Premier Wen’s recent 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 have occurred?
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 SOE’s seem to be increasingly involved in financing activity, 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, socialize 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 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 subsidizing 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 criticize the system – and in fact until recently nearly all China-focused analysts characterized China’s banking system as well organized 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). 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):
- 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.
- 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.
- 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 labor 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.
- 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 labor.
The longer heavily subsidized investment continues, however, the more likely that cheap capital and socialized 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 labor 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 labor for much more expensive laborsaving devices.
Of course credit risk is ultimately socialized – that is all borrowing is implicitly or explicitly guaranteed by the state. Socialized 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 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 uncommonly 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[*].
The second constraint is that policies that force households to subsidize 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 subsidize 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.
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, 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 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 greater 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:
- Reform corporate governance. Banks have to stop allocating credit based on the very 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 socialize credit risk and local officials and SOE heads should have much less ability to influence local lending decisions.
- Liberalize interest rates. This means, in effect, letting rates rise substantially. There are two reasons for doing this. First, 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. Second 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 system, in the use of derivatives, in the stock exchanges, in internationalization 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 liberalization, 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.
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 600 billion yuan 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. Liberalizing 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 liberalization. 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 subsidize rapid GDP growth and even more capital misallocation – simply cannot be sustained.
[*] 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
Hi mike,
I would like to ask you that for this financial doldrums that we are in, does it take a WWIII in your opinion to recover, just like how WWII help U.S. to recover its economy?
This the best post I read on China economy in some time. It gets to something critical in the China policy discussion, and this is the distinction between form and substance. No, don’t mock me this time. Financial reform in China is like a new fancy Hyundai model being sold in China. It looks good. In Chinese, kanqilai hen hao. But this is half derogatory meaning, because it means looks only window dressing. Which is part of may interpretation of the extent of real financial sector reform in China. Looks like a market, but functions like stage play. The post above introduces many older theories which are worth a new look. This also shows problem of the modern economics. The econometric models dont end up explaining all that much. What needs to be explained, and what above explains, is the incentives that set it all in motion. I see an author writing about financial crisis in the US and Europe, argue that excess leverage is not the cause, only an effect. The cause is rooted in incentives. SOEs and the banks act entirely rational for the incentive set they face. Rational for them does not mean efficient for economy. But from post above I understand that optimal level of infrastructure build for China is less than I used to think. Thank you Professor.
Hello Michael. I agree that there is currently huge state-financed over-investment in China. Transferring wealth from the depositors to the banks is an unjust system. But I am compelled to pointed out that the Asian development model is still the most successful development model in lifting poor countries into the developed world by evidence. Latin American countries that followed the Washington Consensus of unregulated capital markets generally failed to grow their domestic industries like Japan and Korea did. What you prescribed for Chinese banking reform may be right, although I would like to read more on interesting rate from Stiglitz to be sure. But deregulation of capital market definitely does not automatically translate into less asset mis-allocation. Take a look at the US housing bubble. The bubble burst more than five years ago, and now the US is half way through its own “lost decade”. Also I think it is still early to suggest China is going to experience the worst aftermath, compared to countries in EU and the US. I do wish all the countries in crisis can lower their unemployment rates so the youth can have an easier time finding jobs. And I am in the camp that believes unregulated banks which socializes its losses are the cause of the current crisis.
as always, topical, thoughtful, balanced and well reasoned. i only wish you would post more often without sacrifice to the foregoing.
Good arguments. But will Wen win? The momentum to continue the current policies is so strong. Is China more embracing of change than Japan? I know that does not sound difficult, considering Japan’s conservatism. But when you talk to ordinary people, Chinese or not, they perceive the current growth plan can do no wrong. Like MITI in the late 80s. Objections are western conspiracies.
So with the people behind them, ironically democratic, I suspect the government will carry on. More government spending on infrastructure is on the way. More mercantilist trade policies to “protect” local workers. More purchases of gold and other commodities. More purchases of T-bills. More talk of exceptionalism.
High growth for the next 20 years was the call today from the Peoples Daily…
I agree with Lucky Wu’s assessment that true forces that drive economies lie deep in the incentives. Incentives, however, are not something opened discussed in the mainstream, much less in the Chinese mainstream, lest that it sounds low level and primitive to educated minds. Incentives are sub-rules, qian gui zes, that work. Unfortuantly this understanding only makes one even more worried after reading Prof.Pettis articulated article. I fear that China has already gone beyond the point for a meaningful and effective reform to turn things around, and the incentives are still not in place for launching such a reform. On a different topic, perversely, such a sobre assessment may perhaps cement the establishment in CCP–as no sane political force is incentivised to take over and cystalise the reality. God bless the Chinese.
Seems to me that corporate governance reform is a much tougher nut to crack than interest rate reform. The latter is a comparatively mechanical thing. Corporate governance on the other hand is a big, complicated ball of string that involves everything from effective enforcement of contracts and statutes governing corporations (rule of law and the judicial system) to the structure of corporate boards and the way that operating officers are placed in big companies, to accounting standards, financial transparency and corporate reporting requirements. Effective reform means untangling that ball and creating something radically different in its place. Such a change is anything but mechanical; it’s guanxi and power and money and law and politics and every other kind of sticky thing rolled together.
Chinese leaders must be extremly pleased that recent events have shown that the policies that Western powers follow do not work well,it is likely that they are looking for alternative economic theories as back up.
Perhaps the new leadership should look into Binary Economics as promoted by Professor Robert Ashford & company.
Interesting and nicely written article but I find something slightly disturbing and ideologically biased in the term “Financial Repression”. Under the thinly veiled moralising guise of robbing the prudent to pay the profligate. I hope we are not being led by the nose to support another fallacy? Private capital is allocated more efficiently than state capital?
Surely state bankers and private bankers are the same flesh and blood, both but opposite cheeks of the same backside. It is the structure of the institutions, quality of governance, performance metrics and nature of incentives that determine the efficiency of investments. Squat to do with private vs public.
@ Andrew
Indeed do what you say, mindful of Lucky’s and Leo’s comments. As the Freakenomics guys say (i paraphrase) “follow the incentives”.
For years CCP cadres were evaluated on GDP growth and virtually nothing else. Environmental degradation, health care, education, quality of life did not matter. Protestors were and are stopped on the way to Beijing. As long as the district reported the GDP numbers and there are no complaints, the cadre gets promoted. It will take a while to change these incentives since quality of life measurables are difficult and also not necessarily in unison with the Party’s ultimate goal of staying in power.
It is all about the 3 P’s. Having control of the PLA! control of the Press and control of Personnel. The Organization Dept names the top 300 or so SOE executives including bank CEOs.
To liaogz82:
Did the US economy recover because of WWII or was it the fact that the rest of the industrial world was destroyed by the war (Japan, Europe, & England) or dragged behind the Iron Curtain (Russia & China) leading to the post-war boom? I think the latter. The war left the US as the only industrial power able to produce to provide the goods needed to live and rebuild the rest of the world. The destruction (or enslavement) of the rest of the world eliminated competition for the US. All of the goods produced during the war (other than knowledge produced by war driven research) were a net loss to the US economy. The only positive benefit of the war was the retention or regaining, by some, of economic freedom. This was counterbalanced by the loss of economic freedom by large parts of the world due to the expansion of communism made possible by the war. (Ironic since communism and facism were early and strong allies. This alliance made possible the start of the war. Remember that the USSR invaded Poland from the east after Germany invaded from the west. FDR has much to answer for, not least his administration’s covert support of communist conquest)
The war economy was a) artificial and could not have continued too many more years without a financial collapse and b) was wasteful of both human and material resources. War destroys economic prosperity, it never (directly) brings prosperity, only the appearance of prosperity as governments spend money they don’t have. This can lead to a short term false semblance of prosperity but not long term benefits unless the war results in better access to resources and markets due to the elimination of competitors. Note also that the benefits accrue to the winners and the losers can suffer greatly making it at best a zero sum game.
This is not to say that war is never necessary or that it does not accomplish political goals that are good (I spent most of my life in the military trying to prevent communism from conquering the world). However, war is always a bad thing economically and only tyrants and mad men resort to war to help the economy. That being said, I think FDR wanted the US in a war with Japan to enable him to give a false boost to the economy and hold onto power.
“like exchanging cheap labor for much more expensive laborsaving devices”
It’s even worse than that, as it denies income to the labour (which would increase domestic consumption etc..)
Wen’s remarks strike me as a red herring. Yes paying people excessive amounts to malinvest is not really the issue.
Financial repression exists because Fiat system allows it. In a banking system not layered by repo activity enabled by a central bank, there is no way to stuff government debt in the banking system. Hong-Kong is a non fiat system and one can look a deposits, loan to deposit, capital adequacy. The regulator can apply prudential loan to value directives at very low levels without interference from the ~state~. China and the US are fiat and are repressing heavily their lending and borrowing rates, and even their financial markets. Both are not allowing the clearing process!!! What a wonderful period we live it, the absence of clearing is a recipe for permanent state of crisis.
It is one thing to argue that state management of investment has gone too far and another to suggest it was economic folly in the first place. As other commentators have noted, this model of state capitalism (wrongly termed ‘Beijing Consensus’) is the only successful model for countries that missed out industrialization by a hundred years or more. China copied it from Japan, Korea, Taiwan and Singapore. All these countries had/have a close and even corrupt nexus between government and big business that mutually benefit by special dispensation from each other. In China it is the Party functionaries and their kin that fill this role. For all that it has worked for economic progress. In India as well, there was state huge investment in basic industries such as steel, cement and power for 2-3 decades after independence. This helped form an industrial base for further economic growth. The alternative in all these cases would have been to allow en masse western enterprises into every basic aspect of the domestic economy and reproduce a newer version of colonialism. Yes, it took money away from the poor and spent it, often inefficiently on mega projects. But it also provided work (maybe with poor pay and high taxes versus no job and low taxes) and ‘externalities’ forming the basis for further growth. It would take a very good economist to prove that the overall costs exceed the benefits and particularly at what point it becomes so. No doubt, the habit continues long after it has ceased to be beneficial and has to be stopped by its own contradictions. That though is the story of all economic processes – they continue because they are established and the participants are thriving and reluctant to change.
Prof Pettis, I would very much like you to comment on the beneficiaries of the financial subsidizing of industry in China. SOEs, favoured businesses and party functionaries and friends all benefit from cheap money. But what about countries that import their products? I was struck by the comment by an Indian busnessman who complained that Chinese products were selling at below the cost of what he could make them for. Isn’t that effectively the chinese household ultimately subsidizing the indian consumer? Is this one aspect that western economists and politicians that complain of Chinese unfair trade practices (‘currency manipulation’, ‘dumping’ etc) fail to acknowledge – that western consumers have a bonanza subsidy on everything they buy from China, courtesy of the ordinary chinese fella? Certainly seems to be an insane policy of the Chinese government – except if their aim is to carry this on long enough to eliminate all competition and establish a monopoly on these products – akin to price wars that oligopolies wage in order to destroy competition.
what about more optimistic view? “China’s actual consumption as a share of GDP may in fact be higher than the official numbers suggest”
http://carnegieendowment.org/2012/06/14/china-s-golden-rule-of-consumption/bubk
@Prof.Pettis
What does ‘unsustainable (public) debt’ mean in an administered economy with state owned banks and no bond issuance?
Real name, I always wondered how Yukon Huang and Pettis could both be at Carnegie. Pettis has really transformed the whole discussion about China with his insights, while Huang seems determined to maintain the old myths and mistakes. I even get the impression that he is trying to build his reputation by rejecting Pettis’s views, but I don’t think he is able to pull it off. His argument, for example, that consumption MIGHT be higher than the numbers suggest is not only not convincing, but it is probably irrelevant. Even the Chinese government says consumption is dangerously low, and investment dangerously high. Is Huang really suggesting that consumption is not a problem in China or is he just trying to get away from Pettis’s shadow?
If you do not read Chinese, look up works by Wang Xiaolu, who has breaken down national income flows data and added on a survey to restate national income. Effective household income is higher than reported, and corresponding consumption is low estimated. This is no surprise. There are lots of other tricks to get to this: take all vehicle purchases in a given year. How so many based on official income distribution? No way. So if small businesses are majority of employers, no surprise that owner of company maybe less than 20 people (millions of these) buys cars for his family and workers using company name, and gets tax receipt. Capex or consumption? Consumption is surely higher than reported, but this only means that maybe imbalances are just a bit smaller than thought. Not any less of a problemn. The anti-consumption systemic bias is still there. I know Huang a long time. He is like all of us. Try to make reason for having job.
@22 Kivalur
“except if their aim is to carry this on long enough to eliminate all competition and establish a monopoly on these products – akin to price wars that oligopolies wage in order to destroy competition.”
This. Look at how helpless everyone became when China cut rare earth exports. And look at the solar panel industry. Both of these require lots of time and capital investment to get going, so once competitors are shut out of the market, Chinese suppliers could enjoy 5-10 years of monopoly pricing. If competition rises up during that period, the gov can turn on the subsidies and flush them out again.
Look at how much blow-back Obama got over $500 million in loans to Solyndra, a US solar panel manufacturer. These loans were something to the affect of 3% what the Chinese give to their own solar panel makers. There’s no political will (in the US at least) for the gov to support these level of subsidies, while in China it’s politically acceptable and encouraged.
Professor Pettis,
The US kept growing to where it is now. China is able to follow the path of innovation more quickly. Can they continue even beyond a major slowdown or lost decade?
Can we relax and think about the future generations?… Rent seeking is too much based on short-term self-interests.
If China can still enjoy sustainable growth in 40 years, I don’t worry about the economic calamities of the next decade.
Professor Pettis,
Rent-seeking is based on short-term self-interests. Can we relax and think about the future generations?
As long as China can still be growing sustainably in 40 or even 150 years, why worry about the economic calamities of the next decade?
There will most likely always be rent-seekers… But how many businessmen will there be who understand sustainable economic growth?
@Lucky Wu
Keep writing my friend. I enjoy your comments.
On the grey income notion, which is rampant in China, my big wonder is what this does to the Gini coefficient. It must be off the chart. And this income imbalance, along with corruption, inflation and egregious government land grabs provides the tinder for a big push back against the Party.
” 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 criticize the system”
Please define rapid growth in their incomes, because by definition of the system the money supply will be increasing at rate faster than household income. This means household income at a real rate is actually declining. Inflation is simply the increase in the money supply (debt). It is not the CPI which measures prices for the peons.
latest Optimistic article expressed by a Chinese writer (bo.liu@ftchinese.com) in FT Chinese.
http://www.ftchinese.com/story/001045392
He lists the Western region development,increased domestic consumption and expected creativity and dynamism of China market to propel China into next phase of its development.
If China fails to switch to domestic consumption and futher development of its private sector (as against SOEs),he predicts that China would follow those fallen Latin-America countries within 10-15 years.
@Adam (28)
You are right about Chinese domination of the solar panel industry backed by heavy subsidies notwithstanding WTO rules. I have no idea how they get away with it but that is just one example of anti-competitive practices which EU and US are guilty of as well. Take the example of car manufacturing subisidies in the US (GM was taken to stand for Government Motors) without which domestic car companies may well have vanished in the US. Till today I have no understanding of why the Japs and Euros didnt fight it at the WTO. There is little doubt that the subisdy and protection-free Japanese car manufaturers suffered from it.
Prof:
How does the role of total factor productivity play into this (specifically your view of capital stock/capita levels)? China’s annual TPF growth from 1990-2008 lead the world and was around 4x that of the U.S., for instance (see link).
http://www.economist.com/node/14844987?story_id=14844987
Dear all,
It would seem that we have arrived at the discussion between Friedrich List and Adam Smith. The ideas of List have been at the heart of socialism with Chinese characteristics since its beginning. This was the only logical choice as full market economics was not a real alternative at the time. The creation of a new nation, which China is, demands a systematic repression of the individual to strengthen the center. As to gain control the central government needs bargaining power. Until the arrival of Deng Xiaoping the bargaining power of the Chinese central government was based on a form of feudal rule with the political experiments of the 1950s, 1960s and 1970s as the Age of Enlightenment in China. The consensus that Deng Xiaoping and the Chinese society arrived at was the simple common denominator growth. Growth can be many things, but in a political environment inspired by Western Enlightenment it can only be GDP growth. The increasing of a production and especially a manufacturing base is at the heart of Communism and Enlightenment. Knowledge is deemed useful only if it produces a tangible good.
To build a society around industrial production gives a new nation transcending from a feudal agrarian economy many advantages as its people feel empowered, skilled and united. The question is what a young nation does when production is no long a goal in itself? There are few today who would argue that China needs more production, but many that would argue China needs better or more efficient production. The problem with this is that it does not create a sense of national belonging because efficiency excludes while growth includes.
To reverse or change course away from an asset investment and manufacturing orientated economical model demands a focus on exclusion of those who hinder growth. In an ideal communist society the less effective would step down by own admission for the good of society. In a free market economy they are forced out of the marketplace based on competition. My point being that to increase production one can focus on inclusion and imitation, while to increase efficiency one needs to focus on exclusion and innovation. China has reached a stage where it has to exclude inefficient parts of its economy.
With regards to those who argue the myth of a grey economy. If the Chinese economy is larger then what is assumed and private consumption, as a percentage of this grey economy, is very high, then the problems of the Chinese economy are really serious, as there would be systemic limits to increasing growth by increasing consumption. There would be less capacity for the economy to grow based on consumption or in other words inflationary pressure would arrive faster than if the consumption growth base was set at lower level.
Dear Mr Pettis,
What if all the criticism about China is true and yet it doesn’t matter, simply because it isn’t a capitalist economy. I refer specifically to the Colonial First State research note here :http://av.r.ftdata.co.uk/files/2012/07/Rise-of-the-ferrodollar.docx.pdf.
Among lots of other things, it says, “China through the prism of financial markets is not a
welcoming economy for capital. Capital returns are low
because of competition, a closed capital account that
makes capital abundant and companies that have more
than just financial motives in mind when they invest. It
takes some skill to identify those opportunities in China
that can offer a sustainable long- term return above the
cost of capital.
But this frosty welcome is positive for the broader
economy. The aggressive use of capital is lowering
the cost of living by raising the productivity of firms
and individuals and cutting the prices households pay
for the goods and services they need and want. The
government, as the largest capital allocator, can both
manage losses from individual projects and capture
the benefits of loss-making projects through its taxcollecting authorities. “
China, EU, US……..developing World, N-11, CIVETS, The Asian Century, The African Century, Movement of Capital, Production, Labor, Resource Curses, ROI, ROE, Banking, Money Growth, Fiat Currency (ies…ALL), Gold (5,000? Would that matter? Certainly not fungible in the case of Fiat), Commodity Boom, Real Estate Boom, Labor Standards, Pensions, Portfolio Flows, FDI, Inequality, HNI, HNW, the 99%, the 1%, Offshore Tax Havens, Offshore Domiciling, Financial Repression, Fractional Reserve Banking System, Ron Paul: Audit the Fed, Quality of Data (Creativity in Such), Picking Winners and Losers, My Bank account is bigger than yours
Chavez has Hair (Crying Oh God Save Me, Guess What, He Did, It’s Providence, You should Elect Me again, with recent Intensive Chemotherapy He didn’t lose his hair????, Russian News Service has the foresight to show him with shaved Grey Hair, rather than the thick Dark hair he had, hence virulence, at his recent campaign announcement, Gotta love Free Satellite TV), Amerika, The Axis of Evil, Banksters, Speculation, “they Produce Nothing, Consume Everything,
Cycle of Investment, Growth, Development, Production, Consumption, and On so, cycling of capital, getting stuck in a place, the asset side of balance sheets rationalizing money growth (played as savings from virtue)
This is a financial crisis
Global Housing (outside of China of late where 40% in spending yielded 10% in growht for a year or two), stalled, at vast levels
What of investment in the days leading up to 2008
Mineral Resources (seemingly sustained)
Shipbuilding (rebounded to 30% of 2007 levels)
FDI (a fraction of 2007 levels)
Spent FDI ( a fraction of those levels)
Global Flows increasing volatility in Emerging Markets (portfolio flows a fraction of FDI, which are a fraction and so on)
The truth in these matters is more maturity is needed and burden sharing at the global level
Further, that expectations need be moderated
That the period from 2000 to 2008 was a negative growth anomaly, due to expectations, and that people might want to lay the foundations for the children and grand-children’s prosperity than the believe the levels of global growth are healthy or sustainable.
Were a country like Costa Rica to experience such levels, marginal impact
Whole regions distort the potential of sustainable growth for the immediacy of profits and the my bank account is bigger than yours type of sentiments.
Highly destabilizing
But, territorial, or sovereignty, or it’s those other guys over there sentiments, can be used to rationalize why the current situation is the way it is.
That this is still played as a Lehman’s story, befuddles me….
It’s a global growth anomaly and irrational expectation story, and on a global level, much more maturity will have to be found in the years ahead to maximize global growth opportunities, horizons, and eventual realization of preferred states.
@Akhond
china’s policies have not lowered the cost of living for it’s own people. Perhaps the rest of the world but not its own people on a relative basis. Go live there. Quality of life for the laobaixing is dreadful. Yes youcan get a bowl of noodles for 6 kuai. But you will also take 2 weeks off your life expectancy because of the chemicals in the tang .
In my view China has used its demographic dividend to catapault itself forward as a world low cost producer using predatory market strategies all the while enslaving three quarters of its population in a collective effort to dominate world production. Unfortunately for China, it is coming up a little short, the demographic dividend is running out, the environment is trashed and the Great China Firewall is no longer capable of ensuring that xinhua is the only voice heard. The heretofore endless patience of the Chinese man in the street is wearing thin. Like rising water pushing against the dam, the pressure for a bust is big.
thank you professor for the article.
i must say that I don’t agree with the following:
“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 labor 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 labor for much more expensive labor saving devices.”
The same argument could have been used for not developing the coastal areas of China 20-30 years ago. Intuitively, having lived and worked in both the US and China, I must say that it makes no sense to me why GDP per capita in the US is 5x that of China. The disparity is probably much higher between rural Americans vs. rural Chinese. Are the average American 5x smarter or works 5x harder? I don’t think so. I think the problem lies in the lack of training, infrastructure/tools and a proper system. And if so, consumption or overly-reliance on private sectors will not solve these issues.
Therefore, I believe that continuously high investments are needed. I strongly disagree with the rationale that China must increase consumption to “rebalance” itself. Rather, we need higher quality investments that will tackle the aforementioned problems which will lead to real improvements in productivity. Many respondents have posted plausible solutions to the issue of mal-investing such as improving corporate governance by increasing transparency, enhancing performance metrics and nature of incentives, liberalizing financial markets and flow of funds, shifting the capital allocation process from the state to the private sector where there will be more accountability.
That, I believe, should be the discussion. And to solve these problems, we will need to combine economic theories with politic realities.
There is nothing wrong with having higher levels of investment as a % of GDP in and of itself. And I hope that Chinese politics will not be swindled into thinking that increasing consumption as % of GDP will solve China’s problem.
@41 Huang
This hasn’t worked any time in history it’s been tried. Why would the China case be different?
There are much better books to refer to than the one of Adam Tooze. Maybe it just serves your purpose but overall his book has little historical value unless your goal is to raise the input of the US in WWII.
Huang,
You raised good points regarding investments that are public goods and how to regard them. Prof. Pettis makes a valid case about value of investment versus cost. Take the example of a village being linked to the nearest city to enable transport of produce to the town and consumption and input materials to the village. A single lane asphalt road, a telephone line and a power line could provide a tremendous boost to economic activity but a 4 lane expressway, high speed internet link and high voltage power supply may be a huge overinvestment. You could argue that the latter facilities would enable future demand but the fact remains that it is wasted investment for the near future. It is the ‘build it and they will come’ school of doctrine and one must admit, works often and is complex enough in outcome that few people can prove it inefficient. The other fact to note is that it is supply driven –either a small group of influential investors or other interested party stands to gain and lobbies for that investment or it is a vanity project by some politician or bureaucrat feathering his own nest. In most instances it is driven by cheap credit which as Prof. Pettis has repeatedly argued, comes at someone else’s cost. But your point is still valid – investment based on a vision of what the economy should progress towards is an important strategy that any government should concern itself with. It is difficult to get it right and avoid misallocation and corruption.
On the other hand it is a myth propounded by western economists that private investment is efficient – we have just seen what private enterprise can do in the banking industry in the US (not to mention the auto industry). They are quite capable of destroying tremendous value and generating huge negative externalities. This is a subject that needs more balanced and objective analysis but unfortunately western economists are wedded ideologically to the virtue of free enterprise. I think that was valid during an era when private enterprise was tiny compared to the economy whereas now a handful of mega corporations and interest groups wield huge influence.
42 Adam
The China case is no different it the sense that it will have to slow down its growth, but not because an investment-led growth model is inherently less stable than a consumption-led model.
There is no way to grow anything big ~ 10% every year for a long period of time. if a country is growing its consumption 10% a year, it will also face unsustainably high debt levels and slowdowns. I fail to see why one is “more stable” than the other.
The key is in the efficiency of the capital allocation process, not whether the money is categorized under “consumption” or “investment”.
Huang, I agree that efficiency is key, and I think #44 Kivalur’s point rings true. A one lane road, internet/power line to a distant village is a huge improvement, and the government could and should do this. If you build high speed rail out there saying “some day the people will use it,” you are forcing banks to hold on to decade-long loans that could be used for something better. That is my biggest problem with the investment led model. Every dollar a bank invests in a government led project is a dollar they cannot lend to the next Bill Gates or Steve Jobs of China. In some cases like my above example it makes a lot of sense. But when you talk about maglev or high speed rail to nowhere, it is taking loan money away from citizens who could use it more efficiently.
I would still suggest a consumer binge is less dangerous than an investment binge. Consumption debt like in the US is often at the household level, and some families may indeed file for bankruptcy or find other ways to default on their debt. Usually banks have to manage this, and during the economic crisis Uncle Sam helped with some recapitalization. Chinese investment debt belongs to the government, which means they have to service it through taxes or financial repression no matter what. Chinese high speed rail can’t go bankrupt, regardless of how financially unsound it may be. Neither can any of the SOEs. Meanwhile the loans keep getting rolled over, and it gets more difficult for an entrepreneur to get a loan from a local bank (since they are all tied up in gov related projects). So they turn to loan sharks who generate a whole set of problems on their own.
Despite all the investment into infrastructure, China logistics is still far more expensive than in the US or even India. So the argument that government investment will make other areas of economic activity cheaper or more efficient doesn’t seem to be the case.
Some part of the “GDP” results from development firms taking land from peasants for compensations below market value and selling apartments at market level. The balance is then declared as profit and saving for the developer. In fact, the peasant is subject to expropriation and negative saving at the same time.
If, for example, the land value was 20% of the value of the complete property, and the peasant could instead retain his wealth and (for example) buy 20% of the apartments (or build on his land for himself), nominal saving would be lower (as he only switched his property from land to building) but the macroeconomic situation would be the same.
In conclusion, savings are less than they appear to be, as negative savings of the expropriated are not accounted for.
Great post.