Download The weakest part of China`s economic emergence is the financial

Large Domestic Non-Intermediated Investments and
Government Liabilities –
Challenges Facing China’s Financial Sector Reform
David D. Li1
Center for China in the World Economy
Tsinghua Univesity
and
Hong Kong University of Science and Technology
First Draft:
April 4, 2006
1
Excellent research assistance by FENG Junxin, JIANG Hongping, MEI Song and editorial assistance by Ryan
Monarch are grateful acknowledge.
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Executive Summary
In order to understand the challenges to China’s financial sector reform and the
implications for the world financial system, this paper identifies two important features of
China’s financial system. The first is that the amazingly high growth rate of fixed asset
investment, which has been fueling China’s rapid economic growth, has been mostly
financed by domestic enterprises’ retained profits together with informal lending from the
households.
We refer to the sum of these two sources of investments as Domestic
Non-Intermediated Investments (DNI). We find that China’s DNI to GDP ratio has been
increasing and has reached a level higher than many industrial countries.
We also find that
a major driver of the high ratio of DNI to GDP is the rapid growth of non-state enterprises in
China, which have been mostly excluded from the formal financial sector. We argue that
the increasing DNI is a potential threat to China’s macroeconomic stability if China chooses
to lift control on capital flow, since the DNI may go abroad instead of remaining in China.
The second feature of China’s financial sector is the mounting liabilities of Chinese
governments accumulated as a result of China’s unique approach to economic reform.
The
mounting liabilities will reach a level of 120% of GDP in 2018 matched by equally high but
perhaps illiquid government assets mostly in the form of state owned enterprise shares.
This implies that the Chinese government will continue relying on borrowing from Chinese
households in various forms, preventing liberalization of capital control in the near future.
Meanwhile, in the near future, continued capital control will imply excessive foreign
currency reserves. How to manage the reserve posts is another challenge to the Chinese
government.
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Introduction
The weakest part of China’s economic emergence is the financial sector.
This is
a conclusion that observers of the Chinese economy would all agree upon.
Especially if one compares China’s financial sector to that of India and most other
transition economies, the weakness of the Chinese financial sector is even more
obvious. Therefore, a natural question is in what ways will China’s weak financial
sector impede China’s continued economic emergence or economic growth?
are the potential problems implied by the weakness of the financial sector.
What
What are
the challenges that China’s economic and political leadership will have to resolve in
order for China to continue sustaining its current trend of economic development?
The purpose of this paper is to understand the challenges facing China’s economic
and political leadership posed by the financial sector. Specifically, we will first try
to understand how China has been able to finance its rapid economic growth via rapid
growth in fixed asset investment.
What are the potential problems in the current
pattern of China’s financing of the rapid growth of fixed asset investment?
How has
China managed to finance the investment despite the inefficient financial sector?
Second, we will try to understand another problem for China’s financial sector: how
can it deal with a potentially high level of government liability?
government finance their future liability?
How will the
Government liabilities are potentially a
source of destabilization for any financial sector.
The third purpose of the paper is to
try to form some certain understanding of potential reforms of China’s financial sector
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keeping in mind the above arguments.
What are the constraints the Chinese
leadership will have to face when reforming the financial sector and what are the
implications of dealing with these constraints?
Following the introduction, part one of this paper will provide some
understanding of how China has managed to finance its rapid fixed asset investment,
despite a very inefficient financial sector. Part two will assess the level of future
government liability and compare that with government assets. Part three provides
analysis based on the assessments in parts one and two on the future direction China’s
financial sector reform, and explores implications for China’s own economic
development and for the international community.
I.
Domestic Non-Intermediated Investments:
The Key to China’s
Financing of High Physical Investment
The obvious but important fact about China’s economic growth is that the single
most important driver is the rapid growth of fixed asset investment in China.
In this
regard, China is no exception among newly industrialized East Asian economies.
Fixed asset investment, which is an economic term used by government officials and
the economic community, refers to investment resulting in physical assets.
This kind
of investment includes infrastructure investment, investment in industrial production
facilities, and investment in social institutions, such as primary schools and
universities. Fixed asset investment also includes investments in the real asset sector,
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including both commercial real assets and residential assets. The concept of the
fixed asset investment does not include investment for the purpose of transferring the
ownership or control rights of assets.
For example, investment by households of
private entrepreneurs to buy efficient equity shares of a listed company in a stock
market is not considered a fixed asset investment.
Therefore, roughly speaking the
concept of fixed asset investment refers to the total amount of investment in the
Chinese economy excluding investment in intangible forms, such as brand names and
knowledge in the economy.
Chart 1 provides a description of the evolution of China’s fixed asset investment
(FAI) as a share of GDP.
It is clear from Chart 1 that there was a general upward
trend of the share of FAI in GDP. The ratio of FAI to GDP was at a level below 30%
before 1993, and after 1993, the ratio steadily picked up, reaching a level of over 40%.
The level of China’s FAI to GDP in recent years is alarmingly high, not only from
China’s own historical perspective but also from an international perspective.
In the
era of central planning and also in the 1980s, the Chinese economy faced a problem of
overrunning investment demand, as characterized by the phrase of “investment
hunger”, as phrased by Janos Kornai (Kornai 1980). China’s economic leaders in
the 1980s, including senior officials such as Chen Yun, repeatedly emphasized that the
government should spare no effort in controlling the FAI to GDP ratio.
In that era,
the target level of FAI to GDP ratio was 25%, and definitely below 30%. These
leaders would have been extremely alarmed by today’s high level of FAI to GDP.
From an international perspective, China’s FAI to GDP ratio is also very high. Japan
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and the Republic of Korea, in their fastest growing years, provide good references.
The Japanese investment ratio, in the rapid growth era after World War II up to the
late 1980s was rarely above 35%, typically in the range of 30 to 35%. Only in very
few years has the ratio exceeded 35%. The same is true with the Korean economy.
In any case, the high level of China’s fixed asset investment to GDP is a unique
feature, but is not a permanent feature of the Chinese economy.
<Insert Chart 1 here>
How has China managed to finance such a high level of fixed asset investment?
In other words, what are the sources of savings that are financing this level of fixed
asset investment in China and how are the savings channeled into such investment?
In the Chinese economy, there are six sources of finance for fixed asset investment.
The first source is called government budgetary and extra-budgetary funds. These
are funds from government budgets, broadly defined.
Chinese governments,
especially sub-provincial governments, collect tax revenue and fees.
they have access to various sources of funds.
In addition,
At the local government level, the
major source of funds is the conversion fee of agricultural lands. Similar to Hong
Kong policy, Chinese county and provincial governments can appropriate agricultural
land from farmers’ collectives at a nominal fee, which is typically very low (for
example, five to six times the annual net income of farmers). After appropriating the
land from farmers’ collectives at a nominal fee, the local government auctions the
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land to various investors, including real estate developers or industrial investors.
These create large one-time revenue for local governments.
Alternatively, a local
government can appropriate agricultural land and make some initial investments and
convert the land into an industrial park with basic infrastructure provisions, such as
water, power, paved roads and natural gas. Then the government will either rent out
or sell portions of the industrial park to industrial investors and obtain the fee.
Through various means, the Chinese government has become a major investor,
especially at the provincial and sub-provincial level.
It should be noted that until the
very early stage of reform in the early 1980s, the Chinese central and provincial
governments were the only shareholders of state-owned enterprises, and these
state-owned enterprises relied exclusively on government budgets for their investment.
In turn, the state-owned enterprises had their taxes remitted and delivered their gross
profits to their respective government agencies.
Since the early 1980s, the practice
of budgetary appropriation of investment for these enterprises was reformed into a
system where state-owned enterprises go to banks for loans for their investment and
they must pay the principal and interest of their accounts with their earnings. This
explains the dramatic drop in the ratio of government budgetary and extra-budgetary
investment.
Chart 2 shows that the ratio of budgetary and extra-budgetary
appropriation as a share of China’s total investment.
Indeed, in the early 1980s and
in the early 1990s, there was a decided drop of the share of that type of investment for
the reasons mentioned.
Since the early 1990s, the ratio of budgetary investment has
been lower than 10% and in recent years has been lower than 5%. Therefore, it is
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safe to conclude that in today’s Chinese economy and in the near future, the budgetary
and extra-budgetary appropriations is not and will not become a major source of fixed
asset investment.
In fact, many of China’s sub-provincial governments have faced
major budgetary problems in balancing their revenue with their expenses, and there
are repeated calls from the central government to reduce local government
involvement in fixed asset investment.
Both trends have contributed to the
continued decline in the share of government budgetary and extra-budgetary
appropriation in total fixed asset investment.
<Insert Chart 2 here>
The second source of investment is, of course, bank loans. As discussed above,
bank loans gradually took over government budget appropriation as the main source
of investment.
China’s banking sector, as surveyed by Chongen Bai, is owned by
four large state-owned commercial banks which are currently under reform.
Additionally, in recent years, there are many new commercial banks entering. Chart
3 shows that the ratio of bank loans in total fixed asset investment.
The figure
conforms to the discussion above, that is, the ratio of bank loans in total fixed asset
investment steadily increased from a level below 15% in the early 1980s to a peak
level in 1993, up to around 28%. Since the early 1990s, however, this ratio is
declining.
investment?
Why the steady declining of the ratio of bank loans to fixed asset
There are at least two very likely explanations. The first explanation
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is that since the early 1990s, the structure of the Chinese economy has gradually
shifted from state-owned production to non-state-owned enterprise, whereas the
banking sector is still governed by the “Big Four” state-owned commercial banks, and
they are configured to manage transactions with state-owned agencies and are not
effective in making loans to non-state-owned enterprises.
For example, state-owned
enterprise accounting practices are agreeable to the lending criteria of state-owned
commercial banks, whereas the non-state-owned enterprises typically do not have
such accounting practices. Another explanation is state-owned commercial banks
are under great pressure to improve their lending quality in the form of reducing
non-performing loans.
Therefore, state-owned commercial banks are increasingly
cautious in distributing loans, and causing a decrease of their lending in the share in
total fixed asset investment.
The ratio of bank loans in total fixed asset investment is
under 20% in recent years.
<Insert Chart 3 here>
The third source of total fixed asset investment is the issuing of new securities,
including Initial Public Offerings (IPO) of enterprise equity shares and corporate
bonds, although corporate bonds are only a small proportion of total securities
issuance. China’s two stock markets in Shanghai and Shenzhen were established in
the early 1990s.
Initially, the Chinese government and people showed a high level of
enthusiasm for the role of the securities market.
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But by the late 1990s, due to the
poor performance of the securities market in China, due to poor regulation and the
Chinese legal infrastructure, the enthusiasm for the security market quickly turned
into disappointment and criticism. As a result, the role of the amount of IPO and
Secondary Public Offerings (SPO) gradually diminished. Chart 4 shows that the
share of new stock of corporate bond issuance in total fixed asset investment. The
chart shows that in 1993, the peak of the share of security issuance, the ratio was 10%.
Since then, the ratio has been gradually falling with a few minor peaks, which
reflected the fact that in this period, the government tried various ways to prop up the
stock market indices, therefore encouraging new issuance of security.
In recent
years, since the beginning of this century, the ratio came down to less than 4%. One
can conclude that the role of the securities market in China has been very limited in
financing total fixed asset investment.
<Insert Chart 4 here>
The fourth source of total fixed asset investment is foreign investment, including
Foreign Direct Investment (FDI) and foreign lending to Chinese agencies, mostly to
government agencies, since in China, in principle, individual corporations cannot
borrow from overseas foreign agencies. There were a few rare exceptions when
provincial governments established investment trust companies, attracting foreign
equity investment, and the regime of this international investment trust caused major
problems because of poor investment decisions by the investment companies matched
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by forced expectations of foreign investors that the Chinese provincial government
will bail out the investment trusts. Foreign direct investment in China was not a
major phenomenon until the early 1990s, after Deng Xiaoping called for accelerated
reform.
In recent years, China has been the best among developing countries at
attracting FDI, and the level of inflow of FDI has been quite stable, in the
neighborhood of USD 60 billion a year. The Chinese central government has been
very cautious in borrowing from foreign investment agencies in the form of bonds.
There is an aggregated level of foreign funds borrowed by the Chinese government
and agencies, explaining the relatively low level of bonds. Chart 5 shows the share
of foreign direct investment.
As shown in the figure, the ratio was high in the early
1980s, when the government tried to import high-technology equipment to modernize
the economy. Then, the ratio began to pick up in the early 1990s, and then has
decreased in recent years. The reason it has come down is due to the rapid growth of
China’s economy and the growth of total fixed asset investment, whereas the absolute
level has remained constant (and high) at around USD 60 billion. Overall, looking at
the future, China’s economic community and the Chinese government are debating
whether China has attracted so much foreign investment with its high savings rate,
meaning perhaps that there are too few detracting points from favorable policies to
foreign investors. Therefore it is reasonable to forecast the ration of FDI in total
fixed asset investment will continue to decline and remain at a relatively low level, in
the neighborhood of 5%.
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<Insert Chart 5 here>
The fifth part of fixed asset investment is informal investment from
households.
Informal investment from households is widely believed to be a major
source of financing for China’s non-state-owned enterprises. But this proposition
tends to be unsupported by empirical evidence.
Lacking direct data, we adopted a
strategy of calculating the upper bound of the level of informal investment from
households by the following approach: each year, we calculate the total increase of
Chinese household disposable income, as reported by the national statistical bureau.
Also, in each year, we calculate the increase in household deposits in China’s banking
sector. The difference between the increase in household disposable income and that
of the household deposits forms an upper bound of household informal investment.
This is the source of informal investment of households.
It is an upper bound rather
than an accurate number because households may put aside part of their income as
cash at home, or they may make investments in the equity market.2
It turns out that
the upper bound is a very small share of fixed asset investment.
In fact, in many
years, this upper bound is negative, showing that households are actually taking
money away from their invested projects.
This ratio is typically less than 1% of total
fixed asset investment.
The last source of investment is enterprise retained profits or funds.
2
We also calculated the consumption level of households, based on statistical bureau surveys, and extract
consumption level from disposable income, thus creating total savings of households. We deduct the increase in
household deposits from the gross total savings of households, creating the upper bound of informal investment of
households.
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Examples include undistributed profits, depreciated funds of enterprise, and special
development funds such as welfare funds, which are allowed to exist by Chinese
accounting practices. These funds are accumulated contributions from the enterprise
earnings each year. Chart 6 puts together the total amount of enterprise retained
funds and informal sector lending as a share of fixed asset total investment.
As
shown here, the ratio since the 1990s has been at a very high level, and shows the
tendency of rapid increase.
In recent years, it has reached 70%.
This is by far the
biggest source of China’s total asset fixed investment. How much is the enterprise
retained fund and informal lending as a share of GDP?
Chart 7 shows the ratio. As
can be seen, the ratio is very high and is quickly increasing, from a level of 10% to a
level of over 35%.
To help illustrate this trend further, we define a new concept
called domestic non-intermediate investment (DNI).
As the sum of enterprise
retained funds and informal lending, these two sources of investment are direct
investment from China’s economic agents, without the help of China’s formal
financial sector, such as banks and securities markets.
These funds are not
intermediated. They find for themselves ways to invest.
In order to understand
DNI better, we divide it by China’s non-agricultural GDP, since it is in the
non-agricultural sector that DNI is mostly active.
This ratio is shown in Chart 8, and
this ratio is also very high, higher than 40% in recent years.
Among DNI, the
enterprise retained funds as a share of total fixed asset investment, is also very high,
as shown in Chart 9.
In recent years, it reached a level of 50-60%, with the amount
of retained profit as a share of GDP (Chart 10), also reach a level of over 35%, and
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this ratio tends to be rather volatile.
<Insert Chart 6 here>
<Insert Chart 7 here>
<Insert Chart 8 here>
<Insert Chart 9 here>
<Insert Chart 10 here>
How high is China’s ratio of 60%?
It is useful to do some international
comparisons. A recent study (Corbett and Jenkinson 1997) shows that for almost all
developed countries, the ratio of internal source of funding to total investment is very
high. Table 1 shows that for Germany, from 1970 to 1994, as high as 78.9% of total
investment was covered by internal funds.
For Japan, the ratio was 69.9%., for the
U.K. it was 93.3 and for the United States, it was as high as 96.1%.
Therefore, in
terms of the share of retained funds in total investment, China’s ratio is not high.
In
fact, China is below the average of developed market economies. However, if we
calculate the total amount of retained profits for the purpose of fixed asset investment,
China ranks very high.
of GDP across countries.
Table 2 calculates the ratio of total retained funds as a share
This shows that China currently has a significantly higher
ratio of returned profits in financing total fixed assets.
<Insert Table 1 here>
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<Insert Table 2 here>
Next we try to explain the variation in China’s total fixed asset investment that is
explained by China’s share of DNI in total fixed asset investment.
preliminary regressions are run.
Two sets of
Table 3 shows the national level, and Table 4
contains a regression of panel data consisting of a few provinces in China. Both
tables indicate that the share of non-state-owned enterprises (in total value added) is
significant, as both an economic and statistical explanation for the share of DNI to
FAI. Next is business cycle nature.
In the regression, we put in dummy variables
for the years 1985, 1988, 1993, and 2003.
high-growth years.
These are dummy variables for
The year dummy for 1993 is the most significant, indicating that
in the economic cycle starting in the early 1990s, the ratio of DNI to FDI was very
high. Also in the regression, the structure of the economy as measured by the share
of heavy industry in GDP is also very important.
In years or provinces with a high
proportion of total industry in GDP, the share of DNI to FAI is very important.
Surprisingly, the growth rate of household savings is not a major explanatory variable.
Overall, the regressions indicate that perhaps the most significant sector affecting the
increase of the DNI-FAI ratio is the increase of non-state enterprises in the economy.
This is not surprising to most observers of the Chinese economy, because non-state
enterprises have difficulty obtaining funds. Meanwhile, they are the most dynamic
and efficient engine of rapid economic growth in China.
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<Insert Table 3 here>
<Insert Table 4 here>
II. Liabilities of Chinese governments
A very important factor concerning China’s financial sector which has not
received adequate attention is the size of government liabilities, specifically, how
much will government liabilities amount to in the coming decade?
To what extent
will the evolution of government liabilities affect China’s financial sector.
In this
section, we argue that it is very likely that the Chinese government will accumulate a
high amount of liability in their reforms, therefore yielding significant implications
for the reform of China’s financial sector.
There are at least three important institutional factors affecting the level of future
government liability in China.
“reform by borrowing”.
The first institutional factor is the principle of
This is the implicit principle of Chinese economic reform,
since the reforms in China have not been preceded by fundamental political change,
shaking up the various interest groups in the economy. Therefore, the process of
reform in China inevitably is one that compensates losers of reform.
That is, various
stakeholders of the pre-reform economic system can potentially block the process of
reform.
The stakeholders have to be bought out.
Meanwhile, Ronald McKinnon
(McKinnon 1994) argues in the reform era, the government’s fiscal capacity is
diminishing. Therefore, the government has to rely on borrowing from households
and enterprises in order to finance the above normal financial burden of compensating
losers of reform.
In sum, the principle of ”reform by borrowing” implies that the
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Chinese government will still face the need to finance the reform by borrowing. The
second institutional factor to consider is that after two and a half decades of reform,
China’s government is becoming attentive to demands of various vocal groups of
society, and to the demands of the so-called “weak groups” of society, including the
unemployed and farmers. The economic consequence of this political change is that
the government has promised or will promise more and more economic progress to
compensate various segments of population.
For example, recently, the government
promised it would resolve the problem of high prices for medical care.
government also promised to promote and invest in rural areas to
The
“Construct the
New Socialist Countryside”. Some scholars recently made the accusation that the
program of “Constructing the New Socialist Countryside” requires physical or
financial capacity of the government amounting to about 25% of Chinese GDP in the
coming five to ten years.
Thus, the populist tendency of the government is leading
to more liabilities of the Chinese government.
The third institutional factor
concerning Chinese government liabilities is the nature of China’s banking sector,
which has been mostly dominated by state-owned commercial banks.
These banks
historically have invested in government projects, including state-owned enterprises.
Many of these investments end up losing money, even if these banks are state-owned
and a large proportion of the assets of these banks are household or enterprise deposits.
The financial loss accumulated over the years of the state-owned commercial banks
eventually will become explicit debt of the central government.
Therefore, this is
another unique source of government liabilities in the years to come in China.
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In addition to the three unique institutional factors affecting Chinese government
liabilities, there is another institutional setup which has to be considered when
discussing Chinese government liabilities.
That is, since the early 1990s, the
Chinese central government has had increasingly improved fiscal stature, as
evidenced by the rapid increase in fiscal revenue, higher than the growth rate of GDP.
Meanwhile, China’s sub-provincial governments are facing dire fiscal difficulties.
Since reform in the early 1990s shifted the rights of collecting taxes and fees from
local governments to the central government, many local governments have
accumulated a large amount of fiscal deficits. Although by China’s fiscal budget law,
local governments cannot issue debt and should not run into fiscal deficits, in reality,
many governments accumulated fiscal debts by delaying payment to their employees,
including schoolteachers and local government officials and staff. Eventually the
fiscal difficulties of local governments will make themselves felt at the central
government level.
The central government has to pay at least those local
governments in economically backward regions.
government liabilities be in coming years?
made a simple calculation.
How high will Chinese
Li and Li, in the Cato Journal of 2003,
According to their calculations, by 2018, the outstanding
conventional debt of the central government will be as high as 45% of GDP. This is
a result of the continued fiscal deficit of the Chinese government, which we forecast
due to mounting government liabilities. The second component of the source of debt
is outstanding foreign debt, which is conservatively assumed to be unchanged from
today, roughly in the neighborhood of 15% of GDP.
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The third item is
non-recoverable non-performing loans of state-owned commercial banks, which,
again conservatively, could be as high as 35% of GDP.
Another liability is
government pensions, due to the fact that the Chinese government promised to pay
pensions to the current working generation.
However, the current working
generation’s input is diverted to pay for current retirees. As a result, their retiree
benefits will have to be paid by the central government.
high as 45%.
This liability could be as
This also partially reflects the aging of the Chinese population.
Overall, the total level of debt is shown in Table 4. The debt could be as high as
115% of GDP. This will put China as one of the highest government liabilities,
similar to today’s Japan.
However, different from governments like Japan and the
U.S., the Chinese government has a high amount of assets in the form of state-owned
enterprises and other institutions.
According to a rough study by Li and Li (2003),
the value of assets under the government’s control should be 125-150% of GDP.
Examples include government shares in companies such as China Mobile, PetroChina,
Sinopec, and so on. When we argue that the total amount of debt will be lower than
the projected value of assets under China’s control, the Chinese government will not
become a major factor destabilizing the financial sector. We disagree with this view,
since the maturity of the liabilities may not be well-matched by the liquidity of the
assets. That is, the government assets may not be liquid enough for the government
to quickly turn them into funds in order to service its debt.
It is very likely that the
government will have to continue to issue high amounts of debt in order to maintain
the high level of liability.
It is unrealistic for the government to gradually convert
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these assets in order to retire their debt.
Therefore, the higher amounts of
government liabilities in China in the coming decades should be a factor deserving
careful consideration.
<Insert Table 5>
III.
Implied Challenges for China’s Financial Reform
There are at least three categories of challenges given our analysis above.
The
first challenge is to improve the efficiency of DNI, or domestic non-intermediated
investment.
China’s DNI is of a higher proportion compared to other countries, as
shown in Table 1. Obviously, a high level of DNI poses a question of efficiency.
Indeed, many indices have shown that China’s DNI has not been particularly efficient.
Examples such as the many unsuccessful projects support this theory.
In order for
China to improve efficiency of total investment, it is desirable to incorporate an
increasing proportion of DNI into the financial sector.
In general, non-intermediated
investments are localized in one enterprise or in enterprises with close relationship to
the source of investment. Therefore, the efficiency cannot be as high as that of a
well-functioning financial sector. Related to the issue of the efficiency of DNI,
China’s financial sector faces the challenge of playing a more active role in improving
corporate governance, forcing business to pay its shareholders before making
investments internally.
In this regard, various regulations and legislations have to be
enacted and properly enforced.
For example, the various laws regarding merger and
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acquisitions are not enacted in China, impeding the process of mergers and
acquisition. The lack of mergers and acquisitions translates into inadequate pressure
on poor managers, causing inefficient investment.
The second category of challenge to financial sector reform is the issue of capital
flow. Will China follow the practice of India in opening up capital flow in the near
future?
The answer is most likely no. There are at least two reasons behind this.
The first is given that the Chinese government will continue to accumulate large
amounts of liabilities, and that its assets are not as liquid as liabilities, the government
will have to rely on household loans. Opening up the capital flow means that the
government will have to compete against foreign firms for household savings. This
will not only increase borrowing costs, but will also add to uncertainty in its
borrowing needs. Another reason is that once China opens up capital flow it is
unclear whether the large amounts of DNI will leave China. China’s enterprises may
not choose to invest domestically. They may transfer their funds to foreign financial
markets.
When this happens the Chinese macroeconomy will fluctuate, causing
major problems for the Chinese government.
The third reason for the unwillingness
of the Chinese government to follow India in opening capital flow is Chinese central
banks foreign currency reserves will be seemingly too high. As of today, these
reserves are number one in the world, other than Japan, in an amount over USD 650
billion.
How to manage such a high level of currency reserves?
Traditional
thinking is these reserves should be invested in liquid assets in order to stand by for
unexpected contingencies, especially large amounts of capital flows out of the
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domestic economy.
In the Chinese case, capital control is likely to remain in place.
The third challenge is: how should the government manage capital reserve?
There are three major strands of though on this issues. One is to keep the status quo,
that is, invest in liquid assets such as U.S. Treasury Bonds, Euro Bonds, and Japanese
currency bonds. The benefit is safety, but the drawback is high cost, because these
financial instruments offer lower rates of return than Chinese average rate of return to
investment.
The second line of thinking is to somehow return the currency reserves
to private investors or enterprises in China. For example, create a kind of investment
fund and let Chinese households buy units of these investment bonds.
These are
then invested in hard currency overseas. The third line of thinking is to use currency
reserves as a strategic investment for the whole country through China’s central bank.
For example, part of the reserves can be used for equity shares of multinationals
having a high ratio of natural resource reserves.
This way the country can hedge the
risk of the price increase of natural resources, on which the Chinese economy is
increasingly dependent.
In any case, whatever China will do with its mounting
currency reserves, the whole world financial market will pay particular attention.
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Chart 1
Fixed Asset Investment/GDP
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
0.00%
FAI/GDP
Chart 2
Budgetary and Extra-Budgetary Appropriation / Fixed
Asset Investment
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
23
Chart 3
Bank Loans for Fixed Asset Investment/Total
Fixed Asset
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
国内贷款用于固定资产投资的部分/全社会固定资产投资
Chart 4
(New Stock & Corporate Bond Issuance)/Total
Fixed Asset Investment
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
(股票+企业债券)/全社会固定资产投资
24
Chart 5
Foreign Investment/Total Fixed Asset Investment
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
外资/FAI
Chart 6
(Enterprise retained funds + informal
lending)/Total Fixed Asset Investment
80.00%
60.00%
40.00%
20.00%
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
0.00%
自筹和其他（减去股票债券和预算外）/全社会固定资产投资
25
Chart 7
DNI/GDP
40.00%
35.00%
30.00%
25.00%
20.00%
DNI/GDP
15.00%
10.00%
5.00%
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
0.00%
Chart 8
DNI/（Non-Agriculture GDP）
50.00%
40.00%
30.00%
20.00%
10.00%
DNI/（GDP-农业）
26
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
0.00%
Chart 9
Enterprise retained funds / Total Fixed Asset
Investment
100.00%
50.00%
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
0.00%
-50.00%
（DNI-infomal）/FAI
Chart 10
Enterprise Retained Funds/GDP
40.00%
35.00%
30.00%
25.00%
20.00%
(DNI-informal)/GDP
15.00%
10.00%
5.00%
27
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
-5.00%
19
83
19
81
0.00%
Table 1: Net Sources of Finance---1970-94(Percentages)
Germany
Internal
Bank
finance
Bonds
New equity
others
Japan
United Kindom
United States
78.9
11.9
69.9
26.7
93.3
14.6
96.1
11.1
-1.0
0.1
10.1
4.0
3.5
-4.0
4.2
-4.6
-7.6
15.4
-7.6
-15.1
Source: Corbett & Jenkinson (1997);
Table 2: A Comparison of Total Investments from Retained Funds as Shares of
GDP across Countries
Country
China
Years
1980-89
Retained Funds
7.19%
China
China
Germany
Japan
United
United
Kingdom
States
1990-99 2000-04
1970-94
1970-94
1970-94
1970-94
19.10%
20.37%
24.07%
18.07%
19.59%
25.95%
Investment/GDP
Source: Calculation based on Corbett & Jenkinson (1997) and author’s
calculation based on China Statistical Yearbook of various year.
28
Table 3: Regressions of Domestic Non-Intermediated Investment/Total
Fixed Asset Investment: National Data 1980-2004
C
0.1393
-0.0284
0.1717
Share of
Non-State
Owned
Enterprises
0.6029
0.5926
0.6734
(4.71)
-0.0642
(5.15)
(5.45)
Growth of HH
Savings
GDP growth
HEAVY_Ind
share
DUMMY85
DUMMY88
DUMMY93
DUMMY03
Adjusted R^2
(-0.42)
-1.1355
(-2.00)
0.3349
(1.76)
0.0216
(0.27)
0.0141
(0.18)
0.1947
(2.50)
0.0424
(0.55)
0.6371
0.4823
0.6240
0.1181
0.0516
(0.22)
-1.3747
(-1.63)
0.4322
0.6814
(2.50)
(2.76)
0.1488
(2.04)
0.1266
(1.56)
0.0902
(0.72)
0.1476
(1.22)
0.1331
(1.23)
0.6469
0.5581
0.0270
0.0522
0.2169
29
Table 4: Panel Data Regressions of Domestic Non-Intermediated
Investment/Total Fixed Asset Investment: 1980-2004
Random Effect
Regression
Fixed Effect Regression
C
0.40
0.42
GDP Growth Rate
-0.07
(0.21)
0.16
-0.16
(-0.48)
0.12
(2.36)
-0.06
(1.75)
-0.06
(-0.91)
(-1.08)
0.10
0.77
0.34
0.10
0.82
0.29
Share of Non-State
Enterprises
Growth Rate of HH
Savings
R^2
within
between
0verall
Notes:
Provinces included are Beijing, Guizhou, Shanghai, and Sichuan.
30
Table 5: An Estimate of Chinese Government Debt by 2018
(from Li and Li, Cato Journal 2003)
Sources of Debt
Percentage in GDP
Outstanding conventional domestic debt
45%
Outstanding foreign debt, assuming no change from 2003
15%
Non-recoverable non-performing loan of state banks
15%
The Pension Liabilities
45%
Grand total of debt
120%
Asset
Book value of capital under government control
31
125% - 150%
References:
China Statistical Bureau: China Statistical Yearbook (Various Years from 1985 to
2005.) China Statistical Publisher. Beijing.
Corbett, Jenny and Tim Jenkinson: How Is Investment Financed? A Study of
Germany, Japan, the United Kingdom and the United States. The Manchester
School Supplement pp. 69-93. 1997.
Kornai, Janos: Economics of Shortage. North Holland Publisher. Amsterdam,
Holland. 1980.
Li, David D. Li and Ling Li: “The Pension Reform Debt: A Simple Resolution of
China’s Pension System Crisis.” The Cato Journal. V.23, n.2, pp.281-289, Fall
2003.
McKinnon, Ronald: The Order of Economic Liberalization. Johns Hopkins
University Press. Baltimore, Md. 1994.
32