COMMENT China's challenge: Balancing state
and market By James A Dorn
The slowing of the global economy is
forcing China as the world's largest exporter to
confront the issue of rebalancing, which at heart
is a problem of striking the right balance between
state and market. State-owned banks still dominate
the financial sector and are kept profitable by a
positive spread between loan and deposit rates
dictated by government policy.
Financial
repression has penalized savers while rewarding
banks. The recent decision of the People's Bank of
China (PBOC) to allow greater flexibility in
interest rates is a welcome sign.
In June,
the PBOC announced that banks will be allowed to
offer loans at interest rates up to 20% below the
benchmark rate and
be free to pay savers a
rate up to 10% above the ceiling rate. With CPI
inflation at about 2%, real rates on saving
deposits are now positive. Wang Tao, chief China
economist at UBS in Hong Kong, calls the deposit
rate reform "unprecedented" and a "milestone for
interest-rate liberalization."
The
influence of the state in controlling key prices -
notably interest rates, the exchange rate, and
prices for refined energy products, water, and
electricity - politicizes investment decisions,
artificially spurs export-led growth, and favors
manufacturing. China's challenge is to expand the
scope of private markets and use competitive
pricing to allocate resources efficiently. Once
prices are right, China's growth path can be
rebalanced toward greater domestic consumption.
President Hu Jintao wants to build a
"harmonious society" by creating a more extensive
growth model that spreads growth to less developed
regions and by decreasing income inequality. Yet,
as Nicholas R Lardy, one of the world's leading
China scholars, notes in his new book,
Sustaining China's Economic Growth after the
Global Financial Crisis (Peterson Institute
for International Economics), present leaders have
not done much to extend liberalization in the
post-Deng Xiaoping era. Modest reforms are not
sufficient to free interest rates and other key
prices from the hand of the state. The new
leadership team that is soon to take over will
need to take bolder steps if China is to end
financial repression and extend prosperity.
China's 4 trillion yuan (US$586 billion)
stimulus program was launched in 2008 to counter
the global financial crisis. Monetary easing and
infrastructure investment, financed primarily by
loans from state-owned banks, helped keep real
gross domestic product (GDP) growing by more than
9% in 2009 and more than 10% in 2010, while the
United States, Europe, and Japan languished.
Critics of that program, such as MIT
economist Huang Yasheng, argue that state
intervention during the crisis has set back the
reform effort and harmed the private sector. In
particular, it is claimed that the bulk of bank
loans went to state-owned enterprises.
Lardy does not accept that verdict.
Relying on official data, he concludes that "the
stimulus program did not lead to a wholesale
advance of the state at the expense of either
private firms or individual businesses." In
particular, "state-owned firms did not increase
their share of bank lending." Nevertheless, he
recognizes that the state continues to retain
control over the so-called pillar industries such
as banking, finance, telecommunications, and
petroleum. And he acknowledges the "stepped-up
level of state industrial policy", although he
thinks it is premature to predict the impact on
"the balance between state and market".
The question about the proper balance
between state and market should be at the center
of any debate regarding China's future. Promoting
capital freedom - that is, the right to acquire
and exchange titles to capital assets - would
allow private individuals a wider range of
investment choices and limit the power of state
officials.
Lardy and others argue that one
way to increase consumption in China is to extend
the social safety net to include rural residents,
who now have to pay most of the costs of
education, health, and retirement. What is
neglected, however, is that reliance on private
savings reduces one's dependence on government and
thus fosters civil society. In contrast, expanding
state welfare would tilt the balance between state
and market toward more government power and less
individual responsibility.
Private firms,
many of which are foreign-funded, have been the
most important contributors to growth in
manufacturing, primarily in tradable goods.
Exporters and import-competing industries have
benefited greatly from China's opening to the
outside world, beginning in 1978. The existence of
widespread shadow banking serving the private
sector, however, indicates that state-owned
enterprises have much easier access to credit.
The recent Wenzhou experiment (based on a
town in eastern China noted for its
entrepreneurial activity), which officially
recognizes and sanctions the informal banking
sector, is an explicit admission of past
discrimination. Also, the use of investment
platforms (special investment vehicles) to fund
local governments steers funds to SOEs involved in
development projects, thereby affecting the
balance between state and market. There is
also the problem of identifying recipients of
loans from state-owned banks by type of ownership.
No official data exists on bank credit by
ownership type. Thus, Lardy looks at bank loans by
firm size, assuming private firms are mostly small
enterprises, and finds that their share of new
loans made under the stimulus program exceeded
credit going to larger enterprises. He also finds
that the share of industrial output produced by
SOEs has continued to decline - from more than 80%
in 1978 to less than 28% today.
Nevertheless, Lardy is critical of the
lack of any significant progress in reforming the
state sector by liberalizing factor prices,
especially interest rates, during the stimulus
program. The government continues to set a ceiling
on deposit rates and a floor on lending rates. The
positive net interest spread enhances bank
profitability and gives state-owned banks an
incentive to favor financial repression.
Low or negative real interest rates on
deposits, including saving accounts, provides a
low-cost source of funding for state-owned banks.
Households appear to have a target rate of saving
in order to meet expected expenditures for
housing, education, healthcare, and retirement.
Thus, Lardy finds that when interest rates
decline, households tend to save more. Meanwhile,
relatively low lending rates encourage investment,
including in residential housing.
The
sources of the imbalances in China's economy are
due to the distortions in the price system and the
politicization of investment decisions. Unless
those distortions are removed by ending financial
repression and allowing a greater scope for
private markets, China will face increasing
disharmony.
The most fruitful reform,
notes Lardy, would be to end financial repression
by liberalizing interest rates, which would
increase real rates on deposits, thereby
decreasing saving if the income effect is strong,
and increasing consumption. That process now
appears to have begun.
Of course, if
interest rates are to be market-determined, there
must be fully competitive private capital markets,
which would require privatizing state-owned banks
and bringing shadow banking into the daylight not
just in Wenzhou. In addition, the renminbi (also
referred to as the yuan) needs to be convertible
for all transactions, not only for trade in goods
and services. Investors need to be free to choose
both domestic and international assets for their
portfolios. Using credit quotas and interest rate
controls to allocate scare capital leads to
corruption and inefficiency.
The essential
condition to normalize China's balance of
payments, shift to a more service-oriented
economy, slow investment growth, and increase
consumption is to get relative prices right -
especially interest rates and the exchange rate.
Economists at the central bank and elsewhere have
called for faster liberalization and
restructuring, but the pace of reform will depend
on political factors in a one-party state.
The United States and others can put
pressure on China for further reform, but such
pressure is limited and could backfire. It would
be better for Western debtor countries to get
their own fiscal houses in order than to attack
China for an undervalued exchange rate and
threaten protectionist measures that would reduce
world trade and wealth.
A capital-poor
country like China should not be a net exporter of
capital. By holding trillions of dollars of
low-yielding foreign debt, China deprives its
citizens of the wealth that could be created by
relaxing capital controls and encouraging imports
by allowing market-determined exchange rates and
freely determined interest rates.
China's
challenge is to undertake institutional reforms
that protect individual rights, strengthen the
private sector, get prices right, and thus tilt
the balance between state and market toward more
freedom and less coercion.
James A
Dorn is a China specialist at the Cato
Institute in Washington, D.C., and co-editor
of China's Future: Constructive Partner or
Emerging Threat?
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