The Structural Nature of Internal and External Imbalances in China

China has a built-in inflationary tendency because of the partially-reformed nature of its economic system. Specifically, the post-1978 marketization of the economy has interacted with the continued state ownership to create an inflationary 'liquidity tango' between the state-owned enterprises (SOEs) and the state-owned banks. Whenever the hard budget constraint is imposed on the SOEs, China's dysfunctional financial system would impart a deflationary bias to the economy and render China a capital exporting country by constraining the growth of aggregate demand to be less than the growth of aggregate supply. The use of price mechanisms as the only instruments for all economic problems is not appropriate for China's transitional economy, e.g. trade surpluses are better handled by the establishment of an efficient financial intermediation mechanism than by appreciation of the Yuan.