Interest rate policy and incentives of state-owned enterprises in the transitional China

Despite many criticisms and high inflation expectations, China has maintained a low interest rate policy since the beginning of her economic reform. Reasons for this persistent underpricing of credit have not yet been fully understood. In this paper we present a formal model that incorporates the notion that the state-owned enterprises (SOEs) are able to influence not only the return; but also the risk, of their investments. In this two-dimensional moral hazard model, we investigate the SOEs' optimal choices of effort and risk, and how they might be affected by changes in interest rates, taxes, and the firms' self-financing. Our results suggest that there are solid incentive-based reasons for the low interest rate policy in China. (C) 1996 Academic Press, Inc.