The two contingent future paths for China's economy are both embedded in its financial sector. On the one hand, extremely rapid financial deepening accompanied by relatively stable prices drives a vigorous growth trajectory that will one-day make China the world's largest economy. On the other hand, the colossal store of nonperforming loans in the banking sector augurs stagnant growth and even an economic collapse. This study argued that China's elite political dynamic has played an important role in fashioning the foundation of both outcomes.

The persistent tension between generalist factions and technocratic factions engendered a credible constraint against high inflation. On the one hand, the generalist factions comprised mainly of local officials favored financial decentralization, which increased inflationary pressure since provincial leaders competed with one another to boost investment and, thus, lending and monetary expansion in their respective jurisdictions. On the other hand, central technocrats, whose power depended on accomplishing monumental tasks for the regime, had an interest to centralize financial authorities in order to finance major undertakings. The divergent policy preferences of these two types of factions meant that each sought to take advantage of both economic and political conditions to implement their preferred financial policies.

Because party generalists commanded authorities that allowed them to set the agenda in the elite decision process, under normal economic conditions, they could enact their favored policy of decentralizing financial authorities to the provinces.

One of the most memorable interviews that I conducted in the course of researching for this book took place in a provincial capital along China's prosperous eastern coast. I interviewed the manager of an asset management company (AMC), which was established to recover the myriad nonperforming loans that had accumulated in China's state banks. Throughout the interview, he belabored the importance of central directives on reducing nonperforming loans (NPLs) in the banking sector. After Zhu Rongji, with the full backing of the Chinese Communist Party (CCP), had imposed a rigid nonperforming loan reduction quota on all Chinese banks, banks were scrambling to remove NPLs from their balance sheets. The manager himself had to meet a cash recovery quota for the NPLs under his charge or face dismissal. He accomplished this by speedily selling the collateral tied to the NPLs to private and foreign investors. When asked about the fate of NPLs not backed by collateral three or four years down the road, his response was simply, “That's for my successor to worry about. I plan to get out after a couple of years with my bonus.” Following the interview, he asked if I was hungry. As it was late in the afternoon and my lunch had been a simple bowl of noodles from a street vendor, I thought I could treat him to dinner and we could continue the conversation.

How do relatively low inflation in the form of inflationary cycles and chronic inefficiency in capital allocation, two phenomena that suggest different policy making processes, coexist in the same financial system? While manageable inflation rates and the absence of hyperinflation suggest technocratic control over financial policies, chronic inefficiency in the form of high nonperforming loan ratios indicates political intervention in the banking sector. In brief, the answer provided in this chapter – and in the entire work – is that top leaders' desire for power and the uncertain political environment in which they operate compel them to pursue factional politics, which creates the political environment for inflationary cycles and the dearth of significant financial market reform.

This chapter builds on institutional features described in Chapter 3 and on China's elite political dynamics to derive a factional model to explain inflationary cycles and inefficiency in the Chinese financial system. The two types of factions – one endowed with broad membership across the party apparatus and the provinces and the other endowed with technocrats in the central government – compete with one another over the degree of monetary centralization, which induces inflationary cycles. Although the competitions between the generalist and technocratic factions are not zero-sum contests for ultimate control of the party, they have clearly divergent preferences over monetary policies, which compel them to mobilize political resources at their disposal to gain the upper hand. This tense interaction manages to constrain inflation in China.

The theory put forth here argues that the struggle to control financial policies between generalist factions, which favor decentralization, and technocratic factions, which champion centralization, gives rise to inflationary and anti-inflationary pressure, respectively. But because both types of factions exploit the banking sector to fund their respective political aims, there is a persistent failure to commercialize the banking system in China. This chapter fully demonstrates this dual logic by examining two “classic” cases of inflationary cycles: the 1978–1982 cycle and the 1983–1986 cycle, respectively.

The two cycles are essential for the main argument for several reasons. First, this period saw the first two inflationary cycles since the 1978 reform. These two inflationary cycles exhibited a “classic” pattern in which generalist factions galvanized local enthusiasm for investment through manipulating the agenda at important party meetings and through restructuring vital economic decision bodies such as the Finance and Economic Committee. Because of the latent competition between generalist factions, they competed to decentralize financial resources to provincial followers, which increased inflationary pressure. When inflation rose above a certain threshold, the central bureaucracy mobilized against the generalist factions in order to regain control over finances. Closely examining the policy coalitions that formed on investment and monetary policies in this period allows us to evaluate whether the assumptions of the theory roughly accords with political reality in China.

The most recent monetary cycle in China persisted for nearly a decade. Despite a seeming lull in monetary fluctuation under Zhu Rongji, the sudden surge of lending and investment in 2002 suggests that monetary cycles are by no means artifacts of the Deng era. Even as China established a series of monetary institutions modeled after Western central banks, politics continued to play an important role in driving monetary outcomes. The central technocrats' prolonged domination over financial policy began in 1997. Unlike previous times when they had gained such control, the cause was an external shock – the Asian Financial Crisis – rather than an internal inflationary crisis. The Asian Financial Crisis gave the Chinese Communist Party (CCP) leadership a rude awakening on the economic front similar to the political shock they had received from the dissolution of the Soviet Union. The crisis, however, was more anticipated than real because foreign exchange control minimized the possibility of capital flight from China. Despite the remoteness of an actual crisis, Zhu Rongji, newly promoted to the position of Premier, mobilized the State Council research apparatus to paint a bleak portrait of the Chinese financial sector in order to centralize financial power. Jiang Zemin, not wanting to risk any instability after Deng's death, abandoned his plans to pursue energetic growth and sanctioned Zhu's centralization policies.

Throughout the nearly three decades of reform, the Chinese banking sector has evolved from an appendage of the Ministry of Finance to a sprawling bureaucracy with specialized roles and an increasingly diversified ownership structure. It also has become a central aspect of China's economy as total lending climbed well over China's GDP. As a result of its immense size, the banking sector is also the key to understanding China's inflation and financial efficiency performance. To the extent that money supply affected inflationary expectation, the speed with which the banking system created money has played a major role in inflationary outcomes. At the same time, the banking sector is still the predominant channel for financing investment in China, making it the key to understanding the efficiency of capital allocation.

Undeniably, the enormously complex set of institutions governing China's banking sector has affected both monetary expansion and the allocation of capital. Nonetheless, the waves of institutional changes in the reform era have not had a significant, independent impact on our dependent variables: inflation and the efficiency of capital allocation. As this chapter demonstrates, institutional changes often followed shifts in political signals. In other instances, institutional changes, although designed to achieve monetary and distributive outcomes, ultimately had little impact on them. Rather than being an independent causal agent, changes in banking institutions were crucial steps in the causal chain that led from elite political shifts to fluctuations in the dependent variables.

The quantitative data used throughout this study are broken into three main databases: Annual Database, Quarterly Database, and Time Series-Cross Section Database. Because no one has attempted to construct three separate financial data sets on China, I had to draw from numerous primary sources from the Chinese government to construct these data sets. This discussion details the structure and the sources of each of the databases in turn.

Annual Database contains national level economic data from 1978 to 2006 and is a time-series data set. The data set includes data on lending, bank deposits, inflation, industrial output, fixed-asset investment, and interest rates. The main sources of this data set are:

National Bureau of Statistics. 1999. Xin Zhongguo Wushinian Tongji Ziliao Huibian (A Collection of Statistical Material for the Fifty Years of New China). Beijing: China Statistics Press.

National Bureau of Statistics. 2000. China Monthly Economic Indicators 2000: 1 (January). Beijing: China Statistical Press.

National Bureau of Statistics. 2001. China Monthly Economic Indicators 2001: 3 (March). Beijing: China Statistical Press.

National Bureau of Statistics. 2003. China Monthly Economic Indicators 2003: 2 (February). Beijing: China Statistical Press.

China Data Online. 2006. China Yearly Macro-economy Statistics. China Data Center, University of Michigan. http://www.chinadataonline.org.

More specific data on banks come from:

People's Bank of China. 1997. Zhongguo Jinrong Tonji: 1952–1996 (China Financial Statistics: 1952–1996). Beijing: China Financial Publisher.

Statistical Division of the PBOC. 2000. Zhongguo Jinrong Tongji: 1997–1999 (Financial Statistics of China: 1997–1999). Beijing: China Financial Publisher.