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China's Road to Greater Financial Stability
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Chapter 12. China’s Road to Sustainable Growth and Financial Stability: A Systemic Perspective

Author(s):
Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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As China becomes a major player in the global economy, what are the key reform issues that would deliver systemic stability with growth in the financial sector? Finance is a key factor in support of real sector growth, but its fragilities can also upset growth. As the Chinese economy integrates more closely with the global economy, the capacity to deliver long-term, sustainable, and inclusive growth will require a careful sequencing of reforms in both the real and financial sectors that provide both internal and external balance. A systemic approach is necessary, since it is increasingly apparent that there are endogenous and exogenous factors accounting for systemic instability, requiring careful calibration of macro, micro, and institutional policies to enable the system as a whole to be more resilient to systemic shocks.

China’s market-oriented reform began in 1978 with a unique economic reform approach that was graphically characterized by the phrase “birds in a cage” coined by Chen Yun, the mastermind of China’s economic planning system from the 1950s to the 1980s. According to Chen Yun, market-oriented reform meant allowing the birds (firms and households) to fly freely in a socialist market economy that is limited by the expanding cage (the bounded resources defined by planning). This gradual “expanding the cage” philosophy has served the Chinese leadership well over the last three decades in its searching and experimenting in terms of macroeconomic and financial stability, while progressively opening and liberalizing the Chinese economy to the world.

There is a practical logic to this philosophy, which was shaped by the reality that China is a continental economy with limited natural resources and, prior to opening up, little access to foreign exchange. With self-sufficiency as a guiding principle, China has been fiscally and financially prudent while bold in the execution of real sector opening and institutional innovation.

Progress in the process of opening has been impressive, as shown by the establishment of strong macroeconomic management and financial and regulatory institutions with modern instruments and staffed by professionals. China’s economic management team has delivered both growth and stability, creating the second-largest economy in the world. But realistically, even these achievements may not be good enough to deal with the ever-rising complexity and scale of the challenges at the technological, social, and global levels. As stated by Premier Wen Jiabao, China is faced with the risks of an “unbalanced, unstable, and uncoordinated economy” emerging in an unbalanced, uncoordinated, and systemically fragile global environment. Since China is a globally large and systemically important economy, its reform is really about maintaining national stability in the context of contributing to the systemic stability of the global economy. Thus, maintaining China’s stability contributes significantly to global stability.

Throughout China’s long history of macro and financial cycles, there has been a persistent feature that, translated from Chinese, means that when the central government exercises tighter control, the economy stops, but when control is relaxed, the system falls into chaos. In other words, Chinese macro control relies more on the “left hand” (quantitative and administrative tools such as reserve requirement ratios, credit quotas, and policy directives), rather than the “right hand” (market-oriented tools such as interest rates, exchange rates, market-driven prices, etc.).

Due to the country’s top-down administrative and institutional structure, Chinese policymakers have much richer experience and stronger implementation capacity in using the “left hand” rather than the “right hand” to manage macroeconomic conditions. But there are inherent risks in this imbalanced and uneven two-handed approach. At this juncture, a systemic, global-local and business-relevant perspective is essential for Chinese policymakers to understand options in rebalancing toward an even-handed approach to the country’s macroeconomic management. As China’s economy becomes more integrated with the global market economy, a balanced two-handed toolbox is necessary to manage systemic trade-offs between efficiency, stability, innovation, and resource constraints. Complexity arises because China needs to simultaneously and dynamically maintain and balance economic, financial, social, ecological, and global stability.

The first challenge in assessing China’s options is to ensure relevancy to the real economy. The underlying structural transformation in the real economy within a global context has produced rising productivity, derived from integrating China into the global markets, which is the most important driver of rapid growth. This rapid rise in productivity has led to a convergence in real income, purchasing power, living standards, and general price levels between China and the advanced economies, shown most clearly in the increase of China’s per capita GDP from about $300 in 1978 to $4,428 in 2012.

This productivity growth was basically facilitated through a stable political environment, prudent fiscal and monetary policies, and an opening up to a favorable external environment. But even as absolute poverty has been reduced, income and wealth disparities, growing resource demands, pollution, corruption, and rising middle-class social expectations are bringing new challenges to managing stability in a dynamically changing landscape.

China’s Trajectory Toward Convergence with Advanced Countries

Productivity catch-up is largely a secular, real-sector issue. However, maintaining macroeconomic stability along the convergence path remains important, and this includes managing volatility in key prices in the economy—wages, consumer prices, asset prices, and the exchange rate. At the same time, there is a need to manage the balance-sheet effect of such changes in prices, since sharp volatility in asset prices may have an impact on the solvency of the household and corporate sectors and also the capacity of fiscal authorities to manage the economy.

China’s growth model over the last 30 years depended on cheap labor. This cannot be sustained once the Lewis turning point has been reached, that is, the point at which rural surplus labor disappears and real wages begin to increase. Moreover, under the Twelfth Five-Year Plan, China intends to increase minimum wages by up to 13 percent per annum.

At the same time, real estate prices have risen substantially in the last 20 years, which will sooner or later feed into higher rents and demand for higher wages, as well as add to cost-push factors. The Balassa-Samuelson theorem suggests that rapid productivity growth in the tradable sector leads to higher wages across the economy, including in the nontradable sector, even though productivity growth there is very limited. Furthermore, upward pressures on real estate prices are amplified by the generous credit flows to state-owned enterprises (SOEs) and local governments at low interest rates. In other words, China will inevitably face a period of higher “structural cost-push” inflation.

Indeed, financial sector arrangements and distortions are a major reason behind the structural misallocation of resources. In China, banks lend excessively to SOEs and local governments and insufficiently to small and medium-sized enterprises (SMEs) and the household sector. It means that SMEs have to pay excessively high real rates to borrow on the informal market while the low deposit rate in the formal banking sector leads to financial repression and fuels speculation in real estate. Hence, current banking sector credit policies are the root of the so-called shadow banking problem in China, as the much higher informal market interest rates in places like Wenzhou are creating opportunities for arbitrage between high real lending rates for SMEs and low deposit rates in the formal banking sector through “creative” wealth management products that may create new risks to the healthy development of Chinese banking and stock markets.

Since real estate prices can significantly affect the collateral and solvency of the banking system, China needs to develop more efficient and robust financial institutions by liberalizing interest rates, so that there is less room for leveraged speculation in the asset markets through low interest rates.

The low interest rates for SOE and local government projects as compared to the prevailing high informal market interest rates have long-term systemic consequences. Keeping them in place would mean that SOEs and local governments would continue their investment-driven business model, which may lead to problems of financial viability. Local governments tend to open up new land and offer it as subsidies to investors, thus distorting foreign direct investment (FDI) flows. This explains why inward FDI is still rising even as China is trying to increase outward FDI.

Deepening capital markets to balance the dominance of the banking system is critical to achieving systemic stability. For example, the low interest rate regime in China encourages distortive behavior in the stock market, as companies invest in low-return projects and then rush into the initial public offering (IPO) markets to raise funds in bubbly markets. This crowds out high-return projects. Moreover, due to the limited access of private and foreign companies to IPOs in the A-share market, the most competitive and profitable companies in China are not well represented in China’s stock markets. The European experience has also shown that the maturity mismatch of allowing long-term sovereign debt to be funded by banks that rely on wholesale funding can lead to systemic instability.

China’s macro policy mix since 2005 has been a careful trade-off between controlling inflation, maintaining growth, and managing export cycles. It consists of a low target inflation rate of 3 to 4 percent, a low and stable interest rate of around 3 to 3.5 percent for one-year deposits, gradual and steady renminbi appreciation of 3 to 5 percent per year, and controls on bank lending through frequent adjustment of the reserve requirement ratio, ranging from a low of 9 percent in early 2007 to a high of 21.5 percent in mid-2011.

The above policy mix set was clearly calibrated with an eye on global macro conditions and policies such as zero interest rate policies in the advanced countries. China’s policymakers did not raise interest rates in the face of domestic inflation, clearly concerned about hot money inflows if interest rates were much higher in China than abroad.

Furthermore, China has started to allow the renminbi to appreciate gradually at a rate of 3 to 5 percent per year since 2005. This contributed to the reduction of the current account surplus from the peak of about 10 percent of GDP in 2007 to 3 percent in 2011.

Nevertheless, there were two effects from this set of policy choices. The first was that it contributed to the accumulation of large foreign exchange reserves. While current account surpluses were the main driver behind this accumulation, financial capital inflows have at times also been large, as investors rushed into renminbi assets, speculating on renminbi appreciation as well as gains on investments in China’s real estate. The second effect was leveraged speculation on real estate, funded through borrowing from Chinese banks at very low interest rates, especially for those who could get access to bank credit. This led to a socially unstable redistribution from poor depositors to rich mortgage borrowers.

In order to maintain system stability in the medium term, the Chinese authorities must not only strengthen the institutional infrastructure and the range and effectiveness of policy tools but also seek to rebalance access to credit by the private sector and introduce competition across different sectors and jurisdictions, which are currently supervised in vertical silos by different ministries. In order to improve the use of market-based tools, China would have to liberalize interest rates and remove impediments to price discovery by lowering barriers to entry, creating futures and options markets, and improving the transparency of market activities and regulatory processes.

For example, to improve the credit discipline of local governments, there should be transparency on disclosure of financial conditions of municipalities and all local government debt vehicles on a timely basis. Greater transparency regarding financial conditions and interest rates paid by SMEs would also enhance credit discipline in the private sector, allowing market forces to better price risks. Improvements in the SME funding market would bring down the usurious rates currently observed in the unofficial credit market, such as those in Wenzhou.

To summarize, microregulatory policies can only work if macroeconomic prices reflect credit and market risks and the distribution of financial resources across sectors is broadly in balance. Given the interactions and interdependence of macroeconomic conditions between China and the global economy, for Chinese policies to achieve systemic stability requires both a big-picture appreciation of transformations in the real and financial sectors at the global and local levels as well as an understanding of specific microfragilities and their institutional causes. In the medium term, global rebalancing will continue as advanced markets adjust to slower growth to repair their balance sheets, and as emerging markets seek capital to finance their urbanization and green and inclusive growth.

To maintain productivity growth, economic efficiency, and social fairness, China needs to rationalize its financial markets by ensuring that the price of capital (real interest rate) is consistent with its scarcity and value in the real sector. This means that China may have to maintain positive real interest rates over time and a real effective exchange rate that is consistent with its rapid growth in total factor productivity. Chinese concerns about systemic stability must be understood in the context of building a more balanced toolbox of market and administrative tools that “fits” the stages of development of the real and financial sectors. Channeling the pattern of growth toward a larger role for consumption and services requires an array of reforms. In the financial sector, it is essential to reward aging savers positive real interest rates so that they have income to spend. Increasing social inclusivity would require removing financial repression and paying labor a fair share of total factor income, while exercising discipline on the efficiency of investment. To achieve these objectives, it is essential for China’s policymakers to adopt a systemic, global-local, and business-relevant approach to study and deal with its macroeconomic management challenges.

1The authors are grateful to Louis Kjius and Sean Quirk for helpful comments.

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