Summary:
– Financial repression (low interest rates, high reserve requirements, etc.) is essential to understanding China’s development
– Capital controls and characteristics specific to China are the basis of this success
– Financial repression is also at the root of significant imbalances in the Chinese economy
– The costs now seem to outweigh the benefits: reforms are therefore needed from the new government
Financial repression is fundamentally bad for growth…
Financial repression is a concept developed in the 1970s by McKinnon.
It refers to the heavy constraints imposed by governments on households (mainly for the benefit of the government itself) in order to capture domestic savings and prevent financial development. The main constraints are: interest rates set below market equilibrium levels, high reserve requirements, directed credit allocation, state-owned banks, restrictions on entry into the financial sector, capital controls, etc. These measures therefore have a negative effect, as there is a link between financial development and growth.
…but not for China
The People’s Bank of China (PBoC) administers interest rates (deposit and lending) within a band around the PBoC reference rate (-10%; +100%) within which banks must operate. As a result, the real (inflation-adjusted) return on bank deposits is low or even negative in China (see Chart 1). This does not depress the average household savings rate or the volume of bank deposits for two reasons.
Source: PBoC and author’s calculations
First, the Chinese are « target savers »: they need to save a minimum amount, particularly to build up a contingency fund and ensure better protection against social risks (health insurance and pension systems are still relatively ineffective, especially for rural populations). Second, there are very few alternative financial instruments that offer the same security as bank deposits. One of the main reasons for the effectiveness of financial repression in China is the presence of very significant capital controls on inflows (only a few hundred investors are allowed to buy and sell securities in China for a fairly limited amount (0.6% of Chinese market capitalization), see QFII), but above all on exit (only capital with a real counterpart can leave, typically imports of goods, see QDII). This prevents Chinese citizens from taking their savings out of the domestic financial system, which, outside the banking sector, is very shallow and unprofitable. The bond market is very underdeveloped: the development of the domestic financial sector is slowed down because there is no safe benchmark asset (see Chart 2).
Source: Asian Development Bank
The stock market is also underdeveloped, but above all it is highly volatile and poorly supervised (the China Securities Regulatory Commission is responsible for this role, but its resources and autonomy are insufficient, see Chart 3). Without such restrictions, China could quickly deplete its abundant savings and, as a result, its development could be jeopardized. It is for these reasons that financial repression is so effective in China, as it creates the conditions for very inexpensive investment in the hands of the public sector, with virtually unlimited possibilities.
Source: Bloomberg
The majority of Chinese savings are therefore held in banks. However, more than 70% of these same banks are owned directly or indirectly by the state. This is of paramount importance because it allows credit to be allocated to the industrial sector (to the detriment of services, whose natural growth has slowed since 2002 and the resurgence of financial repression, see Chart 4) and makes the transmission of the government’s industrial policy more effective. For several years, the Chinese government has been able to finance infrastructure and mainly state-owned industrial companies at the expense of depositors, in order to fuel growth and economic take-off in recent decades.
Source: EIU
Another key component of financial repression is the reserve requirement ratio (the portion of deposits that commercial banks must deposit with the PBoC), which is high in China, even compared to other developing countries. This instrument has been widely used in China, particularly to sterilize the PBoC’s foreign exchange operations at a lower cost. To keep the exchange rate permanently undervalued despite structural pressures for the Chinese currency to appreciate, the PBoC conducts foreign exchange operations by buying US dollars against the renminbi. To buy US dollars, the PBoC creates money on a massive scale. However, this increase in the money supply creates significant inflationary pressures in the economy (with possible social tensions but also pressure for currency appreciation via inflation). Thanks to reserve requirements, the PBoC will be able to remove a significant amount of money from the banking system to sterilize its operation and cancel out the initial increase in the money supply. This costs the government nothing and helps to support Chinese competitiveness by keeping the exchange rate below its fundamentals. It also allows China to accumulate ever-growing foreign exchange reserves and protect itself against any balance of payments crisis, with the Asian crisis of the 1990s still fresh in its memory (see Chart 5).
Source: PBoC
Keeping the exchange rate undervalued in China has been vital to economic development.
Historically, economic development has been driven by investment. To support investment, the Chinese government has opted for a policy of financial repression. With this strategy, investment grows more easily given China’s characteristics. On the other hand, financial repression acts against private consumption via the wealth effect of low returns on bank deposits. If consumption is low and declining, and if investment is massive and growing, as is the case in China, then the economy produces more than it consumes and domestic demand is insufficient. If China had been self-sufficient, the economy would have been in overcapacity and deflationary pressures would have emerged. To avoid entering such a spiral, export markets must be created and excess production must be eliminated. To create export markets, Chinese products must be competitive: the exchange rate must remain undervalued.
Financial repression therefore creates the means for China’s success, but also its excesses and weaknesses.
Although investment is the basis for the Middle Kingdom’s economic takeoff, financial repression creates a vicious circle that is difficult to escape and leads to inefficient, even dangerous excesses. By subsidizing the cost of credit and directing loans mainly to public companies and real estate financing (real estate construction accounted for 10% of GDP in 2012), thereby creating a real estate bubble whose size no one knows, the state has pushed for dangerous overinvestment, especially when compared to other Asian countries. Calculating the ICOR (Incremental Capital Output Ratio), a measure of capital productivity, reveals a clear upward trend since the second half of the 2000s. The amount of capital units needed to create one unit of output is increasing, reflecting growing investment inefficiency (see Chart 6). Better allocation of credit to innovative and more profitable Chinese SMEs could therefore substantially increase productivity and support growth, even if this growth is no longer in the hands of the government. Furthermore, with this preferential access to SOEs (state-owned enterprises), SMEs find it very difficult to obtain financing and therefore turn to an informal market where financing costs and risks are high.
Source: NBS and author’s calculations
By slowing down the structural shift towards services and providing massive support to industry, the Chinese government is creating a significant structural current account imbalance, despite the reduction in the surplus since the late 2000s (due to the government’s stimulus program, which significantly increased investment, see Chart 6).
Source: EIU
Conclusion
It is thanks to this consumer-unfriendly policy that the Chinese miracle has been able to take place. Although China remains very repressive in financial matters, since Deng Xiaoping’s reforms in 1978, it has taken steps towards greater financial liberalization, particularly in terms of supervision and control, with the creation of the CBRC and the CSRC, and in terms of the liberalization of interest rates (increase in the legal fluctuation margin) and exchange rates. This rebalancing trend is likely to continue under the new government. However, it will continue to be approached with great pragmatism and caution in order to avoid repeating the past mistakes of unbridled financial liberalization advocated by the Washington Consensus.
