Last year the
Standing Committee of China's National People's
Congress (NPC), the legislative body, ratified a
resolution on the implementation of a new system
for managing the national debt. From 2006 on, the
NPC was to examine for approval the aggregate
national debt balance, rather than just the annual
amount of new national debt to be issued.
Statistics released by the Budgetary Work
Committee of the NPC Standing Committee showed
that by the end of 2004, China's national debt
balance reached 2.96 trillion yuan (US$370
billion), including 2.88 trillion yuan of domestic
debt and 82.8 billion yuan of foreign debt.
China's 2004 national debt burden rate was 21.6%
of
gross domestic product (GDP), far lower than the
warning level of 60% designated by the European
Union for its members, a generally accepted
international standard.
The Chinese
Ministry of Finance reported that the aggregate
national debt balance rose to 3.26 trillion yuan
in 2005, but it fell to only 18% of 2005 GDP of
18.23 trillion yuan. This reflects the effect on
economic policy analysis with dynamic scoring in
which the growth impact of the national debt on
the economy can outstrip its nominal rise.
By comparison, the US national debt stood
at $8.4 trillion as of April 13, 2006, or 65% of
forecast GDP. About $4.9 trillion of the US
national debt is held by the public and $3.5
trillion is held intra-governmentally. US national
debt is about 20 times China's on a nominal basis,
five times on a purchasing-power-parity basis,
almost four times on a debt-to-GDP basis, and 100
times on a per capita basis. US per capita income
is about 35 times that of China in 2005, which
means each US citizen is carrying almost three
times the national debt-to-income ratio as his or
her Chinese counterpart. On average, US wages are
about 50 times those of China because of higher
income disparity in China.
The national
debt The national debt is a financing
bridge over the gap between a nation's fiscal
policy and its monetary policy.
Fiscal
policy determines government revenue and
expenditures, while monetary policy determines
money supply and short-term interest rates. A
prudent fiscal policy can moderate the need for
national debt by either cutting expenditures or
raising taxes or both.
Monetary policy can
also reduce the need for national debt by the
issuance of more fiat money, which is an
instrument of sovereign credit backed by
government's authority to collect taxes payable in
fiat currency. A rise in the money supply lowers
interest rates in the short term, but the
resultant rise in inflation may cause interest
rates to rise in the long term.
A tax
increase takes money from the private sector into
the public sector and unless the government spends
all the tax increases back into the economy, it in
essence reduces the amount of sovereign credit in
the economy. Unless there are excessive
inflationary trends going forward, a government
that desires an expansionary economy has no
business running a fiscal surplus, particularly if
the economy is plagued with overcapacity. The
controversy is how the surplus revenue should be
spent to yield the most beneficial and equitable
effects for the economy.
The national debt
serves other important financial purposes for the
economy. A government securities market allows the
central bank to carry out open-market operations
to meet short-term interest-rate targets and to
provide a credit-rating anchor for the nation's
debt market.
Dollar hegemony eliminates
default risk Because of dollar hegemony, a
peculiar phenomenon of the US dollar, a fiat
currency, assuming the role of a key reserve
currency for international trade and finance, US
government securities do not carry default risks,
as the United States can print dollars at will
with little short-term penalty. The only risk US
government securities carry is inflation, a
prospect that the Federal Reserve, its central
bank, can control through interest-rate policy.
High Fed Funds rates can reduce dollar inflation
under normal circumstances, unless the economy is
plagued by a debt bubble, in which case high Fed
Funds rates can actually add to inflation.
Government securities of other nations
denominated in US dollars carry default risks, as
these governments cannot print dollars. Even
government securities denominated in local
currencies that are freely convertible carry
default risks because the foreign-exchange market
limits the ability of these governments to print
their own local currencies relative to the size of
their foreign-exchange holdings. In that sense,
dollar hegemony has reduced all freely convertible
and free-floating currencies to the status of
derivatives of the dollar.
The governments
of such currencies have forfeited their monetary
sovereignty with which to manage their economies.
The currencies of these nations no longer derive
their value only from the strength of their
economies, but also from the value of the dollar,
rising or falling against the dollar as a
benchmark.
The Federal Reserve of the US
has become a super-national monetary authority
through dollar hegemony, framing policies that
prioritize the needs of the United States, from
which the prosperity of the rest of the world must
derive. This is why, after the abandonment of the
Bretton Woods fixed-exchange-rates regime based on
a gold-backed dollar, the US has been pushing a
global floating-exchange-rates regime based on a
fiat dollar in order to impose dollar hegemony on
world finance.
Interest rate stability
or money supply stability Monetary-policy
authorities have a choice between interest-rate
stability and money-supply stability, but no
monetary system that operates on fiat money can
have both options. The national debt is the lowest
cost at which a nation can borrow. Sovereign-debt
interest rates act as a benchmark for other debts
because sovereign credit is superior to
private-sector credit under normal conditions.
When the money supply is tight, interest rates on
government bonds rise. This causes interest rates
on all private debts to rise with them. High
domestic interest rates usually exert upward
pressure on the exchange rates of freely
convertible currencies.
Best use for a
fiscal surplus During the years of fiscal
surplus in US president Bill Clinton's second
term, a policy debate surfaced on whether to pay
down the national debt or to cut taxes.
The economic logic tilts in favor of tax
cuts because the national debt needs a future tax
to repay it. Paying down the national debt would
lower the future tax rate so it is merely a way to
defer the tax cut to the future. Thus financially
speaking, a fiscal surplus can be more effectively
used to finance an immediate tax cut to stimulate
an overcapacity economy rather than to pay down
the national debt to reduce the tax burden in the
future.
For example, the US national debt
was paying about 6% interest, while personal
credit-card interest hovered around 18% in the
Clinton years. But the national debt actually paid
less than 6% because the recipients of the
interest payments must pay income tax up to 40%,
reducing the real national-debt cost to the US
government to about 3.5%. The degree of
progressive distribution of the tax cut has more
impact on the economy.
Long-term interest
rates are determined by supply and demand in the
credit market as well as the market's judgment of
the creditworthiness of the debt issuer and the
future health of the economy as affected by fiscal
and monetary policies. Thus the immediate
strengthening of the economy can also have
positive effects on long-term interest rates.
Shift from proactive to prudent fiscal
policy This year, China's fiscal policy
begins a gradual shift from "proactive" to
"prudent".
In the past seven years, a
proactive fiscal policy added 2 percentage points
to the economic growth rate every year. China now
urgently needs to deal with a series of pressing
economic and social problems that have been
created by its transition from a socialist planned
economy to a "socialist" market economy. And all
solutions point to the need for a sustainable high
economic growth rate for decades to come.
If the steps of "prudent" fiscal
adjustment are taken too abruptly, it will lead to
a slowdown in growth, with serious adverse impacts
on national economic performance. China does not
need to slow down its overall growth as much as it
needs to redress the imbalances in its
transitional economy caused by the overheating of
certain sectors through market failure. It does
need to reconsider fixation on conventional
measures of growth in narrow GDP terms and begin
to aim for balanced growth with renewed focus on
domestic social development and environmental
preservation as the real engines of growth, away
from over-reliance on export and dysfunctional
domestic market forces driven by speculation.
The exchange deficit between environmental
deterioration and single-minded industrialization
is a formula for negative growth. The same is true
for the mindless privatization of public goods.
The shift of emphasis toward balanced development
does not necessarily mean a slower growth rate. In
fact, it means an acceleration of the growth rate
measured by a more meaningful standard.
The Chinese bond market In
China, government bonds used to be allocated by
the issuing central government to state-owned
banks as captured buyers, with funds from
depositors who had few if any alternative
investment options. With the Finance Ministry
scheduled to pay back the 18th issuance of
national debts due in 2005, China has entered a
five-year peak debt-repayment period. Between 2005
and 2009, the Finance Ministry's annual debt
repayment will amount to about 400 billion yuan
($50 billion). While China can easily meet this
repayment schedule, its impact on the nation's
money supply will be significant unless new
national debt is issued.
In addition, as
part of the shift from a national banking regime
to a central banking regime, China is reforming
its four major state banks to become commercial
banks, looking to list them in overseas equity
markets as commercial enterprises to meet WTO
requirements of liberalizing its banking sector by
the end of this year. To do so, substantial funds
need to be injected into these banks to reduce
their residual bad-debt ratio by the issuance of
corporate bonds and government bonds.
The
funds these banks need to cure their systemic
non-performing-loan (NPL) problems left by the era
of national banking are so huge that a
considerable amount of the bonds will have to be
borne by the Finance Ministry. The resolution of
systemic NPLs will have a contracting effect in
the nation's money supply, as the extinguishing of
debt removes money from the economy. Under these
circumstances, China has decided to speed up the
opening of its embryonic bond market to foreign
capital.
Similarly to post-World War II
Germany, China has a historical phobia about the
political impact of hyperinflation, a condition
that played a major role in the fall of the
previous Nationalist government in 1949. Unlike
the German Third Reich, which was deprived of
foreign credit and had to rely on sovereign credit
to revive the collapsed German economy after World
War I, China in the past two decades has been
lured by the availability of easy foreign credit.
This is a mixed blessing. Finance globalization is
an illegitimate child of dollar hegemony, which
forces all nations that accept foreign credit to
emphasize low-wage export to earn dollars to repay
dollar-denominated loans. Under such
circumstances, export keeps domestic wages low
while it ships real wealth overseas in exchange of
dollars that cannot be used in the domestic
economy.
In the early 1990s, China
experienced high inflation due to disproportionate
credit expansion that came with a "proactive"
fiscal policy under the premiership of Zhu Rongji,
who was nicknamed the "debt premier" by his
critics. The problem was not the expansion of
credit, but that such credit was used mostly for
speculative purposes.
Corrective policies
were subsequently introduced to deal with
debt-driven inflation and imbalances. Central
regulatory controls and new regulations over the
Shanghai and Shenzhen stock exchanges were imposed
to rein in runaway speculative debt expansion. But
these tightening measures were accompanied by
financial-market liberalization and bank-reform
measures that had countering effects on the
government's effort to deflate the speculative
debt bubble.
The public soon discovered
that other higher-yielding investment options,
such as the stock market and real estate, were
open to them besides bank saving accounts, without
any awareness that the improved returns were paid
for with cuts in social-welfare benefits and
employment security until its was too late. As US
workers saw their jobs shipped overseas to
low-waged locations to provide higher returns on
their pension funds, Chinese workers saw the
profits from their low wages and meager benefits
shipped back to the United States in the form of
Chinese foreign-exchange holdings in US
Treasuries.
Similarly to the situation in
Japan or perhaps even inspired by it, Chinese
corporations began to take low-interest loans from
banks to speculate in the equity and real-property
markets to make easy profit rather than to invest
in plant modernization or expansion, which was
left mostly to costly foreign direct investment.
Experienced overseas speculators moved in to
manipulate the small and under-regulated Chinese
equity and real-property markets at the expense of
inexperienced and naive local investors.
Move from national banking to central
banking Until the mid-1990s, China's
state-owned banks acted mainly as agents of the
state in a national banking regime to fund
government economic policies. Bank profitability
was not the controlling factor in loan decisions.
The Central Bank Law and the Commercial
Bank Law were adopted in 1995 at the same time as
a series of financial-sector reforms were
introduced, including exchange-rate unification,
formal establishment and regulation of the
inter-bank market (IBM) for short-term loans, the
creation of an inter-bank foreign-exchange market
(IBFEM), the start of open market operation (OMO)
by the PBoC, the new central bank, and other
market-reform measures. Together, these reform
measures of 1994-95 contributed to the development
of an embryonic domestic market for government
bonds in China.
Bond markets are organized
into two categories: government bonds (GBs) and
corporate bonds (CBs); the creditworthiness of
both is rated by independent credit-rating
agencies according to well-established standards,
albeit not always neutral or free of political
bias. GBs are sovereign debt instruments,
guaranteed by the full faith and credit of a
sovereign nation; CBs are backed by the assets of
the issuing corporation. Interest rates on all
bonds are affected by their credit ratings. Aside
from the banking sector, CBs are widely used in
the telecommunication sector. It can be expected
that as the Chinese bond market develops, the CB
market will become much larger than the GB market.
The PBoC formulates and implements
monetary policy. The central bank maintains the
banking sector's payment, clearing and settlement
systems, and manages official foreign-exchange and
gold reserves. It oversees the State
Administration of Foreign Exchange (SAFE) for
setting foreign-exchange policies. The 1995
Central Bank Law gives the PBoC full autonomy in
applying monetary instruments, including setting
interest rates for commercial banks and trading in
government bonds. The State Council maintains
oversight of PBoC policies.
The China
Banking Regulatory Commission (CBRC) was
officially launched on April 28, 2003, to take
over the supervisory role of the PBoC. The goal of
the landmark reform was to improve the efficiency
of bank supervision and to allow the PBoC to focus
on the macroeconomy and currency policy.
New commercial banks The CBRC is
responsible for "the regulation and supervision of
banks, asset management companies, trust and
investment companies, as well as other
deposit-taking financial institutions. Its mission
is to maintain a safe and sound banking system in
China."
As part of the 1994 monetary
reform measures, commercial lending and policy
lending in the state banking sector were
separated. The four specialized banks under the
aegis of the People's Bank of China - the Bank of
China (BOC), Industry and Commerce Bank of China
(ICBC), China Construction Bank (CCB), and the
Agriculture Bank of China (ABC) - were transformed
into independent commercial banks to be operated
for profit for the benefit of shareholders rather
than to support national development aims for the
benefit of the nation, while at the same time
assuming full market and credit risks as
stand-alone profit-driven commercial institutions.
There are also second-tier commercial
banks and trust and investment companies. However,
the government continues to be the major
shareholder in these banks and trust companies.
These new commercial banks put their funds to work
in the market where return is highest but not
necessarily in the best national interest in terms
of where investment is needed most.
Policy banks Three policy
lending banks - the Long-Term Development and
Credit Bank, the Import-Export Bank and the
Agricultural Development Bank - were also set up,
separate from the commercial banks. The function
of policy banks is to grant policy loans in
accordance with state industrial policy and
national plans. The capital sources of these
policy banks are mainly government budgetary
funds, social insurance, postal and investment
funds from a shrinking public sector, central bank
credit, and a developing GB market.
Interest rate liberalization The
central government has recently allowed several
small banks to raise capital through bonds or
stock issues.
The reform of the banking
system has been accompanied by the central bank's
aim to decontrol interest rates gradually.
Market-based interest-rate reform is intended to
establish in an orderly manner an effective
pricing mechanism of bank deposit and lending
rates based on supply and demand. The PBoC will
continue to adjust and guide interest-rate
liberalization to allow the market mechanism to
play an increasingly dominant role in financial
resource allocation.
The sequence of the
reform is to liberalize the interest rate on
foreign currency before that on domestic currency;
lending before deposit; large amount and long term
before small amount and short term. As a first
step, the PBoC liberalized the interest rates for
foreign-currency loans and large deposits ($3
million and over) in September 2000. The interest
rate of deposits below $3 million remains subject
to PBoC control.
In March 2002, the PBoC
unified foreign-currency interest-rate policies
for domestic and foreign financial institutions in
China. Small foreign-exchange deposits of Chinese
residents with foreign banks in China were
included in the PBoC interest-rate administration
of small foreign-exchange deposits, so that
domestic and foreign financial institutions are
treated equally with regard to the interest-rate
policy of foreign-exchange deposits.
As
interest-rate liberalization progressed, the PBoC
liberalized, simplified or eliminated 114
categories of interest rates initially under
control since 1996. At present, 34 categories of
interest rates remain subject to PBoC control. The
full liberalization of interest rates on other
deposit accounts, including checking and saving
accounts, is expected to take much longer.
On the lending side, market-determined
interest rates on loans will first be introduced
in rural areas and then followed by rate
liberalization in cities. This decision, while
intended to attract more lending funds to the
rural areas, appears to be out of synch with the
policy to subsidize rural development, as it makes
rural borrowing more costly.
China
surprised global markets on April 27 by raising
interest rates for the first time in 18 months to
slow a debt-driven boom that risks destabilizing
the world's fastest-growing major economy. The
central bank raised its benchmark one-year lending
rate to 5.85% from 5.58% but kept its deposit rate
unchanged at 2.25%, widening the profit margin for
banks, which badly need better profits.
The move was billed as a measure "to
further consolidate macro-control effects,
maintain a sound trend in the sustained, fast,
coordinated, and healthy development of the
national economy and continue to let economic
means play a role in resources allocation and
macro-control." But as experience has shown in
other economies, higher interest rates do not
always reduce borrowing. Often they only shifts
credit allocation to distressed borrowers who are
desperate for funds even at higher cost.
Debate on sovereign credit Since
the mid-1990s, China has adopted a "proactive"
fiscal policy, raising large amounts of debt for
public investments to drive impressive economic
growth. Ministry of Finance data show that
cumulative long-term construction debt rose from
100 billion yuan ($12.2 billion) in 1998 to 990
billion yuan ($123.6 billion) by 2005, a tenfold
increase in seven years.
This policy has
generated heated debate among economists. Support
for sovereign debt financing is based on three
arguments. First, with a ratio of 1:4 between
national debt and bank loans, any rise in national
debt will result in a fourfold increase in bank
loans, easing critical capital shortage in
national construction.
Second, since the
funds raised through national debt are used to
finance public infrastructure that contributes to
economic growth as measured by GDP, rising
national debt has played a significant role in
China's economic growth without changing the
national debt-to-GDP ratio, which has remained
substantially below world standards. Since 1998,
projects funded by national debt have added about
2 percentage points per year to China's GDP.
And third, the EU limit on debt burden for
its members is 60% of GDP, and China is far below
that level at only 22%. Therefore China can safely
assume a still higher national debt level to
accelerate the pace of balanced national
development, particularly in social development to
boost domestic demand.
Many planners
believe that sovereign debt financing is an
important tool in macro-management of the economy,
provided that the national debt-to-GDP ratio
remains below the 60% danger level and that the
loan proceeds are spent wisely. China had earlier
estimated that its debt balance in 2005 would
reach 2.2 trillion yuan ($270 billion), or 16.8%
of its estimated GDP. Actual data from the
Ministry of Finance showed the debt balance to be
3.26 trillion yuan in 2005, nearly 18% of 2005 GDP
of 18.23 trillion yuan. By 2010, the debt balance
is expected to be 4.1 trillion yuan, or 22.4% of
its GDP; and by 2020 it will top 15.2 trillion
yuan, or 40% of its GDP. Experience suggests that
these estimates are likely to be too conservative,
although the debt-to-GDP ratio estimates may hold
or even decline if the economy grows faster than
the national debt.
Other planners point
out that high national debt is not a free lunch.
Questions have been raised on the appropriate use
of the national debt.
To date, not much of
it has been used to support social development and
environmental preservation, contributing to
serious imbalances. Much of the national debt has
been used to finance local infrastructure and
real-estate development projects and redundant
industrial and commercial ventures that did not
fit into a coordinated national plan. Thus the
high GDP growth rate has become a problem in
itself, rather than an index that reflects
balanced national growth.
Furthermore, the
national debt-to-GDP ratio does not include
potential financial burdens such as contingent or
implicit liabilities, eg, the national debt that
the central government lends to municipal
governments for infrastructure construction;
special national debt used for systemic bank
reform with losses from the state-owned banks'
massive non-performing loan portfolios in their
transition to commercial banks; about $60 billion
borrowed from the World Bank, Asian Development
Bank, and foreign governments in the name of the
nation but not included in the government budget;
debt due to wage-payment arrears by local
government and state-owned enterprises; losses due
to government grain-price support; and a serious
funding shortage in social-security and
health-care obligations.
Further, most of
the national-debt proceeds have been used to
finance local physical infrastructure, while the
social infrastructure has been largely and
critically neglected in the reform process toward
a market economy during the past two decades.
China today exhibits all the symptoms of a
19th-century boom economy in the age of industrial
revolution as described by Charles Dickens, with
urban slums, migrant workers, working poor and
sweatshops at the foot of shiny new skyscrapers.
Income and wealth disparity is rampant, while most
of the social-welfare network built through the
early decades of the socialist revolution lies in
ruins.
If all the government's residual
implicit and indirect social liabilities are
included, the official Chinese government total
fiscal debt is about 55% of GDP. According to one
estimate by the World Bank, the Chinese
government's total liability has already reached
100% of GDP. For China to reach the level of a
modern socialist society, the nation's social
liability would be more than ten times current
levels.
For a sizable portion of the
population, China's policies of market reform and
opening to the outside world of the past two
decades have only meant systemic exposure to
unemployment, loss of health care and social
security, unequal education opportunity for the
young, below-standard housing, wages falling
behind inflation, and loss of social benefits due
to privatization.
For everyone, rich and
poor alike, a deteriorating environment from a
shortsighted, frenzied rate of industrialization
will take enormous sums of money and decades to
restore. Economic loss from environmental
degradation and industrial pollution and accidents
is reaching crisis levels.
New
Socialist Countryside Program At long last,
Chinese leaders are taking concrete steps to
reorient policy priority toward people-based
social development and environmental restoration.
The focus now is to build a New Socialist
Countryside (NSC), a program launched on March 14
at the Fourth Session of the 10th National
People's Congress, stressing economic efficiency
and social equity by narrowing the gap between
rich and poor, putting more emphasis on democratic
and scientific policymaking, and balanced
development to ensure that reforms benefit the
majority, if not all, of the population.
This paradigm shift is clear if the 11th
Five-Year Plan Guidelines are compared with the
10th. The latest version contains fewer new plans
for multibillion-dollar construction projects,
aside from critically needed investment to divert
water from the country's wet south to the dry
north, or a gas pipeline from western frontiers to
the coastal east. Instead, more government funds
will be used to improve standards of living for
the country's 900 million rural residents, and
boost sci-tech research and development.
The aim is to transform the country from a
low-age workshop of exports into a powerhouse
manufacturer of home-grown quality global brands
anchored by strong domestic demand. Infrastructure
investment will be shifted from the urban areas to
the countryside, with a focus on farmland, roads,
safe drinking water, methane facilities, power
grids and telecommunications networks.
Premier Wen Jiabao pledged that rural
children will receive free nine-year compulsory
education of national standard, a correct decision
to break away from the market-fundamentalist
policy on privatizing education in the reform era.
China's external debt The three
main indicators for external debts for China in
2005 are all well below the internationally
accepted line of alarm reference: 20-30% for debt
repayment, debt-service ratio 20-30% of fiscal
revenue, and external-debt ratio to
foreign-exchange income of 100-165%.
Debt-service ratio (DSR) refers to the
ratio of debt repayments to the fiscal income of
the same year, an indication of the government's
debt-repayment capability. China's DSR in 2005 was
3.07% of fiscal revenue, below the 8% for
international standards. The ratio of external
debt to GDP was 12.63%, and the ratio of external
debt to foreign-exchange income was 33.59%. The
Ministry of Finance reported that debt balance was
3.26 trillion yuan ($407.5 billion), nearly 18% of
2005 GDP of 18.23 trillion yuan. China's
outstanding foreign debts (excluding those of Hong
Kong and Macau) stood at $281 billion at the end
of 2005, an increase of about $33.6 billion over
the figure at the end of the previous year,
according to statistics released by the State
Administration of Foreign Exchange on March 31.
The ratio of China's government fiscal
income to GDP had been erratic, either too high or
too low from year to year. In 1978, central
government revenue was 31% of GDP but only 15% of
total national revenue. In 1995 it fell to 11% of
GDP and 55% of national total.
But in
2004, central government fiscal revenue rose to
slightly less than 20% of GDP and about 56% of
total national fiscal revenue. The US had federal
revenue of $1.8 trillion in 2004, about 15.8% of
GDP, with a $412 billion deficit at 33% of GDP.
In 1997, the central government incurred a
56 billion yuan fiscal deficit at only 0.8% of
GDP. By 2003-04, the fiscal deficit had increased
to 320 billion yuan at 2.5% of GDP, according to
Ministry of Finance data. However, the Asian
Development Bank reports that China's fiscal
revenues expanded considerably in 2004-05, rising
by 21.4%, driven by high levels of economic and
trade activity and strengthened tax collection.
Fiscal expenditures rose by only 15.1%.
SOE earnings China's fiscal
revenue grew by 14.6% year-on-year during the
first half of 2005, to 1.64 trillion yuan ($202
billion). China's state-owned enterprises (SOEs),
turning around from their loss-making, inefficient
past, had a combined profit of 628 billion yuan in
2005, more than the total earnings of the United
States' General Electric Co for the past five
years at an annual average of $15 billion.
But while GE shareholders received about
$40 billion in dividends, at a 57% payout ratio,
the Chinese government did not get a fair dividend
from these profitable SOEs. Government
administrative measures on bank lending to
overheated sectors are neutralized by SOE managers
who choose to finance plant expansion with
internal accruals rather than bank loans. The
state, as the major shareholder of these SOEs,
should be paid dividends of 50% of SOE earnings -
$40 billion in 2005. The World Bank estimates that
SOE profits represented 3.3% of China's GDP. This
would be 20% of the government's fiscal revenue in
2005 that the government failed to collect.
Shift in public spending
priorities Priorities
in public spending shifted in 2005 from physical
infrastructure in urban arrears to rural
development, agriculture, social security, health
care and education as part of government efforts
to rebalance economic growth and social
development. The 2004-05 fiscal deficit narrowed
to 1.5% of GDP from 2.5% in 2003-04. However, if
off-budget obligations, including the implicit
pension debt and costs related to curing NPLs in
the banking sector, were considered, the fiscal
shortfall would be much higher.
The
usage efficiency of the funds raised by national
debt has been a subject of debate. Since 2000,
transportation and communication infrastructure
have taken up to 40% of the total. Second are
municipal infrastructure and urban reconstruction.
The last are environmental and social-welfare
programs.
But the national debt yield from
national construction projects has been much lower
than average market return. Yet this is to be
expected as market-driven private investment tends
to externalize the social and environmental costs
from their project accounting. Low internal rates
of return in national construction projects are
acceptable if they contribute to national economic
growth. But the National Audit Office annual audit
reported in 2002, after auditing 37 environmental
projects funded by national debt in nine provinces
to the amount of 2 billion yuan, only nine
projects finished according to plan and meeting
quality requirements.
A study by Professor
Song Yongming at the People's University of China
reported that "after the economic reform, national
debts were mostly used by corrupt officials in
conspicuous consumption, and not in construction
expenditure as most people expected". There were
frequent reports of corrupt officials converting
projects funded by national debt into extensive
bribery networks and fraud schemes. Such
corruption is rooted in the absence of a separate
independent supervisory and auditing authority in
project management.
Yet the focus should
be on rooting out corruption rather than reducing
sovereign credit for financing national
construction. Unregulated market economies have an
equal if not higher penchant for fraud and
corruption as planned economies. For all
governments, regardless of ideology and economic
system, anti-corruption is a basic responsibility.
Monetary and obligatory
debts Debt comes in two forms. This is true
for both private and public debts. One is money
borrowed or monetary debt, which is expected to be
repaid with money.
Monetary debt requires
periodic interest payments, for three reasons. The
first is rent for the use of the loan proceed; the
second is to preserve the purchasing-power
equivalence of the principal in anticipation of
future inflation; and the third to compensate for
risk of default. Thus interest-rate calculations
are affected by these three factors.
The
second kind of debt is obligatory debt, which is
caused by obligations yet unmet, such as payouts
on health-insurance claims, social-security
entitlements, and pension obligations. Obligatory
debt is different from monetary debt because it
generally does not require periodic interest
payments but needs to be paid with equivalent
purchasing power at time of payment instead of
face value at time of commitment. Thus obligatory
debt, being usually indexed against inflation,
cannot be cured by inflation the way monetary debt
can.
For governments everywhere, health
care, social security and pension underfunding in
both the private and public sectors are
macro-material debt time bombs that have serious
monetary and economic consequences. When universal
health insurance or social security/pension is
privatized, any potential of privatized insolvency
adds to the public material debt.
Sovereign governments seldom default on
either monetary or material debt denominated in
their own fiat currency, as they can usually issue
more fiat money to meet such debt obligations,
provided they are prepared to accept the monetary
and economic consequences. Such consequences take
the form of domestic inflation and a fall in
credit ratings of sovereign debts, both of which
cause interest rates to rise. Holders of sovereign
debt denominated in domestic currencies seldom
face default risks, only inflation risks.
The real systemic danger is of course
hyperinflation, which can take a destructive path
of its own. Hyperinflation can occur when
governments issue debt in excess of economic
expansion, causing the credit rating of government
debt to fall substantially below those of other
borrowers. A healthy debt market is one in which
government debt is at the top of the credit-rating
structure. Material debt, unlike monetary debt,
can accumulate at a scale and speed that render
normal monetary structure inoperative. Government
default on material debt has direct and immediate
economic consequences that can spill over to the
political arena.
The risk of foreign
currency debts When sovereign governments
take on debts denominated in foreign currencies,
the risk of default becomes material, as no
government can issue foreign currency and must
earn it through taxes on export to repay foreign
currency loans.
When a sovereign
government buys foreign currency with its domestic
currency in the exchange market, it is in essence
selling claims on its future exports. In a global
economy of overcapacity, for an economy that
incurs recurring trade deficits, the
foreign-currency debt can only be paid with
domestic austerity, causing a downward economic
spiral. Such disasters have been commonplace all
through the developing world in the past two
decades and are continuing today.
When
governments adopt freely convertible currency
regimes, the exchange rates of their currencies
are subject to market forces that can often be
manipulated by speculators such as hedge funds,
which seek to squeeze profit from discrepancies
between current exchange rates and the fundamental
economic value of currencies. With an
exchange-rate regime exposed to market forces,
sovereign debt denominated in domestic fiat
currencies will be subject to speculative forces
beyond the control of the issuing government. This
leads directly to a loss of sovereign authority on
monetary and fiscal policies and places
restriction on the option to use sovereign credit
for domestic development. The sovereign government
that faces foreign-currency debt default will be
put under financial house arrest in a debt prison
in its own country by "conditionalities" imposed
by the International Monetary Fund, which operates
as a vicious loan shark against the indebted
government.
The Mundell-Fleming thesis,
for which Robert Mundell won the 1999 Nobel Prize,
states that in international finance, a government
has the choice among (1) stable exchange rates,
(2) international capital mobility and (3)
domestic policy autonomy (full employment,
interest-rate policies, counter-cyclical fiscal
spending, etc). With unregulated global financial
markets, a government can have only two of the
three options. When spending for domestic
development is financed by not by sovereign credit
denominated in local currencies, but by sovereign
debt denominated in foreign currencies, a
government faces risk of loss of financial and
monetary sovereignty. Even if sovereign debts are
issued only in domestic currencies, cross-border
capital mobility will expose domestic currencies
to speculative attacks.
It is becoming
increasingly obvious that restriction on
international capital mobility is the least costly
of the three options. Through dollar hegemony, the
United States is the only country that can defy
the Mundell-Fleming thesis, because the dollar, a
reserve currency for international trade and
finance, can be printed at will by the US central
bank without penalty.
The non-bond debt
market Monetary debts are generally
tradable, intermediated through debt markets,
which consist of bond and non-bond markets. The
non-bond market is relatively new and falls
generally within the field of structured finance -
the securitization of debt through which packaged
debts are unbundled into tranches of varying risk
to be marketed at varying rates of return to
investors with varying appetite for risk.
Along with debt securitization grew a
market for financial derivatives, initially
developed as a hedging venue against risk, but
they soon developed into a profit center that
exploits the ballooning of risk. This market is
not well understood by either market participants
or regulators and data on it are imperfect (see The dangers of
derivatives, May 23, 2002).
Timothy Geithner, president and chief
executive officer of the New York Federal Reserve
Bank, warned in a speech ("Risk Management
Challenges in the US Financial System") before the
Global Association of Risk Professionals' (GARP)
seventh annual Risk Management Convention and
Exhibition in New York City on February 28 that
the scale of the over-the-counter (OTC)
derivatives markets is dangerously large.
"Although the notional total value of
these contracts, now approaching $300 trillion, is
not a particularly useful measure of the
underlying economic exposure at stake, the size of
gross exposures and the extraordinarily large
number of contracts suggest the scale of the
unwinding challenge the market would confront in
the event of the exit of a major counterparty,"
Geithner said. "The process of closing out those
positions and replacing them could add stress to
markets and possibly intensify the direct damage
caused by exposure to the exiting institution."
Geithner observed that "credit
derivatives, where the gaps in the infrastructure
and risk-management systems are most conspicuous,
are less than 10%" of the total OTC derivatives
universe, but are growing rapidly. Large notional
values are written on a much smaller base of
underlying debt issuance. "The same names show up
in multiple types of positions-singles-name, index
and structured products ... These create the
potential for squeezes in cash markets and greater
volatility across instruments in the event of a
default, magnifying the risk of adverse market
dynamics."
Chinese commercial banks, in
joining the game of international competition
under WTO rules, will be forced to participate in
the credit derivatives markets, which are time
bombs of massive systemic financial destruction.
Next: Development financing and
urbanization
Henry C K Liu is chairman
of a New York-based private investment group. His
website is HenryCKLiu.com.
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