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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.