Local Governments’ Ownership and Incentive Compatibility

Abstract

The preceding chapter argued that the excessive expansion of bank credit and the violation of credit ceilings occurred because central policymakers were compelled to increase bank loans as a means of rectifying the irrational investment patterns of local governments, and in particular, to ensure adequate investment in technical updating and in the bottleneck infrastructure sectors. This leads to the question as to why local governments tended to neglect investment in the priority sectors in favour of manufacturing and other activities. By focusing on the institutional and systemic characteristics of the Chinese economy and reform, this chapter will argue that although decentralisation based on the (effective) property rights of local governments’ alleviated incentive failure, it exacerbated problems of incentive incompatibility between the central and local governments in resource allocation. The chapter first describes the uniqueness of the Chinese economic system — local government ownership. It then applies theories on incentive compatibility to analyse the investment behaviour of local governments. Finally, it examines fiscal factors, which are related to local governments’ ownership, in the incentive structure.