The first brief in this pair described some basic features of the Chinese financial system, especially in its links to the global economy. This brief outlines some of the problems and their wider implications.
1. The Chinese financial system has large marshy areas, the full extent of which is unknown to the Chinese authorities. A guide to the Chinese financial system published by the China Centre at the Brookings Institution put the matter this way:
China has a large and diverse informal lending sector that helps fill the gap left by a formal sector excessively focused on funding state owned enterprises and politically favoured businesses. Lenders in this sector include loan sharks, pawn brokers, formal or informal cooperatives of locals lending to each other, state owned enterprises lending out excess cash, and many other privately, and sometimes secretly, raised funds that invest in start-ups.
Moreover, there has been government specification of rates of interest which can be offered on bank deposits. These have been low historically, so that there have been workarounds for high net worth individuals, including participation in loans made by the banks. There is reliance by individuals on implicit guarantees by the bank, and so banks may have more credit risk than is shown on their balance sheets. Not knowing where risk is located in the system makes it difficult to regulate. It will amplify any financial crisis, as the global experience since 2007 has indicated. Moreover, the Chinese system is vulnerable to accounting fraud. There is a hedge fund called Muddy Waters which finds frauds and publicises them after selling short the stock of the firms.
2. There is a marked tendency to believe in political solutions to every economic policy problem. One source relates, in the wake of the recent stock market crash, that party propaganda officials told students at Tsinghua University School of Economics and Management to loudly chant at the start of their graduation ceremony: “Revive the A-shares! Benefit the people!”. The message has changed, but the style has echoes of the China of fifty years ago. The Chinese reaction to the stock market crash shows an unwillingness to accept adjustments accepted as normal in market economies.
3. The regulatory system is not always coherent and is always subject to political intervention. The World Bank’s China Economic Update Report in June contained the following warning:
Instead of promoting the conditions for sound financial development, the state has interfered extensively and directly in allocating resources through administrative and price controls, credit guidelines, pervasive ownership of financial institutions and regulatory policies.
Adverse Chinese reactions forced a redaction of the report, the World Bank claiming that the original had not gone through the necessary clearance processes.
It may well have been the case that the Chinese authorities had welcomed the rapid run-up in share prices as creating a chance to sell equity stakes in dangerously debt-burdened enterprises, especially in a stock market as heavily speculative as the Chinese is widely acknowledged to be. The political backlash has put a temporary end to that project.
4. The Chinese have been adept in making incremental reforms, but unwilling to come to terms with the cumulative consequences.
China, as Francis Fukuyama has observed, delivers high quality authoritarianism. As opposed to Russia which exemplifies low quality authoritarianism. There has undoubtedly been skill in a succession of moves the Chinese government has made. Deng Xiaoping, in folksy fashion, referred to the country as ‘crossing the river by feeling its way over the stones’. And in recent decades, state management has avoided economic dislocation.
But together, the reforms have put China in an uncomfortable halfway house. Capital flows have become much larger. A recent Financial Times blog put it thus:
With some channels quite open but others still closed, there is much illicit use of the open channels to disguise capital flows…The debate is not about whether or not to open the capital account, because it is in fact already partially open. The question is where to go from here.
What China will want to do is attract longer term investors, and insulate itself as far as possible from destabilizing short term movements. It will also want to retain, indeed augment, administrative measures which may not be applied routinely, but which can be invoked in an emergency. Which is how it has responded to the stock market crash. Firstly, it lowered interest rates. Then it went on to place a moratorium on all new public offerings, a six month prohibition on share sales by company directors or any shareholder with a more than 5% stake. State owned enterprises were instructed not to sell shares, a market stabilization fund was created and the China Securities Regulatory Commission started to purchase shares through its own proprietary accounts.
The problems here are that in response to domestic political pressures, policies may be adopted which are counter-productive, that in bigger crises (after all, shares are a small part of total financial assets) the government may run out of fingers to put in leaking dykes, and that to the extent that the renminbi does become a reserve currency, other countries may resist China’s discretion to solve its problems by extraordinary measures at their expense.
5. At the end of the day, there is no separation between external and internal economic relations when it comes to the strength of a reserve currency. A reserve currency needs a deep and well functioning set of financial markets across the board.
6. China is attempting to reorient its economy from exporting with an undervalued yuan to one where personal consumption is allowed to rise faster than national output.
Whereas the yuan has been undervalued in foreign exchange terms as recently as a few years ago, the IMF believes that it is no longer undervalued. In that sense, one condition for the transition has been met. On the other hand, this transition has to be accomplished with a rapidly aging population, an unintended consequence of the one child policy designed to reduce the population growth rate. Japan has confronted both a credit bubble and an aging population over the last thirty years. The result has been chronic deflation and low growth. While foreign institutional investors in China would certainly be harmed by a financial crisis, the potential for systemic international contagion remains limited for now. The internal result might be more akin to the path that Japan has already trodden.
7. There are two channels through which a Chinese financial crisis can affect the global economy: one which works through international financial asset markets and the other which works through slowing Chinese economic growth. The Chinese have an interest in not roiling international financial markets more than they have to. The impact of slowing economic growth on global growth and domestic social and political stability is where the serious repercussions are likely to occur.
Charles Simkins
Senior Researcher
charles@hsf.org.za
