023). UC San Diego, School of Global Policy and Strategy. Standing Committee of the National People's Congress. “Budget Law of the People's Republic of China (2018 Amendment).” Order No.22 of the President of the People's Republic of China (2018). Tang, Frank. “'no free lunch' as U.S. prints trillions; Ex-central banker warns blind faith in modern monetary theory will lead to more inflation, asset bubbles, and is one of 6 main issues facing China.” South China Morning Post [Hong Kong], (2021) 9. Gale General OneFile. Accessed March 26, 2024. https://link.gale.com/apps/doc/A676183128/ITOF?u=nysl_se_millbrk&sid=bookmark-ITOF &xid=3d540edb. Trading Economics. “China’s Foreign Exchange Reserve from 1981 to 2023.” People Bank of China. Accessed April 3rd, 2024. 17 Trading Economics. “China Inflation Rate from 1986 to 2023.” National Bureau of Statistics of China. Accessed April 3rd, 2024. Trading Economics. “China Government Spending from 1991 to 2023.” National Bureau of Statistics of China. Accessed April 15th, 2024. Trading Economics. “China unemployment rate from 2002 to 2023.” National Bureau of Statistics of China. Accessed April 15th, 2024 Trading Economics. “General government gross debt to GDP from 1996 to 2023.” IMF. Accessed April 3rd, 2024. Trading Economics. “M0 in China from 1986 to 2023.” People Bank of China. Accessed April 3rd, 2024. Wray, L. Randall, and Yolanda Fernandez-Lommen. “Monetary and Fiscal Operations in the People’s Republic of China: An Alternative View of the Options Available.” Asian Development Bank Economics Working Paper Series 380 (2013). Yan, Jun, et al. “Complexity theory for the modern Chinese economy from an information entropy perspective: Modeling of economic efficiency and growth potential.” Plos one 15.1 (2020): e0227206. Yang, Zhiyong. “China’s Fiscal Policy in the Past Seven Decades: Characteristics, Experience and Prospects.” China Finance and Economic Review 8.4 (2019): 29-48. Yeung, Raymond. “Could China Turn to MMT?” Greater China, ANZ (2020). Accessed March 26, 2024. https://institutional.anz.com/insight-and-research/May-20/could-china-turn-to-mmt Yi, Gang. “The Money Supply Mechanism and Monetary Policy in China.” Journal of Asian Economics 3.2 (1992): 217-238. Yunqi, Li. “Changes in China's monetary policy.” Asian Survey 31.5 (1991): 422-433. Zhong, Ying. “China’s Solution and Experience in the Comprehensive Implementation of Supply-Side Structural Reform.” Frontiers of Economics in China 18.3 (2023): 391. Zhu, Rongji. “1999: Premier Zhu's Government Work Report.” Delivered on March 6, 1999. Accessed April 3rd, 2024. 18 AI Statement In the first stage, ChatGPT has been used to gather 20 facts related to the topic of this essay, providing me with a foundational understanding of MMT, which I incorporated certain definitions into the introduction. In the final edit, I used Chat Gpt to correct my word choice and reword some analytical sentences. Otherwise, all the resources are collected by me, and all the arguments are made by me. 19
Back
Modern Monetary Theory (MMT) is an unorthodox macroeconomic framework that offers both a descriptive model of fiat currency operation and a prescriptive approach to domestic economic funding. On the descriptive side, MMT points out that policy makers overemphasize the significance of the government debt. A government that does not execute a currency peg policy can have full monetary sovereignty to operate as a currency issuer instead of a currency user, so that it can always clear the national debt by printing money. There should be no worries about the government’s solvency, as the deficit on the central bank’s balance sheets is just numbers. Moreover, government spending should not be limited by the national debt, as long as it does not cause inflation. On the prescriptive side, MMT suggests that the government should invest in the society: it should offer more job opportunities, increase the domestic demand and stimulate the economy through enlarging the scale of government spending, since the government can always pay. Therefore, the previous (TAB)S model (“Tax, Borrow, and then Spend”) of government 1 spending should be replaced by the S(TAB) model (“first Spend, then Tax and Borrow”) to better support the domestic economy.
The Evolving Monetary Policy from 1949 to 1999
Since the PRC was established, the Chinese central bank has played the role of funding the government project by money creation, which laid a solid background for the MMT framework. It was widely acknowledged that China changed its major monetary policy three times in the past 70 years.1 There was a planned economic regime from 1949-1977, a fiscal dominance regime from 1977 to 1993, and a monetary dominance regime from 1994 till now2.
In 1949, under the guideline of communism, Mao’s government created a highly centralized system, and distributed the resources through a strict planned economy regime. All the enterprises were state-monopolized and there were no individual property rights defined. The local government collected all the fiscal revenue and gave it to the central government, the only agent to direct the government fund and devise the future provision. By that time, the central bank served as both a central bank and a commercial bank, issuing the currency and clearing the payments for state-owned enterprises (SOEs).3 This “all inclusive mono-bank system” has a similar characteristic to MMT–it issued money according to the contemporary monetary policy, and was subordinated to the economic plan made by the central government.4 The strict monetary system (keeping majority of money in credit instead of cash), eliminated other money bearing tools like interest rate. Hence, the central bank holds full power over the money supply, as it only offers loans to SOEs with real goods5, which eliminates the potential inflation. However, this MMT framework is nothing if not aimed to create a better life for people. Without a free market, people lacked incentive to produce goods and services. An economic reform became urgent to incentivize people and save the lagging economy.
In 1978, led by Deng Xiaoping, China shifted to a decentralized, market-oriented economic system.6 It expanded the fiscal power of the local government and SOEs, allowing them to decide its future plan and individualize the policies in response to the market, rather than solely follow the instruction from the central government.7 The open-door policy allows the foreign capital to flow in, bringing new demand and technology to promote economic growth.8 Most importantly, the central bank was split into two: its responsibility of the central bank was specialized, and its commercial bank business was taken over by the state-owned commercial banks such as Agricultural Bank of China (which it still does today).9
However, after the economic boost slowed down, China faced the problem of inflation. On the one hand, the central bank overuses its monetary sovereignty to heat up the economy. In 1984, the net issuance of RenMinbi (RMB) was 26.2 billion yuan, which was larger than its total amount throughout the whole planned economic regime.10 In the 1980s, all the government projects were centered at local industrialization and agriculture for export, instead of small consumer goods.11 As a result, China did not develop enough light industry to meet the domestic demand. The central bank must keep printing money to prevent the decline in the industrial products12, but the price of electronic utilities (TV, radio) is still not affordable for normal people.
On the other hand, commercial banks issued a lot of bad loans without regulations, whereas they also borrowed unlimitedly from the central banks, as in Table 1. (Table 1. Growth rate of Loans in Percent in China, 1982-1988. People’s Bank of China.)13
In the past days of the planned economy, offering loans to SOEs was regarded as a major way to redistribute public funds.14 This special view of loans with Chinese characteristics heavily impacted the assessment of SOEs’ liability from the state-owned bank–the main financial institution in China. Both supported by the government, the commercial bank was always willing to lend to the SOEs with little collateral, while the central bank also kept funding the commercial banks with little collateral.15 As shown in Figure 1, China encountered two inflation peaks from 1984 to 1994. The central bank overlooked the potential inflation brought by the increased spending, which should be the most crucial indicator in the MMT model. The government projects in 80s transferred money into the society, but failed to raise the productivity of light industry in response to the domestic demand, which created the classic economic scenario of inflation: “more money chasing fewer goods”. (Figure 1. China Inflation Rate in Percent, 1986-2023. National Bureau of Statistics of China.)16
Following the inflation, the Chinese government set up the structural reform of SOEs. Since then, China pegged its currency to the U.S dollars at a ratio of 8.28:1 until 2005. To some extent, it weakened the monetary sovereignty of China as a country, but it also stopped the central bank from unlimited spending. It was not equivalent to fully giving up its monetary sovereignty. Rather than directly transform the U.S dollar into RMB, the central bank of China leaves space to maneuver the money supply besides accumulating massive foreign reserves, which will be further discussed in the next section. In fact, Premier Zhu Rongji’s government report in 1999 clearly suggested that the Chinese government had full control over the issuance of RMB: “When many neighboring countries devalued their currencies by a large margin (during the Asian financial crisis), we weighed the pros and cons and decided not to depreciate the Renminbi. …The state increased the national debt by 100 billion yuan last year…yet the volume of currency issued during the year was still some 50 billion yuan less than the target figure set at the beginning of the year… Both retail prices and consumer prices dropped compared with those in the previous year. Under normal circumstances, increasing the deficit to spend more on development would bring about inflation. However, under current special conditions, there is little possibility of such a danger.”17 According to MMT, in “normal circumstances”, the society operates at maximum production capacity. Under these conditions, any increased spending can trigger inflation because there are no additional goods available in the market to match the surplus currency in circulation. However, if prices remain stable despite increased spending, it means that there is enough fiscal space for the government to encourage people to produce more. Zhu applied this theory to absorb the non-performing loans, and propose infrastructure development from agriculture to transportation, water conservation to public facilities by government financing. His re-employment project, financed by the government, worked together with enterprise and unemployment insurance funds to reimburse the living costs for people who were laid off in the textile sector from 1997 to 1998.18 Zhu was correct; high government expenditures did not lead to inflation over this period, as shown in Figure 1. Under his leadership, China pivoted to the diversified industry from the SOEs, aiming to better supply the domestic demand. Shown in Figure 2., since then, China has strided on the path of growing national deficit to support the economy. (Figure 2. General Government Gross Debt to GDP in Percentage, 1996-2023. IMF.)19
The Monetary Policy in 21th century China
Since China pegging the RMB to U.S dollars in 1994, China seems to diverge from the principles of MMT by relinquishing some aspects of its monetary sovereignty. However, evidence shows that pegging to dollars does not weaken China’s liabilities. It still controls its money issuance and keeps accumulating the national debt to stimulate the economy. In the other words, China still sees itself as a currency issuer. Its central bank creates a buffer before transforming the foreign reserve to the domestic currency, which is different from the orthodox theory.
The orthodox monetary model, or the Mundell–Fleming model, usually simulates a small economy with restricted capital flow. It argues that if a country pegs its currency with one or more other countries, its foreign reserves would directly transform into the combination of Money in Circulation (M0) and the bank reserve balance, which can harm its indepence of the monetary policy. If the government allows the foreign capital flow, currency arbitrage can easily happen when the interest rate fluctuates, which is called the “Mundell Trilemma”.20
However, shown in Figure 3. and 4. (see below), there is no perceived relationship between the foreign exchange reserves to the Money in Circulation (M0) in China. Hence, it is widely argued that the Chinese central bank applies the compensation thesis instead, transforming the fluctuation in foreign reserves onto its balance sheet to keep its monetary sovereignty and control the interest rate.21 Table 2, the balance sheet of People’s Bank of China (PBoC), reveals how Chinese government financing works. It has more monetary power to manage its total assets, which constitutes the basis of MMT. (Figure 3. China’s Foreign exchange reserve in Billion, 1981-2023. People Bank of China.)22 (Figure 4. M0 in China in US Dollar Million, 1981-2023. People’s Bank of China.)23
(Table 2. Balance sheet of People’s Bank of China (PBoC), 1999, 2007 and 2010.)24
Different from what the Mundell–Fleming model suggests, the compensation thesis believes that the central bank can maintain the independence of a pegged currency from the foreign currency market from the foreign market by maneuvering its balance sheet, which offers the central bank the flexibility to achieve its monetary policy target.25 China has accumulated massive foreign reserves to practice this compensation thesis. People’s Bank of China (PBoC) lends out a substantial amount to local governments, banks and other financial institutions and increasingly issues bonds. PBoC’s assets not only consist of foreign reserves; it holds at least 3 tools to increase its assets: decrease the claims on commercial banks, increase the government deposits in the central bank, and issue bonds, but the PBoC could freely choose whether to do so.26 For instance, the legal requirement of the ratio of required reserve (RRR) in China forces commercial banks to borrow from the central bank, or other commercial banks by the end of the quarter to keep rolling, as an interest-rate managing tool since the 1980s.27 The claim from PBoC to these local commercial banks is set up to fund their day-to-day business. “Some of these advances [claims] are linked to the bailout of non-performing loans made by state-owned banks in the 1990s and are unlikely to be retrieved.”28 Likewise, the central bank transforms the deprecation in foreign reserves onto the balance sheet, implying that the foreign reserve isn’t crucial to the currency, but a tool for risk management.29 In brief, China does not lose its monetary sovereignty, but seeks to fund the society in a more implicit way. (Figure 5. China Government Spending, 1991-2023. People’s Bank of China.)30
How so? On the fiscal side, China has increased its government spending since 1991. In 2009, there was about 12 trillion RMB of household savings in China, which raised economists’ concern of excessive liquidity. The orthodox theory views money in circulation and deposit as liquidity. Having excessive liquidity usually signals too much money supply and potential inflation.31 However, this did not happen in 2009 in China. Due to the 2008 financial crisis, Chinese people preferred to increase their liquidity, while their government offered them local government projects as a safe investment option. The Chinese government allows its citizens to inject capital to the local government projects including infrastructure and university construction, as a conservative investment combination. Even though these projects have a high default rate, people hold trust in the government to finally step in and clear the bad loans. Until now, “bad loans by banks have not had bad consequences.”32 The allowance of private investment in the government project creates the interest-bearing RMB, which would only benefit the people.
The Current MMT Approach in China
In recent years, the Chinese local government has transitioned from the traditional (TAB)S model (“Tax, Borrow, and then Spend”) to the S(TAB) model (“first Spend, then Tax and Borrow”), resulting in a substantial increase in government debt. Moreover, China obscures its national debt behind the local government debt to alleviate the investors’ concern, while both of it would finally be paid by the central bank. Following the principles of MMT, this should not raise alarm as long as 1) China can perpetually print RMB to alleviate its debt burden, 2) currency issuance does not trigger inflation, and 3) there is still fiscal space in China to be realized, such as decreasing the unemployment rate.
In 1994, China centralized its fiscal system. It allowed the central government to mandate the local government to reach the GDP growth target, which seemed to transform the fiscal burden to the latter. Article 28 of the 1994 Budget Law claimed that, “local budgets…shall not contain deficits. Except for where provided by law or State Council regulation, local governments shall not issue local government bonds.”33 The local government found the funds from the central government funds were either delayed or insufficient, since all the provinces joined the so-called “competitive development”, trying to attract as much capital and good jobs as possible34. Hence, the local officials created local government financial vehicles (LGFVs) to finance the government project and reach the target growth,35 which was a prototype for the subsequent accumulation of high local government debt.
Twenty years after, in 2014, China amended the budget law to grant the local government power to issue bonds36, and prohibited LGFVs on paper, which essentially changed the fiscal dynamic. In 2016, China’s Ministry of Finance updated the local debt policy through The Measures for the Budget Management of General Debt of Local Governments. It notes that, “general debt revenue and expenditure are mainly repaid with general public budget revenue; special debt revenue and expenditure are mainly repaid through special revenue generated from government fund revenue and project income.”37 For both the provincial government and the city and county-level government, their “debt income and arranged expenditures transferred from higher-level governments should be included in the budget adjustment plan.”38 In the other words, the Chinese central bank is in charge of all of these deficits by incorporating them into the “general budget”, and it will finally clear these debts as a whole through local government bonds.
These local bonds are created for supporting the infrastructure program, but they are not paid by the local tax revenue, but by the central bank. After the amendment of the budget law, the local government not only utilizes LGFVs, but also issues bonds to meet that goal, with no further consideration for default. In the 2022 government report, the central government issued 2.8 trillion yuan to fund the local government and issued a total 3.65 trillion yuan of special-purpose bonds for local governments.39 As Table 3. shown below, more local governments were allowed to carry outstanding debt in 2022 than in 2017. For example, Guizhou province has 60 billion RMB monthly debt payment in 2022, which is several times more than its own tax revenue.40
The local bonds are not always going to support the infrastructure construction as the Chinese government claims, but also become a way to hide China’s implicit national debt. For instance, Zhejiang, with “a dynamic, technology-driven economy”, increased its debt from 31% to 61% of provincial GDP in 5 years, while it is a well-developed area which “presumably did not need infrastructure investment to generate growth.” One could reasonably argue that Zhejiang subsidizes the deficit in other areas based on its own economic advantages.
Nonetheless, there is no evidence that China is under the serious burden of a high government debt. That’s because the state-owned commercial banks, who do not care about the default, always buy these bonds back. According to the China Ministry of Finance, by 2023 November, commercial banks hold 82.17% of total local government bonds, amounting to 33,231.753 billion yuan.42 The central bank behind the state-owned commercial banks will buy the bonds when needed and be responsible for the future payment, while default does not have any impact on these commercial banks. All the evidence shows that China fully controls its national debt, and is still able to increase its government spending to pump in more money to fund the private sector, which in fact, is a successful MMT approach to grow its domestic economy.
Unfortunately, the increase of government spending does not lower the overall unemployment rate in China, which floated at 4% from 2002 to 2018, and has not yet dropped below 5% after covid.43 Liu has argued that the problem of “excessive saving” in 2009 is “rather, depressed domestic consumption.”44 The MMT model has been proven to be successful in China, which allows more investment to the society to improve welfare for its citizens. The next-step goal for the Chinese government should be creating more job opportunities for its vast population and bolster local demand. China has already initiated efforts toward this goal: look at the Belt and Road Initiative. The Chinese government invests in infrastructure construction in foreign countries and engages Chinese companies for these projects. Chinese workers employed overseas subsequently send their earnings back to China, thereby boosting local demand and stimulating the economy.45 As of 2024, there has been no significant inflation in the RMB, indicating that China can continue to increase its debt to maximize production capacity and address its unemployment challenges in the coming years.
Conclusion
During the gradual reformation of the decentralized government system in the past 70 years, the Chinese government applied Modern Monetary Theory in its economic policy. The analysis shows that its central bank has enough money-issuing power to accomplish its econmoic goal. China maintains its own monetary sovereignty, and stimulates the economy by running the government deficit. In response to investors’ concern, China hides its increasing government deficit on the balance sheet behind the local government debt, but that deficit does not harm the economy. As this MMT approach does not create inflation in RMB, China should work on improving its people’s welfare, and keep spending on government-funded projects until achieving the goal of full employment.
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Otherwise, all the resources are collected by me, and all the arguments are made by me. 19
