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China – a straggler?!
As China was fast approaching its collapse in the 1830’s, something happened at a German
university that has a profound impact on China today, but also begs the question above.
What happened was that Friederich List, a former pupil to Adam Smith, a consul for Hanover
in Boston, and one of emerging Germany’s leading economists, published a thesis that came
to have far-reaching consequences. He stressed the role that the state must play in order to
support industrial development in countries late into industrialisation. The primary task of
government was to support the ‘infant industries’ by protecting them against foreign
competition as well as by ensuring the supply of cheap capital to support their growth. List
not only influenced German chancellor Bismarck, but also, profoundly, Karl Marx. Duly, this
became the theoretical foundation for the German model, creating the “Made in Germany”
label, as well as one of the intellectual influences behind the socialism ultimately leading to
central planning.
An important aspect of the originally German model is the importance given to the banking
system in providing industry with the means to grow, rather than by it relying on equity
capital. Bank funding is historically cheaper than equity, as it supposedly is cautious with risk
in order to mobilise also risk averse, and thus cheaper savings. To mitigate the increased
exposure to high-risk start-up ventures, banks were allowed to be tightly connected with their
borrowers, creating the distinct system of financial/industrial groups centred on banks.
The attentive reader of course now associates this not only to the German bank spheres, but
also to the Zaibatsu/Keiretsu of Japan and the Chaebols of Korea, and rightly so.( One could
even toss in e.g. the Salim group of Indonesia for measure.) With the Meiji restoration, Japan
copied not only German products but also its model, and with the obvious success, the
Japanese model came to inspire Korea’s strategy from the 1960’s, and successively spread
across most of East and South East Asia to be branded the Asian model (exceptions were
Taiwan and Hong Kong).
What characterises that model is that the government actively develops a financial system to
channel credit at low interest rates to companies expected to become national champions. This
would work well on sunny days, but in downturns, when the borrowers would have problems
servicing their debt, banks would step in to roll over interest payments by granting new loans.
Basically, this means that favoured parts of the economy operate under what has been named
a ‘soft budget constraint’ – a concept developed in the 1960’s by the Hungarian economist
Janos Kornai, then referring to the economies of central planning. In the Listian model, this
results in two interrelated developments:
 The corporate sector becomes increasingly leveraged through the recurring capitalisation
of interest payments, with debt eventually several times in excess of equity, while banks
become increasingly under-capitalised as their assets grew faster than accumulated profits.
Moreover, the level of non-performing loans becomes a question of definition. As long as
the economy is closed and the government is able to guarantee the banking system, this is
not really a problem. The problem comes, however from the other development:
 The highly politicised lending process means that it is not necessarily the most efficient
user of capital who receives credit, but the best connected. This means that national
savings are allocated to projects yielding lower and lower return to the general economy
and hence, as time goes by, producing less and less growth. Simply put – a glass ceiling is
established for growth, which is the fundamental weakness of the Listian model. Arriving
at the glass ceiling and facing declining growth rates, governments face the choice to
adjust the system, or import capital. Most Asian countries did the latter which explains
why the countries with the highest savings rates in the world got problems with their
external debt in the late 1990’s
Drawing on this distinction between credit and equity financing one can categorise countries
along the relationship between these two forms of capital, which reveals a very interesting
pattern. The diagram below presents a selection of countries, with stock market capitalisation
versus domestic credit to the corporate sector on one axis. Along the other, it combines the
two forms of corporate financing relative to GDP to reflect the level of development of the
financial system (being a recent phenomenon, money and bond markets are not included). On
data from 2002, the graph shows four clusters, the two to the right with large financial
systems relative to GDP, and the two to the left with smaller, less developed financial
systems, as follows counter-clockwise:
1. The East Asian countries and Germany form one where bank financing predominates in a
highly financed economy,
2. The Anglo-Saxon countries form another together with Scandinavian countries, South
Africa and, as a border case, India, where equity financing is more important.
3. Among the smaller financial systems, Argentina, Brazil, Mexico and Turkey, where
inflation long repressed the banking system and made business more dependent on equity
capital and capitalisation of retained earnings for financing.
4. East European transition countries form a group largely relying on banks as stock markets
took longer to develop.
Having created a banking system out of the monobank model of central planning, China falls
squarely into the Asian category as the concept of socialist market economy intrinsically had
qualms about the concept of equity capital. Domestic credit, largely to the corporate sector, is
about one and a half time as large as GDP, while stock market capitalisation is around one
third of it. It is tempting to say that this indicates an average corporate indebtedness of five
times equity, had all enterprises had equal access to both. As this is not the case, the exact
level cannot be established, but China is nevertheless clearly within the Asian model, and
squarely so.
So why did it not share the fate of the Asian countries in the Asian crisis, and why is the
question raised why it is a straggler?
China distinguished itself from the crisis countries of the Asian model in two ways: Firstly, its
currency was non-convertible for capital account transactions, insulating it from the impact of
pressure from foreign capital, secondly because its foreign reserves were larger than external
debt, reducing the potential for such pressure to affect the exchange rate. It simply was not
possible for foreign speculation to force a change in that rate, as long as the Standing
Committee of the Politburo of the Central Committee of China’s Communist Party did not
agree.
But China also avoided the trap of the glass ceiling for growth from politicised credit
allocation by letting in a different form of foreign capital than the other Asian countries did –
foreign direct investment. A rough back-of-the-envelope calculation indicates that the
addition to GDP from the actual inflow foreign funded investment, together with the
additional exports it generated, correspond to about two thirds of China’s exceptional GDP
growth, say 5-7% annual averages. The reverse side of this is that the growth generated by the
far bigger domestically funded investment yielded much less growth, or 2-4%.
The frailty of the banking system inherent to the Listian model, but becoming exposed to
increasingly open exhange regimes, was what triggered the Asian crisis. (It may be of interest
that it was triggered by problems in the banking sector, while the crises in countries like
Brazil and Turkey originated in problematic public debt.) Furthermore, one could argue that
the Listian/Asian model had fulfilled its usefulness by bringing the East Asian countries well
along on the path of industrialisation, but , when the crises hit, turned out to be a bell-weather
system. Consequently, the former crisis countries have spent the time after the Asian crisis to
shift their economic models towards the Anglo-Saxon model. Korea, Malaysia and Thailand
now, according to IMF, report equal shares of corporate debt and equity, while Indonesian
corporates still have debt twice as large as equity. While possibly the Anglo-Saxon model
offers a more expensive capital structure, it also means a more robust one, in which they can
cope with a rainy day or two by relying more on equity than on credit.
Having escaped the Asian crisis, China remains well within the Listian/Asian model even
with the recent stock market surge. It may also mean that, in a downturn, China’s banking
system is likely to suffer from rising levels of non-performing loans (NPL). As long as the
government is able to guarantee the banking system, the problem should be manageable. This
will, however, essentially force the government to assume those non-performing loans, adding
to its existing debt. As long as those are relatively limited, the fiscal pressure arising from that
will be marginal, but assuming a level of NPL around 50 % of GDP added to the present level
of debt, presumably around 20 %, would yield a debt slightly above the Shengen criteria. This
would be unproblematic, if the Chinese tax take equalled the Shengen countries. But with
fiscal revenues just below 20 % of GDP, China’s public finances would be very vulnerable to
high levels of interest, as interest payments on its public debt would consume a corresponding
share of fiscal revenue (not forgetting amortisation payments), at the expense of other budget
lines. China’s financial stability would depend on the level of its interest rate…
Remaining well entrenched within the Asian model means that China’s growth remains
relatively more dependent on foreign capital inflows that operate under a harder budget
restriction than is generated within the concept of socialist market economy. In its gradualist
way, the present policy of gradual opening of the banking sector for foreign interests, as well
as widening the scope for the stock market of China, may help in strengthening the budget
constraint.
Assuming that the analysis above is correct, and that the incremental capital output ratio of
domestically sourced investment yield a relatively smaller growth contribution than
investment sourced from abroad, a fall in the inflow of capital would have a bigger negative
growth impact than their absolute size would indicate.
Straggling behind its neighbours in reforming its financial system into an ‘all-weather’ one,
this means that the room for manoeuvre of the government in coping with an economic
downturn, e.g. if the international climate would make capital flows find reasons to bypass
China. Which begs the question if such a downturn is likely. But that question is beyond the
theme of this article, leaving to the reader to try to answer it.