Reforms in China have shifted investment financing from financing via direct government transfers to financing through the banking system. As part of this change the state bank system has grown from 60,785 branches with 973,355 employees in 1985 to 143,789 branches with 1,893,957 employees in 1993. An important monetary policy instrument of China's Central Bank are credit ceilings that it establishes for each specialized bank and its local branches. These credit ceilings have been frequently revised upward, thus contributing to economic overheating and inflation. Inflation reached 22% in 1994, the highest inflation rate in China since 1949.
Conflicting project valuations between central and local authorities are one source of pressure on the Central Bank's credit ceilings. The elimination of price controls in the light industry and service sectors has transformed these sectors into high-yield investment prospects for local authorities. In contrast, price controls and state production requirements make the agriculture, infrastructure, and energy sectors less attractive to local authorities. Nonetheless, investment in these sectors is considered essential from the perspective of central authorities.
Central bank credit ceilings have lacked sufficient credibility, given the conflicting project valuations between the central and local authorities. While the Central Bank can enforce the credit ceilings, it cannot manage the allocation of credit across all the local state bank branches. Local authorities exert great influence over local credit allocation. By underfinancing investments that the central authorities consider to be essential, the local authorities have been able to induce the Central Bank to revise its credit ceilings upward. Such a revision is necessary ex poste to make more credit available for the essential projects that were underfinanced.
The above case summary is based largely on Jun Ma, "China: Central Government Credibility and Economic Overheating." See this paper for a formal model of the interaction between local and central objectives and the credibility issue.
Policy Credibility Learning Module