Summary:
– The Chinese growth model appears to have reached the end of its cycle with declining external demand and a significant drop in investment efficiency.
– To move on to the next stage of development and escape from financial repression, which creates many inefficiencies, financial reform in China is essential: interest rate liberalization is an important step in this direction.
– An increase in interest rates would have three beneficial effects: it would eliminate unproductive overinvestment, promote consumption, and prevent the country from remaining stuck in a development trap.
– However, we must not underestimate the barriers that could significantly hinder a reform of this magnitude.
Financial repression (low interest rates, high reserve requirements, directed credit allocation, etc.) is essential to understanding China’s significant but unbalanced development. Although financial repression is generally considered to be an obstacle to development (see McKinnon (1973) and Shaw (1973)), capital controls and China’s specific characteristics are the basis for its development. However, the costs now seem to outweigh the benefits, and reforms are therefore necessary for the new Chinese government (see Beijing-style financial repression (I)).
Investment is becoming less and less effective
One of the consequences of financial repression is low capital efficiency (see Beijing-style financial repression (I)), which poses risks to China’s long-term growth. Bank loans (125% of GDP, according to data compiled by the People’s Bank of China for bank loans granted to households and businesses), which are the most common means of financing in China, are most often allocated to the public and semi-public sectors, which have virtually unlimited and inexpensive access to the abundant savings of Chinese households. However, these funds are most often used to finance infrastructure projects or sectors that are already suffering from overcapacity (particularly renewable energies, especially solar panels) and therefore offer low returns. This leads to a substantial decline in the productivity of the Chinese economy, as productive investment is underdeveloped, resulting in a decrease in potential growth.
To remedy this, liberalizing interest rates could provide several solutions and promote economic rebalancing. This reform would have three positive effects: it would eliminate unproductive overinvestment, promote consumption, and prevent the economy from remaining stuck in a development trap.
Rebalancing the economy towards the private sector and the market
Interest rates are low compared to GDP growth, which continues to provide incentives for overinvestment and creates inefficient distortions in the allocation of capital. An increase in the cost of capital would therefore have two consequences.
First, higher rates would remove the least profitable projects from the financial circuit. If interest rates rose above the rate of return, the government would not be able to indefinitely support public enterprises investing in low-profit projects. This could increase the average efficiency of investment and savings would be allocated in a more optimal manner.
Second, interest rate reform would bring the credit market closer to equilibrium. Assuming that quotas and directed credit allocation will disappear over time, an increase in the interest rate on loans would increase the supply of credit to levels closer to market equilibrium. This new supply would meet the demand of private companies that were unable to obtain financing through traditional channels. They would pay a lower interest rate than they pay on the informal market, despite the increase in the nominal rate.
Rebalancing the economy towards private consumption
Interest rate reform would also affect the consumption-investment balance.
Using five simple equations, we can attempt to estimate the effects of an increase in interest rates on deposits and loans.
Let Y, X, W, C, S, r, i, p, w, L, and K respectively represent total income, savings income, labor income, consumption, gross savings, the real interest rate on deposits (adjusted for inflation), the nominal interest rate on deposits, inflation, wages, labor, and capital.
X = (1+r)S (1)
C = Y-S (2)
r = i-p (3)
Y = W+ X (4)
r/w = L/K (5)
At constant inflation, an increase in the nominal interest rate on deposits increases the real interest rate. According to (1), an increase in the interest rate r would create a price effect: as the return on savings is higher, financial income X (with constant savings S) would increase, which would lead to a consequent increase in consumption according to (4), since total income Y increases.
According to (1) and assuming that the Chinese are « target savers » (they aim for a certain amount of savings X), this would first create a volume effect: to obtain the same amount X at time t+1, it would be necessary to save less at time t, resulting in a decrease in the savings rate and an increase in consumption since S decreases. Here, Y is constant.
The third effect of an increase in the interest rate on consumption would be through the relative prices of capital and labor. All other things being equal, an increase in the price of capital would decrease the relative price of labor, which would push companies to be more labor-intensive, to hire more workers who would see an increase in their income and consume all the more (equation (5)). This would also enable the development of labor-intensive services relative to industry. On the other hand, with the resulting increase in income and development, demand for services will grow and lead to increased employment in China, creating a virtuous circle. A decline in investment, coupled with an increase in consumption, would help rebalance the Chinese economy: if private consumption grows faster than investment, then the share of consumption in GDP will increase, all other things being equal.
Avoiding the development trap
At a certain level of development, traditional (extensive) sources of growth (in this case, mainly investment) are no longer sufficient to enable an economy to move to the next stage of development. It should be noted that many countries, after experiencing accelerated growth, have failed to catch up with the group of developed countries because of this inability to reform (particularly Latin American countries such as Brazil, Mexico, Peru, and Argentina, which was considered an emerging power during the first half of the 20th century and has since been in almost permanent crisis). If China does not want to find itself trapped in this development trap, it will have to transform its extensive growth into intensive growth, i.e., higher-quality growth. China will therefore need to implement structural reforms that ensure a more optimal allocation of resources, particularly financial resources.
As early as 2007, Prime Minister Wen Jiabao noted that Chinese growth was « unstable, unbalanced, uncoordinated, and unsustainable. » And the12thFive-YearPlan(2011-2015) takes into account the new challenges facing China: rebalancing the economy towards consumption and the private sector, reducing social inequalities, innovation, environmental protection, and energy efficiency. The next ten years will be decisive, and China’s new leadership team seems to agree on gradually giving more weight to consumption and the private sector. Financial reform should be a key element of this new strategy.
Special interests versus the public interest
China’s centralized economic planning system has worked very well so far, delivering results that few countries can boast. However, the gradual slowdown of the Chinese economy, overinvestment, and reduced export opportunities are all signs that the cycle is coming to an end. Moreover, the authorities seem to have taken these new developments on board and are increasingly announcing a paradigm shift towards lower growth that is more sustainable and less fictitious (the five-year plan’s target for annual GDP growth is 7%).
According to Zhang Jun in an article for Project Syndicate, « an economic system is only effective if it can adapt to promote a new phase of development. » The centralized and undemocratic institutional organization of power, independent of any influential groups, has undoubtedly been a factor in promoting decision-making and economic development over the past 30 years and has shown great resilience in the face of economic shocks. However, with rapid development, large companies and commercial banks mainly owned by the public sector have acquired excessive political weight. The question that comes to mind is therefore: is China capable of adapting?
Indeed, since financial repression ensures Chinese banks a monopoly profit, the liberalization of interest rates, which would increase competition to attract household savings, would reduce the profitability of these banks, most of which are publicly owned. Not to mention the increase in the cost of capital for public companies and the more general increase in public debt following the rise in borrowing rates, which could create some problems. In addition, a rise in interest rates would attract capital, pushing up the RMB. This would further weaken China’s competitiveness, which is already eroding. Finally, higher interest rates would require slower growth in the money supply, ruling out any recourse to the accumulation of foreign exchange reserves (see China: the impossible exit from financial repression, Natixis (2012)).
Given the dangerous links between the political, economic, and financial worlds, implementing such a reform could be seen as shooting oneself in the foot and would push the government to make the wrong decisions.
However, if the ruling elites want to maintain their dominant position, they will have to implement reforms that will ensure long-term growth and remain neutral in the face of special interests. It is nevertheless clear that such a reform will be phased in over time in order to avoid upsetting those who want to maintain the status quo. And let’s not forget that this reform is only one part of a broader framework of financial liberalization: exchange rate liberalization, opening of the capital account, improvement of financial supervision, etc.
References:
Artus and Xu, 2012, China: the impossible exit from financial repression, Natixis
Shaw, A.S. 1973. Financial Deepening in Economic Development. Oxford University Press.
McKinnon, R. I. 1973. The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. Baltimore: Johns Hopkins University Press.
