Soft Budget Constraint, Interest Rate Marketization And Macro - Control

In the aftermath of 2008 global financial crisis, China introduced so-called "Rmb 4tn investment stimulus package". This resulted in rapid expansion of state-owned enterprises(SOE) and local government financing vehicles(LGFV), substantially crowding out investment and financing activities of private enterprises and medium-and-small companies. Structural issues have become increasingly obvious on micro-economic levels. From the macro perspective, traditional monetary policies face dilemma between growth and risk control(leverage control). The key question is how People’s Bank of China(PBOC) should bring structural factors into its monetary policy framework? As one of the most important macro economic policy tools, should government investment plans(fiscal policies) consider those structural factors as well? In the context of financial reforms, the development of China’s shadow banking system put a lot of pressure on relaunching interest rate deregulations. But as recent evidence shows, interest rate deregulations without considering structural factors may not be effective, and even leads to more distortion of resources allocations. The main purpose of this paper is to build up an analytical framework that integrates various participants(structural factors) of the economy into a single model.The paper has devised a general equilibrium model that includes entities under soft budget constraints, and seven financial markets: 1)deposit market, 2) informal financing market, 3)loan market of entities with soft budget constraints, 4) loan market of entities with hard budget constraints, 5) direct financing market of entities with soft budget constraints, 6) direct financing market of entities with hard budget constraints, and 7) inter-lending market between the two above-mentioned types of enterprises. Building on the model, we have assessed the aggregate and structural impacts of interest rate liberalization, monetary policy and investment plans(fiscal policy). On the basis of the study, we have made policy recommendations on a number of issues, including choices in various paths of interest rate deregulations and supplementary measures, implementation and choices of instruments of structural monetary policies, and reform of macroeconomic framework.This paper consists of six chapters. Chapter Two builds up benchmark models based on detailed illustrations of entities with soft budget constraints. Chapter Three studies conditions necessary for successful interest rate liberalization. Chapter Four covers structural implications of monetary policies and the options of policy tools. Chapter Five looks at aggregate and structural impacts of government investment stimulus plans(fiscal policies). Chapter Six proposes policy recommendations.The key conclusions and policy recommendations are summarized below:On financial reforms: In presence of entities with soft budget constrains, 1) deposit rate liberalization will likely boost aggregate financing and investment amount for companies with soft constraints, crowding out financing and investment by companies with hard constraints. This results in further distortion of economic structures; 2) China’s shadow banking may lead to worse outcome of resources allocation than interest rate liberalization; 3) interest rate liberalization reforms can improve efficiency in resource allocation only with complementary policies to limit financing by entities with soft budget constraints; 4) as for interest rate deregulation, existing-type reform(reform of on-balance sheet lending at commercial banks) would be better than ncremental-type reform(through the growth of shadow banking system). This would result in relatively less efficiency loss; 5) expansion of direct financing markets may improve financing conditions for the two types of companies, but the proportion of companies with soft constrains could rise, leading to structural deterioration of resources allocation. Allowing companies of hard constraints with more access to direct financing and banking system could improve economic and financial structure.On monetary policies: In presence of entities with soft budget constraints, 1) interest rate loosening by the Central Bank will lead to expansion of total social financing with structural improvement; on the other hand, interest rate tightening may lead to contraction of total social financing and structural deterioration. 2) Quantitative easing policy may lead to aggregate expansion of total social financing but with worsening structures and worse aftermath of interest rate liberalization; quantitative tightening results in aggregate contraction and improvement of economic and financial structures. 3) In consideration of structural objectives, expansionary monetary policies should use more pricing tools while contractionary monetary policies should resort more to quantitative tools. 4) institutional cost and risk premium mean most important on comprehensive financing cost for companies with hard constraints. Excessive financing by entities with soft constraints leads to significantly higher funding cost for companies with hard constraints. Monetary policies can affect financing cost of companies with hard constraints.On investment plans(fiscal policies): aggregate effect of investment plans by entities with soft constraints equals to zero before interest rate liberalization as those entities can completely crowd out activities by entities with hard constraints. After completion of interest rate liberalization, aggregate effect of investment plans by entities with soft constraints is negative as those entities can crowd out more activities by companies with hard constraints.