The Necessary Demand-Side Supplement to China's Supply-Side Structural Reform: Termination of the Soft Budget Constraint

21 Pages Posted: 23 Jun 2016

See all articles by Wing Thye Woo

Wing Thye Woo

University of California, Davis - Department of Economics

Date Written: May 13, 2016

Abstract

President Xi Jinping pronounced in April 2014 that China has entered a New Normal in economic growth, and the common perception was that it meant a new trend growth rate of about 7.0 percent. After growth came in at 6.9 percent in 2015, and the World Bank’s projections in January 2016 that China’s growth rate would drop to 6.7 percent in 2016 and then to 6.5 percent in 2016, President Xi Jinping announced in May 2016 that comprehensive supply-side structural reforms would be enacted. In this paper we (1) identify some of the major structural reforms that would entrench dynamism into China’s economy, and (2) emphasize that China needs to expunge the soft-budget constraint on the demand-side if supply-side structural reforms are to generate the desired outcomes. The existence of the softbudget constraint guarantees the existence excess capacity and zombie firms. A crude but previously effective instrument to curb the over-investment proclivity of local governments and SCEs is to hold the top management of the state-controlled banks (SCBs) accountable for the appearance of NPLs. A much more effective curbing of the soft-budget constraint behavior will require that the career-maximizing practices of the managers of state-controlled enterprises (SCEs) and SCBs become identical to the long-run profit-maximizing practices that owners of private firms in a modern market economy would adopt. Structural-side structural reforms (like more privatization of SCEs and SCBs, and the establishment of social safety nets and job retraining programs) will correct the incentives faced by China’s managers and government officials.

Keywords: Supply-Side Structural Reform, New Normal, Soft-Budget Constraint, Excess Capacity, Zombie Firms

JEL Classification: E30, E62, H32, L33, O53, P31, P35

Suggested Citation

Woo, Wing Thye, The Necessary Demand-Side Supplement to China's Supply-Side Structural Reform: Termination of the Soft Budget Constraint (May 13, 2016). Available at SSRN: https://ssrn.com/abstract=2798763 or http://dx.doi.org/10.2139/ssrn.2798763

Wing Thye Woo (Contact Author)

University of California, Davis - Department of Economics ( email )

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Davis, CA 95616-8578
United States
530-752-3035 (Phone)
530-752-9382 (Fax)

HOME PAGE: http://www.econ.ucdavis.edu/faculty/woo/woo.html

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