Download What is financial reform in China? Michael Pettis, Chief Strategist Macro Research

Macro Research | HK & China
China Financial Markets
June 18, 2012
What is financial reform in China?
Michael Pettis, Chief Strategist
Before jumping into the main topics of this newsletter, I wanted to start off with a
quick anecdotal impression that might or might not be meaningful. This year so far
has turned out to be extremely busy for me with several investors meetings a week
in Beijing and around the world. For the past few years, most of these meetings
tended to focus very heavily on straight economic issues – how the Chinese growth
Sales Contact
Dan Weil
Global Head of Institutional Sales and Trading
Managing Director
+852 2248 3588
[email protected]
model works, how much debt there is, what the rebalancing process entails, and so
Chris Berney
on – with occasional discussions about the political process.
Managing Director
+852 2248 3568
[email protected]
But as I was returning from some meetings on Tuesday it occurred to me that for
Roger Chiman
the past few months a lot of my discussions, especially when I met with more
Managing Director
+852 2248 3598
[email protected]
sophisticated investors who have been tracking China closely, have been
dominated by politics. There is a lot more interest in Chinese corporate and political
governance than there has been in the past, and many of the questions focus on
the issue of “vested interests”, on factional disputes, and on political constraints to
rebalancing. Investors now, more than ever before, want to discuss prospects for a
greater “federalisation” of Chinese politics, the potential role of the military, the
strength of the reformist camp, and how the redistribution of wealth from the state
Andrew Collier
Director
+852 2248 3528
[email protected]
Joe Chan
Director
+852 2248 3578
[email protected]
sector to the household sector – a sine qua non of rebalancing – is likely to be
treated in the context of Chinese politics.
Cancy Kong
Vice President
+852 2248 3538
[email protected]
Part of this rising interest in politics, of course, is driven by the rather astonishing
set of events surrounding the Bo Xilai affair, as well of course the rumours
surrounding the leadership transition later this year. But it seems to me that there is
more to it than just that. I think that there is a growing recognition among both
Gary Wong
Associate
+852 2248 3548
[email protected]
Chinese and foreign investors that China has no choice but to rebalance, that the
rebalancing is going to be difficult, and that the form in which the rebalancing takes
place will be determined largely by political, and not economic, constraints.
This makes sense to me. I have been arguing for the past two years that
rebalancing almost by definition means that state sector assets must grow much
more slowly in the future than they have in the past, and that this has important
political implications.
In his excellent 1993 book, Debt, Development and Democracy, about Latin
America’s experience in the 1960s and 1970s with its own version of China’s
investment-driven growth model, Jeffrey Frieden pointed out that economic
distortions in Latin America benefitted certain sectors disproportionately, and as
these sectors consequently saw their political power grow, they became the
greatest impediments to reform, especially to the extent that reforms were aimed at
eliminating the distortions.
For important disclosures, refer to the Information Disclosures at the end of this report.
1
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
This is perhaps a useful way of thinking about some of the challenges China will face,
and it is clear to me that investors are increasingly recognising that economic reform in
China is likely to face some of the constraints discussed by Frieden in the Latin American
context. In itself this growing recognition of the political challenges shouldn’t be a surprise,
but the fact that politics have moved to the center of the debate on China shows just how
widely accepted the whole rebalancing thesis has become.
I suspect that over the next few years we are going to be talking less about why China
needs to rebalance and more about the political constraints surrounding the various
paths to rebalancing. In that context the recent economic data coming out of China, and
especially the higher-than-expected growth in May loans (RMB793 billion, compared to
expectations of RMB700 billion), suggests that the economic slowdown is continuing but
Beijing is likely to be more aggressive in taking steps to combat it. Loan demand, as I
discussed in the last issue of my newsletter is weak but I expected then, and continue to
expect, that Beijing can create growth anyway by allowing and encouraging local
governments to expand infrastructure investment.
Planes, trains and automobiles
This seems to be happening, although needless to say there is a great deal of worry,
within Beijing policymaker circles as well as among economists inside and outside China,
that although expanding infrastructure investment addresses the problem of slow growth,
it will do so at the expense of worsening the domestic imbalances by putting additional
downward pressure on consumption growth. The debt supporting increased investment,
after all, must be serviced, and if economic value creation is insufficient to pay for the
servicing costs, the household sector will end up subsidising it through repressed interest
rates.
Here, according to an article in the South China Morning Post, is where some of the new
lending will eventually be going:
China will build 70 new airports within the next three years, the head of the
country's aviation watchdog said on Monday, as part of ambitious expansion plans
in the industry despite an economic slowdown.
Civil Aviation Administration of China (CAAC) chief Li Jiaxiang also reiterated
pledges that carriers would buy on average more than 300 planes a year from last
year to 2015 – the country’s current five-year economic plan. “China plans to build
70 new airports in the next few years and to expand 100 existing airports,” he told
delegates in Beijing at the annual general meeting of global airline industry group
IATA.
The justification for expanding an already overbuilt air-travel network – and more money
is also being channeled to the railway network, according to local newspapers – is that
rapid growth in China will ensure that these airports will eventually be needed even if they
aren’t now. The article goes on to quote Ma Kai, a state councilor in charge of economic
development, as saying that China’s aviation market had the “biggest growth potential” in
the world. “Ever since 2005,” he argues, “the industry has realised an annual growth rate
of 17.5 percent”.
Guosen Securities (HK) Brokerage Co., Ltd.
2
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
This kind of reasoning, of course, is always used to justify substantial additional
expansion in infrastructure beyond current needs, but it is a risky justification. If China
continues growing at a ferocious rate, the expansion in investment, which itself gooses
growth, will probably pay off, but if it does not, it will simply add to the debt burden that
slows growth even further. This is very pro-cyclical, and pro-cyclicality, remember,
automatically increases expected volatility, which itself becomes a drag on growth by
affecting the business climate.
Capacity in China is so high, and demand, excluding the building of even more capacity,
is so weak that I worry that we are simply exacerbating the overinvestment problem. This
certainly seems to be the case in the automobile industry. According to an article in
Bloomberg:
Carmakers are giving Chinese dealers no relief in their effort to reduce a glut of
unsold automobiles in a slowing economy, as factories pump passenger vehicles
into showrooms faster than distributors can sell them.
Wholesale deliveries, including multipurpose and sport-utility vehicles, climbed 23
percent from a year earlier to 1.28 million units in May, the China Association of
Automobile Manufacturers said June 9 in Beijing.
That beat the 1.2 million average estimate of seven analysts in a Bloomberg
survey, the third straight month shipments exceeded forecasts.
The surge…may raise pressure on distributors to deepen discounts and sell cars
at a loss to meet mandatory targets set by automakers. Factory managers may
have to slow production unless the discounts and potential government policies to
encourage sales ease the glut.
…Average inventory carried at Chinese showrooms bloated to a level exceeding
two months of sales by the end of May, compared with more than 45 days at the
end of April, Luo Lei, deputy secretary general of the state-backed China
Automobile Dealers Association, said in an interview last week. The glut at the
dealerships, which is leading to price cuts, is unsustainable, he said. “The picture
we have is very different from what the automakers are painting,” Luo said. “The
sales increases they’re reporting are achieved by loading dealers with stock.”
But as a response to the recent slow-down, and perhaps to the dismay of policymakers
who see rebalancing as increasingly urgent, on Thursday the PBoC announced that for
the first time since 2008 it was lowering interest rates. The one-year lending and deposit
rates were reduced by 25 bps, although the PBoC also announced that it was allowing
banks the flexibility to pay 10% more than the maximum deposit rate. There may be more
to come on the interest rate front. According to an article in Friday’s South China Morning
Post:
The Chinese government is more likely to implement further reforms or cuts in
interest rates and reserve ratios, rather than launching an expensive new stimulus
plan, current and former officials told a conference on Thursday.
Two more interest rate cuts and three more reserve ratio (RRR) cuts were
possible before the end of the year, said Cao Wenlian, the former deputy director
Guosen Securities (HK) Brokerage Co., Ltd.
3
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
of the finance department at the National Development and Reform Commission.
But China does not need another stimulus package like the one in 2008, which
super-charged growth but left local governments saddled with debt, he added.
With inflation having declined so much it may seem to make sense to cut the lending rate,
but I worry that lending rates are still too low and that for the sake of rebalancing and to
limit more asset misallocation it makes sense to raise them, not lower them. There is,
however, a tradeoff between short-term growth and medium-term rebalancing that isn’t
easy to resolve, especially since the external environment is so fragile, and policymakers
in Beijing are very seriously debating this tradeoff.
Did deposit rates drop, or rise?
To return to last Thursday’s PBoC announcement on interest rates, a lot of analysts
hailed the 10% flexibility in setting the deposit rate as an important step towards interest
rate liberalisation. For example here is what the Financial Times had to say about it on
Thursday:
When China cut interest rates last week, the move was seen as an effort to
stimulate the slowing economy. But in the long term, the greater significance may
lie in a less-noticed change to the way that Chinese banks set deposit rates.
The new measure permitted banks to set deposit rates 10 per cent above the
benchmark level. This seemingly minor adjustment was a hugely important first
step towards dismantling a ceiling on deposit rates that the government had
previously used to limit competition among banks.
Perhaps allowing banks to pay 10% more than the deposit rate cap is a real innovation
that really will lead towards deposit rate liberalisation, but I can’t help but think that there
is a lot less to this “flexibility” than meets the eye. After all, the PBoC hasn’t in anyway
relinquished its capping of deposit rates.
The central bank instead said that the maximum deposit rate has declined by 25 bps but
banks are allowed to charge 32.5 bps above the maximum. Doesn’t this just mean that
the maximum deposit rate went up by 7.5 bps? Would it have been much different if the
PBoC had simply raised the maximum deposit rate by 7.5 bps and allowed no “flexibility”
or are we, as we often tend to do, giving far more weight to what regulators say they are
doing than to what they actually do?
Certainly, and not at all surprisingly given the fierce demand for deposits, the response of
banks was not to lower the deposit rate but rather to raise it. Here is China Daily on the
subject:
Chinese lenders are in fierce competition to attract savers after the central
raised
the
deposit
rate
ceiling.
Smaller
lenders
such
bank
as
Shenzhen Development Bank and Huaxia Bank raised their one-year deposit
rates to 3.575%, a day after the Big Five lenders raised the interest rate they pay
to 3.5%.
Xinhua had an even more interesting story, showing just how banks think about the
“benchmark” once you add this kind of “flexibility”:
Guosen Securities (HK) Brokerage Co., Ltd.
4
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
Many of China's banks have maintained or raised their deposit rates after the
central bank announced last week that it would allow the country's banks to set
competitive deposit and lending rates. The People's Bank of China said Thursday
that lenders would have the flexibility to set deposit rates as high as 110 percent
of the benchmark rate and offer rates on new loans as little as 80 percent of
official policy rates.
The People's Bank of China also cut the benchmark one-year interest rates by 25
basis points on Friday to 3.25 percent in a bid to spur growth in the world's
second-largest economy. But despite the interest rate cut, China's five
state-owned banks have maintained their one-year deposit rates at 3.5 percent.
Some commercial lenders, including China Minsheng Banking Corp. and China
Merchants Bank, set their rates at 3.25 percent on Friday, but raised them to 3.5
percent one day later. Meanwhile, some small lenders and city banks, such as the
Bank of Nanjing and Bank of Ningbo, have set their rates at 3.575 percent, the
top-end of the floating range of the benchmark deposit rate.
Regardless of whether Thursday’s announcement can best be described as a reduction
or an increase in the deposit rate, because it increases the household income share of
growth, raising the deposit rate is certainly a good thing for rebalancing, especially since
the continued decline in inflation (an unexpectedly low of 3% in May) means that the real
deposit rate has risen by a lot more.
But it is worth remembering that for real rebalancing China also needs to raise the
lending rate. Why? Because aside from the impact it would have on capital misallocation,
reducing the profitability of the banking sector by raising the cost of bank funding simply
means that banks will have less capital with which to cover future NPL losses. If future
NPLs exceed bank capital, as many of us believe they do, less profit for the banks will
just mean more losses that have to be passed on to someone else, and traditionally the
losses have been passed on to the household sector.
In that case what households are receiving on the one hand they might just have to
return on the other. This isn’t going to help in the medium term. We will see if this recent
move by the PBoC really is the beginning of a longer-term process of interest rate
liberalisation, but I still think a little skepticism about these things has always been a
winning strategy, and I see no reason to believe that this time will be different.
One part of the economic data did surprise me. May’s export numbers were substantially
higher than almost any of us had expected. Exports increased 15.3% since last May,
compared with 4.9% growth in April, and imports were up 12.7% y-o-y, compared with
0.3% last month. Normally this would suggest that external demand was recovering, but
it is hard to see how this might have happened. The global environment is worse than
ever, and as far as I know other export countries did not replicate China’s surprisingly
good export numbers. So what happened to explain May’s great numbers? I am not sure,
but perhaps there was some sort of technical factor related to April’s very poor numbers. I
would want to wait another month or two to see if export growth can be sustained.
Guosen Securities (HK) Brokerage Co., Ltd.
5
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
Financial reform?
To move away from the recent numbers, Premier Wen’s attack on the Chinese banking
system last month has highlighted what was already a very interesting debate on
Chinese banks and the Chinese financial system. There is a growing sense that the
Chinese banking system is deeply flawed and needs to be reformed.
But why should China reform its banking – hasn’t the financial system been a key
component of China’s economic success in the past three decades? Just as importantly,
what does financial reform mean – what kind of changes would need to be implemented
for a real reform to occur?
Before addressing these questions we should be clear that there is no meaningful
difference between China’s banking system and its financial system. Commercial banks
dominate the country’s financial system and they largely determine pricing even in the
informal banking system and in non-bank financial institutions. It also seems pretty clear
that much of the funding within that ambiguous thing called the informal banking sector
originates in the commercial banks. For example, SOEs seem to be increasingly involved
in financing activities, but they are probably doing so largely as a function of the
“arbitrage” between the rates at which they can obtain funding from the banks and the
rates at which they can lend.
So China’s financial system is, for the most part, its commercial banks, and the key
characteristic of the banking system is what we would call financial repression. What is a
financially repressed system and why does it matter? In a recent paper (“Financial
Repression Redux”, Finance & Development, June 2011) Carmen M. Reinhart, Jacob F.
Kirkegaard and M. Belen Sbrancia described a financially repressed system this way:
Financial repression occurs when governments implement policies to channel to
themselves funds that in a deregulated market environment would go elsewhere.
Policies include directed lending to the government by captive domestic
audiences (such as pension funds or domestic banks), explicit or implicit caps on
interest rates, regulation of cross-border capital movements, and (generally) a
tighter connection between government and banks, either explicitly through public
ownership of some of the banks or through heavy “moral suasion.”
Financial repression is also sometimes associated with relatively high reserve
requirements (or liquidity requirements), securities transaction taxes, prohibition
of gold purchases, or the placement of significant amounts of government debt
that is nonmarketable. In the current policy discussion, financial repression issues
come under the broad umbrella of “macroprudential regulation,” which refers to
government efforts to ensure the health of an entire financial system.
As the passage above implies, most savings in financially repressed countries, like most
of the countries that followed the Asian development model, are in the form of bank
deposits. The banks, furthermore, are controlled by the policymaking elite, and they
determine the direction of credit, socialise the risks, and set interest rates. Financial
repression is a way of describing a system in which the rates of return and the direction of
investment of domestic savings are not determined by market conditions and individual
preferences but rather are heavily controlled and directed by financial or political
Guosen Securities (HK) Brokerage Co., Ltd.
6
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
authorities. At the extreme the financial system is often little more than the fiscal agent of
the government.
If the central bank – or whichever institution has the appropriate responsibility – sets at
an excessively high level the rates that household savers earn on their savings, it is
effectively transferring resources from borrowers to depositors. If it sets the rate
excessively low, of course, it does exactly the opposite. In most countries that create the
conditions of financial repression – for example the countries that broadly followed the
Asian or Japanese development model – interest rates have been set extremely low.
This is very clearly the case for China, as I have discussed many times in this newsletter.
Normally under these circumstances we would expect the losers in the system, the
depositors, to opt out of depositing their savings in local banks, but it is extremely difficult
for them to do so. There are usually significant restrictions on their ability to take capital
out of the country and there are few local investment alternatives that provide similar
levels of safety and liquidity.
Depositors foot the bill
Depositors, in other words, have little choice but to accept very low deposit rates on their
savings, which are then transferred through the banking system to borrowers, who
benefit from these very low rates. Very low lending and deposit rates create a powerful
mechanism for using household savings to boost growth by heavily subsidising the cost
of capital.
The ones who lose under conditions of financial repression are net depositors, who tend
for the most part to be the household sector. The ones who win are net borrowers, and in
most countries in which financial repression is a significant policy tool, these tend to be
local and central governments, infrastructure investors, corporations and manufacturers,
and real estate developers. Financial repression transfers wealth from the former to the
latter.
But, as the case of China shows us, the fact that net depositors “lose out” is not
necessarily a cause for concern. If the amount of growth generated by the system is so
high that households still experience rapid growth in their incomes even as their share of
GDP declines, then there is no reason to criticise the system – and in fact until recently
nearly all China-focused analysts characterised China’s banking system as well
organised and a critical source of China’s economic success.
But there was nonetheless a serious flaw in the banking system and this flaw, I would
argue, has been at the heart of the imbalances that will ultimately force China into a
difficult rebalancing. To see why, it makes sense, I think, first to understand under what
conditions the system adds value. To do so it is useful to go back to the work of the
Ukrainian-born American economist, Alexander Gershenkron (1904-78).
Gershenkron posited in the 1950s and 1960s the concept of “backwardness”, and argued
that the more backward an economy was at any point in time – with relatively low
manufacturing capacity and infrastructure, and perhaps higher levels of social capital –
the more growth could be generated under conditions in which consumption would be
constrained in favor of investment and the savings rate forced up (see, for example,
Economic Backwardness in Historical Perspective, Cambridge, 1962, Belknap Press).
Guosen Securities (HK) Brokerage Co., Ltd.
7
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
He argued that because of failures in the private financial sector to identify investments
with positive externalities, there was likely to be, and ought to be, a greater reliance on
state-directed banks to allocate capital.
In a 2003 book review Columbia University economist Albert Fishlow very usefully
elucidated Gershenkron’s position (“Review of Economic Backwardness in Historical
Perspective”, February 13, 2003, EH.net):
1.
Relative backwardness creates a tension between the promise of economic
development, as achieved elsewhere, and the continuity of stagnation. Such a
tension takes political form and motivates institutional innovation, whose product
becomes appropriate substitution for the absent preconditions for growth.
2.
The greater the degree of backwardness, the more intervention is required in the
market economy to channel capital and entrepreneurial leadership to nascent
industries. Also, the more coercive and comprehensive were the measures
required to reduce domestic consumption and allow national saving.
3.
The more backward the economy, the more likely were a series of additional
characteristics: an emphasis upon domestic production of producers' goods rather
than consumers' goods; the use of capital intensive rather than labour intensive
methods of production; emergence of larger scale production units at the level both
of the firm as well as the individual plant; and dependence upon borrowed,
advanced technology rather than use of indigenous techniques.
4.
The more backward the country, the less likely was the agricultural sector to
provide a growing market to industry, and the more dependent was industry upon
growing productivity and inter-industrial sales, for its expansion. Such unbalanced
growth was frequently made feasible through state participation.
This of course sounds a lot like the Chinese growth model, and that of a number of other
countries that experienced growth “miracles” in the 20th Century. In fact countries
undergoing the process described by Gershenkron were able to generate fairly
substantial increases in wealth for long periods of time – as clearly happened in China, at
least during the first fifteen or twenty years since the reforms of 1978.
But the case of China, and every other case of an investment-driven growth miracle,
suggests that the model cannot be sustained indefinitely because there are at least two
constraints. The first has to do with the constraint on debt-financed investment and the
second with the constraint on the external account, and one or both constraints have
always eventually derailed the growth model.
Overcoming backwardness
To address the first constraint, in the early stages for most countries that have followed
the investment-driven growth model, when investment is low, the diversion of household
wealth into investment in capacity and infrastructure is likely to be economically
productive. After all, when capital stock per person is almost non-existent, almost any
increase in capital stock is likely to drive worker productivity higher. When you have no
roads, even a simple dirt road will sharply increase the value of local labour.
Guosen Securities (HK) Brokerage Co., Ltd.
8
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
The longer heavily subsidised investment continues, however, the more likely that cheap
capital and socialised credit risk fund economically wasteful projects. Dirt roads quickly
become paved roads, paved roads become highways, and highways become super
highways with eight lanes in either direction.
The decision to upgrade is politically easy to make because each new venture generates
local employment, rapid economic growth in the short term, and opportunities for what
economists politely call rent seeking behavior, while the costs are spread throughout the
entire country through the banking system and over the many years during which the
debt is repaid (and since most debt is rolled over continuously, this means effectively that
the cost is repaid over the next fifteen to twenty years).
It also seems easy to justify intellectually the infrastructure upgrades. After all, rich
countries have far more capital stock per person than poor countries, and those
investments were presumably economically justified, so, according to this way of thinking,
it will take decades of continual upgrading before China comes close to overbuilding.
The problem with this reasoning of course is that it ignores the economic reason for
upgrading capital stock and assumes that capital and infrastructure have the same value
everywhere in the world. They don’t. Worker productivity and wages are much lower in
China than in the developed world.
This means that the economic value of infrastructure in China, which is based primarily
on the value of labour it saves, is a fraction of the value of identical infrastructure in the
developed world. It makes no economic sense, in other words, for China to have levels of
infrastructure and capital stock anywhere near that of much richer countries since this
would represent wasted resources – like exchanging cheap labour for much more
expensive labour-saving devices.
Of course credit risk is ultimately socialised – that is all borrowing is implicitly or explicitly
guaranteed by the state. Socialised credit risk means the lender does not need to ask
whether or not the locals can use the highway and whether the economic wealth created
is enough to repay the cost.
In fact the system creates an acute form of what is sometimes called the “commonwealth”
problem. The benefits of investment accrue over the immediate future and within the
jurisdiction of the local leader who makes the investment decision. The costs, however,
are spread widely through the national banking system and over many years, during
which time, presumably, the leader responsible for the investment will have been
promoted to another post in another jurisdiction. With very low interest rates and other
subsidies making it hard to determine whether investments actually reduce value or
create it, the commonwealth problem ensures that further investment in infrastructure is
always encouraged.
The problem of overinvestment is not just an infrastructure problem. It occurs just as
easily in manufacturing. When a manufacturer with privileged access to the banking
system can borrow money at such a low rate that he effectively forces most of the
borrowing cost onto household depositors, he doesn’t need to create economic value
equal to or greater than the cost of the investment. Even factories that systematically
destroy value can show high profits, and there is substantial evidence to suggest that in
China the state-owned sector in the aggregate has probably been a value destroyer for
Guosen Securities (HK) Brokerage Co., Ltd.
9
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
most if not all the past decade, but is nonetheless profitable thanks to household
subsidies.
And these subsidies are substantial. A mainland think tank, Unirule, estimated in 2011
that monopoly pricing and direct subsidies may have accounted for as much as 150
percent or more of total profitability in the state owned sector over the past decade. I
calculate that repressed interest rates may have accounted for another 400 to 500
percent of total profitability over this period. Monopoly pricing, direct subsidies, and
repressed interest rates all represent transfers from the household sector.
At some point, in other words, rather than create wealth, capital users begin to destroy
wealth, but nonetheless show profits by passing more than 100% of the losses onto
households. The very cheap capital especially means that a very significant portion of the
cost – as much as 20-40% of the total amount of the loan – is forced onto depositors just
in the form of low interest rates.
How? Because artificially lowering a coupon on a ten-year loan by 4 percentage points
effectively represents debt forgiveness equal to 25% of the loan. Lowering the coupon by
6 percentage points represents forgiveness of 35% of the loan. Although most bank
loans in China have maturities of less than ten years, these loans are rarely repaid and
are instead rolled over for very long periods of time, so increasing the value of the implicit
debt forgiveness. Low interest rates are effectively a form of substantial debt forgiveness
granted, usually unknowingly, by depositors.
The rise of debt
Under these circumstances it would take heroic levels of restraint and understanding for
investors not to engage in value destroying activity. This is why countries following the
investment-driven growth model – like Germany in the 1930s, the USSR in the 1950s
and 1960s, Brazil in the 1960s and 1970s, Japan in the 1980s, and many other smaller
countries – have always overinvested for many years leading, in every case, either to a
debt crisis or a “lost decade” of surging debt and low growth 1.
The second constraint is that policies that force households to subsidise growth are likely
to generate much faster growth in production than in consumption – growth in household
consumption being largely a function of household income growth. In that case even with
high investment levels, large and growing trade surpluses are needed to absorb the
balance because, as quickly as it is rising, the investment share of GDP still cannot
increase quickly enough to absorb the decline in the consumption share.
This is what happened in China in the past decade until the crisis in 2007-08, after which
Beijing had to engineer an extraordinary additional surge in investment in order to
counteract the contraction in the current account surplus. As Chinese manufacturers
created rapidly expanding amounts of goods, the transfers from the household sector
needed to subsidise this rapid expansion in manufacturing left them unable to purchase a
constant share of the goods being produced. The result was that China needed to export
a growing share of what it produced, and this is exactly what it did, especially after 2003.
1
The German experience, of course, ended in war, and not in a debt crisis, but according to Yale historian
Adam Tooze, the German invasion of Eastern Europe occurred three or four years earlier than the military
command was prepared largely because the country was almost insolvent and could not afford to wait any
longer. See Adam Tooze, The Wages of Destruction: The Making and Breaking of the Nazi Economy, London:
Allen Lane, 2006
Guosen Securities (HK) Brokerage Co., Ltd.
10
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
As long as the rest of the world – primarily the United States and the trade deficit
countries of Europe and Latin America – have been able to absorb China’s rising trade
surplus, the fact that domestic households absorbed a declining share of Chinese
production didn’t matter much. A surge in American and European consumer financing
allowed those countries to experience consumption growth that exceeded the growth in
their own manufacture of goods and services.
But by 2007 China’s trade surplus as a share of global GDP had become the highest
recorded in 100 years, perhaps ever, and the rest of the world found it increasing difficult
to absorb it. To make matters worse, the global financial crisis sharply reduced the ability
and willingness of other countries even to maintain current trade deficits, and as we will
see this downward pressure on China’s current account surplus is likely to continue.
So China has probably hit both constraints – capital is wasted, perhaps on an
unprecedented scale, and the world is finding it increasingly difficult to absorb excess
Chinese capacity. For all its past success China now needs urgently to abandon the
development model because debt is rising furiously and at an unsustainable pace, and
once China reaches its debt capacity limits, perhaps in four or five years, growth will
come crashing down.
Defining financial sector reform
So Gershenkron’s argument, that when the private financial sector can’t do it, let the
public financial sector do it, requires both that elites can identify economically viable
projects and that elites only invest in what they believe are economically viable projects.
Relax either condition and it can’t work.
The various pricing distortions, most importantly in the cost of capital, of course make it
very hard to determine exactly whether or not a project is economically viable, and this
problem is exacerbated because much of the value of an infrastructure project may come
in the form of externalities, which are always hard to measure accurately. Part of the
problem with valuing externalities is that they depend in part on the assumptions you
make about future growth. If we assume, for example, that Chinese worker productivity
will grow very rapidly over the next twenty years, the present value of infrastructure today
can be significantly higher than if we assume much slower growth in productivity.
Unfortunately, this reasoning has a tendency to be self-reinforcing. The more we invest
today, the higher GDP growth and also the higher the recorded level of productivity
growth can be achieved, in which case we can more easily justify additional investment.
Of course if we overestimate current productivity growth (in part because the
infrastructure we build turns out to be excessive), we are likely to overinvest, in which
case lower than expected productivity growth will ensure that the debt associated with
the infrastructure becomes a greater drag on future growth than the investment’s positive
impact on current growth.
Have we passed the point at which the Gershenkron model works? There is still a great
deal of debate about whether or not China is overinvesting and to what extent it is, but
rapidly rising debt levels, the rising ratio of credit expansion to GDP growth, the
continuing contraction in the household share of GDP, and evidence from the
manufacturing sector that capital is being wasted all suggest strongly to me, at least
Guosen Securities (HK) Brokerage Co., Ltd.
11
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
circumstantially, that we have long passed the point at which a financially repressed
banking system is useful for Chinese growth.
Recently the Economist had an article arguing that China is not overinvesting, it is, they
claim, malinvesting. I am not sure that I fully understand the distinction, but I do not think
it is meaningful in the context of this debate. The key point is that if the debt-servicing
costs associated with the investment (adjusted of course to exclude subsidies and
repressed interest rates) are less than the additional debt-servicing capacity generated
by the investment (adjusted to include externalities), then either debt is rising at an
unsustainable pace, wealth is being transferred from some sector to cover the difference
(usually but not necessarily the household sector), or both.
If we have reached or passed that point then I would argue that financial sector reform is
meaningful only if it does the following:
1.
Reform corporate governance. Banks have to stop allocating credit based on the
skewed incentives that reward local officials or businesses with privileged access to
credit who engage in large investment projects whether or not these are
economically viable in the long run. This means that the state should not socialise
credit risk and local officials and SOE heads should have much less ability to
influence local lending decisions.
2.
Liberalise interest rates. This means, in effect, letting rates rise substantially. There
are two reasons for doing this. Firstly, higher deposit rates will reduce the large
transfers from the household sector, and so will raise both the household income
and household consumption share of GDP. Secondly, higher interest rates will
make it much more expensive for investors to fund projects that are not
economically viable.
What reform?
Last week at a conference in San Diego, in which I was lucky enough to share the panel
with the very knowledgeable Nicholas Lardy of the Peterson Institute, my attempt to be
provocative may have shocked several people (although not, I think, Lardy) when I
asserted that there had been no meaningful financial sector reform in China in the past
decade. What about reforms to the QFII and QDII systems, in the use of derivatives, in
the stock exchanges, in internationalisation of the RMB, and so on? They didn’t matter, I
argued. None of these reforms is really meaningful unless it involves corporate
governance reform or interest rate liberalisation, and none of the reforms so far have
seriously involved either. Since the banking system drives everything else in China’s
financial sector, distortions in the way credit is allocated by the banks and the way
interest rates are set drive almost everything else, even on so-called “market”
instruments.
If I am right, then no changes in the banking system really matter unless they involve one
of the two reforms I identify above, and I would argue that neither corporate governance
nor the setting of interest rates has changed much in the past decade. There is of course
a very serious debate taking place within China on just these issues, and I interpret
Premier Wen’s April 3 radio interview, in which he attacked the banks, as part of this
debate.
Guosen Securities (HK) Brokerage Co., Ltd.
12
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
What did Premier Wen say in the interview? A very meager report on Xinhua says, in its
entirety:
Premier Wen Jiabao has called the country’s big bank a monopoly that needed to
be broken during his visit in East China’s Fujian province few days ago. This was
the first time that top leadership acknowledged the monopoly of state-owned
banks, following last month’s announcement of a pilot project to reform the
financial sector in Wenzhou, an eastern coastal city with a tradition of
entrepreneurship. The country’s big four banks raked in a combined profit of over
RMB600 billion last year, despite a backdrop of slowing economic growth.
David Barboza at the New York Times put Premier Wen’s comments in a little more
context:
Prime Minister Wen Jiabao of China said on Tuesday that the nation’s biggest
state-run banks have too much power and ought to be broken up because they
earn far too much money. The remarks, delivered during a national radio address
while the prime minister was traveling in southern China, were unusually bold and
appeared to be a direct challenge to others in the nation’s Communist Party
leadership to speed up reforms of the nation’s financial system.
According to China National Radio, Mr. Wen said: “Frankly, our banks make
profits far too easily. Why? Because a small number of major banks occupy a
monopoly position, meaning one can only go to them for loans and capital.”
“That’s why right now, as we’re dealing with the issue of getting private capital into
the finance sector, essentially, that means we have to break up their monopoly,”
he added. Mr. Wen, who is expected to step down later this year as part of a
once-in-a-decade leadership change, has been striking an increasingly vocal tone
in recent months about political and economic reform and suggesting that vested
interests in the Communist Party leadership were stubbornly protecting their hold
on power and derailing his reform efforts.
This it seems brings us full circle to the beginning of the newsletter. Liberalising interest
rates means that those sectors of the economy who have benefitted from very low
lending rates – SOEs, local and municipal governments, real estate developers, and
other large borrowers – are likely to find many reasons to oppose interest rate
liberalisation. Likewise, corporate governance reform is also likely to be opposed by a
number of very powerful interests.
So how will banking reform in China turn out? In the long run everything must balance,
and one way or another financially repressed interest rates must adjust. One way this
can happen is through a sharp increase in interest rates, but it is important to remember,
as Japan showed us, that it can also happen by a collapse in GDP growth rates. In either
case, the spread between the nominal growth rate and the nominal lending rate contracts,
and so the extent of financial repression is sharply reduced. The alternative – that the
household share of GDP continues to decline as depositors subsidise rapid GDP growth
and even more capital misallocation – simply cannot be sustained.
Guosen Securities (HK) Brokerage Co., Ltd.
13
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
Trade and no trade
Before finishing this long issue of the newsletter I wanted to bring up trade again. Since
the crisis began in 2007-08, I have argued that one logical consequence of this crisis is a
sharp rise in trade intervention. As Keynes pointed out many years ago, if the full burden
of adjustment is placed on the deficit countries – that is if they deleverage and deflate
domestic demand without a corresponding re-leveraging and reflation of domestic
demand in the surplus countries – the only way the world can adjust is with a rise in
unemployment.
What I would add to Keynes’ argument is that where the increase in unemployment
occurs depends on policies in the deficit countries. If they do not intervene in trade, they
will suffer most of the consequent increase in unemployment – as we see in the US,
Spain, and other deficit countries. If they intervene in trade they will force the rise in
unemployment back onto the surplus countries.
Under those conditions I argued that it was perhaps irrational to expect deficit countries
to insist on maintaining conditions of free trade, and that we would inevitably see a sharp
rise in global trade intervention. Quite a lot of economists were very disturbed by my
argument and argued that it was wrong – the most important evidence for which is that
the world had shown remarkable restraint in trade intervention. I disagreed, because
there are many obvious and not-so-obvious ways to intervene, but on Thursday the
Financial Times had a very interesting article that, I think, supports my argument:
The dog that did not bark is stirring restlessly in its sleep. Trade protectionism,
emblematic of the destructive economic policies followed in the Great Depression of the
1930s, has been remarkably absent since the onset of the global financial crisis in 2008.
Exhibit 1: Wordwide protectionist measures
Share implemented
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2009
2010
By non-G20
2011
2012
By G20
Source: Centre for Economic Policy Research
But with high unemployment in the rich countries and renewed threats of economic
weakness across the global economy, experts and policy makers are becoming less
sanguine that the beast will remain deep in slumber.
Global Trade Alert – a monitoring service run by Simon Evenett, a professor at St
Gallen University in Switzerland – reported on Thursday that protectionist actions
including tariff increases, export restrictions and skewed regulatory changes were
Guosen Securities (HK) Brokerage Co., Ltd.
14
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
much higher in 2010 and 2011 than previously thought, with many more in the
pipeline.
“The world trading system did not settle down to low levels of protectionism after
the spike in beggar-thy-neighbour policies in 2009,” Mr. Evenett says. The World
Trade Organisation, whose analysis has been markedly more optimistic than Mr.
Evenett, set off a distress flare last week when it published its most recent
report before next week’s summit of the Group of 20 leading economies. “For the
first time since the beginning of the crisis in 2008, this report is alarming,” said
Pascal Lamy, WTO director-general. The EU, in a similar report last week, said
rises in protectionism were “staggering”.
I don’t think we should expect that over the next few years this process will be reversed. If
surplus countries with low unemployment and rapid growth don’t take active steps to
push their surpluses into deficit, deficit countries with low growth and high unemployment
will not be able to adjust without forcing up global unemployment. Whether this rise in
unemployment occurs at home or in the surplus countries will depend on the willingness
of the deficit countries not to intervene in trade. Under those conditions, I cannot see why
they would insist on non-intervention.
Sections of this newsletter may be excerpted but please do not distribute.
Guosen Securities (HK) Brokerage Co., Ltd.
15
What is financial reform in China?
June 18, 2012 | Macro | HK & China | China Financial Markets
Information Disclosures
Interest disclosure statement
The analyst is licensed by the Hong Kong Securities and Futures Commission. Neither the analyst nor his/her associates serves as an
officer of the listed companies covered in this report and has no financial interests in the companies.
Guosen Securities (HK) Brokerage Co., Ltd. and its associated companies (collectively “Guosen Securities (HK)”) has no disclosable
financial interests (including securities holding) or make a market in the securities in respect of the listed companies. Guosen Securities
(HK) has no investment banking relationship within the past 12 months, to the listed companies. Guosen Securities (HK) has no
individual employed by the listed companies.
Disclaimers
The prices of securities may fluctuate up or down. It may become valueless. It is as likely that losses will be incurred rather than profit
made as a result of buying and selling securities.
The content of this report does not represent a recommendation of Guosen Securities (HK) and does not constitute any buying/selling or
dealing agreement in relation to the securities mentioned. Guosen Securities (HK) may be seeking or will seek investment banking or
other business (such as placing agent, lead manager, sponsor, underwriter or proprietary trading in such securities) with the listed
companies. Individuals of Guosen Securities (HK) may have personal investment interests in the listed companies.
This report is based on information available to the public that we consider reliable, however, the authenticity, accuracy or completeness
of such information is not guaranteed by Guosen Securities (HK). This report does not take into account the particular investment
objectives, financial situation or needs of individual clients and does not constitute a personal investment recommendation to anyone.
Clients are wholly responsible for any investment decision based on this report. Clients are advised to consider whether any advice or
recommendation contained in this report is suitable for their particular circumstances. This report is not intended to be an offer to buy or
sell or a solicitation of an offer to buy or sell the securities mentioned.
This report is for distribution only to clients of Guosen Securities (HK). Without Guosen Securities (HK)’s written authorization, any form
of quotation, reproduction or transmission to third parties is prohibited, or may be subject to legal action. Such information and opinions
contained therein are subject to change and may be amended without any notification.
Guosen Securities (HK) Brokerage Co., Ltd.
16