The Political Economy of Central-Local Relations in China: Inflation and Investment Controls During the reform Era

Abstract

Inflation control is deeply political because it has distributional implications. This paper studies the characteristics of the Chinese political system and their impact on controlling inflation demand--the state-sectoral investment component of the aggregate demand. The paper first shows (1) the connections between inflation demand and investment and (2) the divergence in inflation preferences between central and local authorities. Five investment hypotheses are proposed to link two bureaucratic variables of local officials--integration and stability--with preference divergence and monitoring. Preference divergence and monitoring, by theoretical conjectures, are linked with local investment behavior. Evidence from panel data suggests strongly and consistently that integration and instability reduce investment shirking and hence inflation demand. The cross-sectional evidence on provinces is then reconciled with China's aggregate inflation performance and the paper suggests that China's relatively good macroeconomic performance is due to the strength of its political institutions.