Important planks of China’s economic growth (and the rest of the fast-growing economies in the East) are the efficiency and innovation capabilities of the domestic banking and financial system. Banks and financial markets are an important engine of economic development and growth. They are also a source of potential disasters.
But to keep pace with the expectations of high economic growth, banking and financial markets need to be liberalised, freed up to become more competitive and responsive to the financial and investment needs of other important domestic sectors. The practical problem here is that too much liberalisation and deregulation without the necessary countervailing risk-reducing (prudential and supervisory) regulation and bank managerial experience and expertise can produce the opposite to that intended (at least in the short run).
Overdoing liberalisation and other deregulation moves can create the conditions for a financial relapse or even crisis. The modern history of emerging economies, especially those with the kind of impressive growth rates that China has achieved, serves as a warning to learn from the lessons of others.
In the meantime, an immediate and pressing issue for China is whether and how it should relax its present capital controls. This liberalising move entails a freer movement of capital both within China and across its borders.
Why should China make this move? Unlike many other emerging economies, China has an ample supply of domestic funds. Chinese firms and people save more than enough.
The problem for China is that in channeling these savings via the banking system into companies, the interest rates paid to depositors are skewed in relation to corporate banking rates (see The Economist, March 3). Effectively, bank lending subsidises domestic industry and taxes Chinese depositors. This, in turn, distorts the economy since it suppresses consumption and private business through prioritising investment, industry and state-owned borrowers.
As a result, savers switch to housing instead (to avoid this de facto bank tax) and housing bubbles can start to inflate (and housing and property bubbles are notorious forerunners of possible financial crises). At the same time, restrictions on capital outflows abroad lead to a burgeoning stockpile of foreign currency reserves. Effectively, these reserves are denied the opportunity to make good investments abroad.
But immediately relaxing these capital controls (both within China and across its borders) has its dangers. The Asian financial crisis in the late 1990s was fueled by tides of ‘hot money’ flowing into and out of Asian economies. So China needs to learn from the past mistakes of some other countries.
The Peoples Bank of China (PBOC) has recently produced a report that argues the case for opening up the financial system. This study sets out a ten-year, staged timetable for liberalising capital restrictions. The process begins with Chinese businesses purchasing foreign companies.
There are many good reasons for China to go ahead with these plans, especially if the government wants the yuan to become successful as an international currency (which it apparently does).
Nevertheless, there are dangers. Too rapid a liberalisation could seriously disrupt the Chinese financial system. For example, liberalising external capital controls before deregulating domestic restrictions could lead to large outflows by depositors in China’s state-owned bank into foreign bank accounts and stockmarkets. Domestic interest rates need to be liberalised first in order to incentivise depositors keeping their money within the Chinese banking system.
In this context, China has a dilemma. To do nothing is tempting. There will be costs and may be negative outcomes (at least in the short run) if things go wrong. So ‘doing nothing’ clearly has its attractions. It is at least an apparently ‘safer’ option.
But to do nothing also carries risks. If China is to continue growing strongly and remain politically stable, capital must be allocated efficiently. This requires liberalisation of the domestic financial system and easing restrictions on capital outflows.
Reform, then, is needed, but it must be staged if China is to avoid the mistakes that other countries have made. The first step is a series of staged moves to liberalise and strengthen its own domestic financial system. The message from recent history is …’to prevent bubbles and crashes, capital account liberalisers should remain in the back seat while the domestic reforms keep pedalling’ (The Economist, March 3).
China is clearly at a challenging cross-roads in its present trajectory towards establishing its global position. At the same time, this is the first year that China will target a growth rate of under 8 per cent (7.5 percent is the target for this year). This will certainly help reduce global trade imbalances, although it will impact on commodity-rich supplier countries to China.
China cannot avoid the need to liberalise and reform its domestic economy. The signs are encouraging that the savvy Chinese will surely not repeat the mistakes of the recent financial experiences of other liberalising and deregulating countries. Whatever they do and however they do it, though, there will surely be consequences – not only on their own domestic economy, but also on the global one.
Professor Ted Gardener