ENGINEERING CHINA S FINANCIAL REFORM

Transcription

1 ENGINEERING CHINA S FINANCIAL REFORM FRIDAY, SEPTEMBER 16, 2011 WASHINGTON, D.C. WELCOME/MODERATOR: Douglas Paal, Vice President for Studies, Carnegie Endowment for International Peace SPEAKERS: Nigel Chalk, Mission Chief for China and Hong Kong SAR, International Monetary Fund Yukon Huang, Senior Associate, Asia Program, Carnegie Endowment for International Peace Nicholas Lardy, Anthony M. Solomon Senior Fellow, Peterson Institute Transcript by Federal News Service Washington, D.C.

2 DOUG PAAL: Good morning, everyone. Welcome to Carnegie Endowment for International for Peace. My name is Doug Paal; I m vice president for studies and director of the Asia program here. It s my privilege this morning to be moderator for a panel on a very important subject with a very distinguished panel of experts. [00:00:25] This is a second in a in a period of increasing cooperation between the Carnegie Endowment and the many distinguished international representatives of the International Monetary Fund. And a new report has been done on China s financial reform, and we re privileged to have present that to us this morning, Nigel Chalk. Looking at Nigel s biography, which all of you have and I won t read, it s I would really emphasize the episodes in his career: Argentina, Brazil, Korea, and now people are warning us about China. He may be he may go where the crises are or the crises may follow him. We ll find out. (Laughter.) Also on our panel today is Yukon Huang who joined us from the World Bank earlier this year here at Carnegie. He s had a lot of experience in Beijing and Moscow and has been developing some very original ideas. And then it s our privilege to welcome from across the street at the Peterson Institute of International Economics (sic) Nick Lardy who is widely considered the most eminent observer and analyst of Chinese economic affairs and certainly one of the most eloquent. And with that very brief introduction, let me turn it over to Nigel. [00:01:49] NIGEL CHALK: Thanks. MR. PAAL: Thank you. MR. CHALK: Thanks so much, Doug. Me and crises, I think, are definitely correlation, not causation. So have to be careful of those things. So we ve been doing a lot work lately, particularly this year, on financial sector issues in China. We ve undertaken a financial sector assessment program in collaboration with the Chinese government, which took a very broad look at the financial system, and we ve been thinking a lot about where the system is now and where it should go in the coming years, and so I m going to talk about that in broad terms today. [00:02:17] Before I start, let me just give you an overview of how we see the financial system in China and put the big characteristics that define it. First of all, as everybody knows, China s got very high savings. They re kept captive domestically by capital controls. So you ve got a lot of the savings sitting inside the domestic financial system. It s a very bank-based system. It s highly regulated in the sense that interest rates, particularly loan deposit rates, are determined by the government directly. Monetary policy is predominantly relies on quantity tools to restrain the pace of credit growth, and the exchange rate s highly managed and leads to large foreign currency intervention.

3 So that s sort of a broad overview of the system as it is now. And I want to first motivate why financial reform in China s important. I think we think it s as important, for example, as the state enterprise reform that was done in the 90s. It s going to transform the economy and, if it s done right, it ll be move China into a much more modern market-based economy. And then I want to talk a little bit about sequencing, which we also think s very important, mainly because we see this underlying exercise of financial reform or liberalization in China as inherently risky. And so getting the sequencing right really matters in order to mitigate some of those risks. [00:03:37] So let me start with a little bit of motivation. So the first motivation is, as I said, China controls macroeconomic policy, particularly monetary policy, predominantly through the use of quantity tools, quotas on credit and particularly quotas on bank credit, and what we ve seen over the past few years is an increasing amount of intermediation moving outside of the banking system and into a nonbank financial system. That inherently is going to reduce the effectiveness of the quantity tools that they use right now to control monetary aggregates, and so we see that there s a risk continuing with the current path. It s not an immediate risk, but it s a present risk in the, say, three- to five-year horizon, that the main macroeconomic controls that they have at their disposal actually become much more diluted in their effectiveness. And the concern we have is that reduction in effectiveness of macro controls is that coming exactly at the point when you re actually going to need more macroeconomic policy levers because demographic changes in China will change the way the labor market works. You re going to see continued and rising inflationary pressures, particularly from food supply. Property price inflation clearly is an ongoing problem that s not going to go away. As I said, you re going to have more nonbank channels for financial intermediation, and all of that s going to boil down to a weakening of the credit controls. So the first point to make is financial reform s important because the current system is going to become less effective through time, and that s risky. [00:05:04] And the second point I d make is that we see financial reform as really a critical part of the whole rebalancing agenda. We want to get consumption going in China. We want to get household incomes up. As you can see, China s consumption is way below where other countries would be. China s level of development really stands out from an international perspective. And on the right hand on the right-hand side there s a picture here that shows that really the households are really getting shortchanged on their savings in the banking system. They basically don t get remunerated on those savings, despite the fact that the productivity of capital in China is quite high. So this picture takes a look at the productivity of capital in China and tries to divide it up between households, the banks and the corporate sector. Who s getting those rents from that productivity? [00:05:50] And you can see in China, the red the red spot is the households, the depositors. They re not getting anything, and effectively the productivity of capital is being divided up between the banks and the corporate sector, which is quite different from a lot of Asia and certainly from the Western economies. So we think the financial reform in China is an important mechanism effectively to take some of those productivity gains out of the corporate sector, to some extent out of the banking sector, and put them in the hands of the households. That will raise household income, and households will then consume that, and you ll facilitate a rebalancing of the economy.

4 In addition, but it ll facilitate an increase in the cost of capital, which we see as very low in China. So the cost of capital more closely reflects the productivity of capital, and that will change the incentives to away from heavily capital investment capital-intensive investment and towards more labor-intensive means of production, which will, again, boost household income through labor income. [00:06:45] And as I said to the start, the problem is, is that financial reform in China, it s risky continuing with the current system, but the changing the system is also very risky. And we ve seen from international experience lots of and I ve been involved in a few of these countries, although not as I said, not causal (laughter) the I was a I was a child when this was happening; so it couldn t it couldn t possibly be (laughter) MR. : OK. MR. CHALK: so but you re seeing and a lot of countries have moved towards liberalization, particularly the liberalization of interest rates. What happens is they lose control of the monetary aggregates. So as you liberalize interest rates, they unintentionally inject an enormous amount of credit and monetary stimulus into the economy. So you see here cases of interest rate liberalizations. Starting point is where they began to liberalize interest rates, and then you see credit growing and growing and growing, and eventually the little square dot is when they end with a banking crisis. So you end up with a big injection a stimulus to the economy, eventually all those loans go bad, and you have a big banking crisis. [00:07:42] And it s pretty clear that the countries that have liberalized interest rate(s) correctly, as they liberalize, they actually tighten monetary conditions, and they drove up the real rate of interest. The ones on the left-hand side the Argentina, Chile and Mexico, which ended up with problems these are the ones that actually injected stimulus into the economy as they were liberalizing. So that s the that s the risk, is the process of liberalization itself will actually create overheating pressures, asset bubble pressures, nonperforming loan pressures in the economy. So you re faced, as a policymaker in China, you re faced with two options. You keep with the current system, which works pretty well, but you know it s going to become less effective over time. Or you try and switch to another system, which you know that process of switching itself is a risky adventure. And that s a complicated decision to make from a political economy perspective. So this is how we see the main motivation for financial reform: One is to preserve macro control, and two is to facilitate rebalancing in the economy. So I want to just talk briefly about sequencing. [00:08:40] Now, normally in China, as many of you know, the approach to reform tends to be gradualist and tends to be experimental in nature. So they ll do pilot cases; they ll do experiment in one province with a particular type of reform. Our concern is that approach to reform, while well suited for things like health care reform or reform of the VAT, is not well-suited for financial sector reform.

5 You can imagine, for example, experimenting with allowing some banks more freedom to set interests rates on deposit and loan rates in some provinces or certain banks. That s going to create huge incentives for arbitrage, I mean, huge potential instabilities in the system. So we think it s very important that there s a clear game plan going into the process of financial reform and a clear strategy that will have to be flexible because there s going to be some unexpected events along the way. But it has to have a clear road map, and we ve tried to define what we think that road map will be. And there s at least six components that I m going to go through. [00:09:45] The first one is the exchange rate. They China could not engage in financial reform if it s continually injecting $300 billion of reserve accumulation a year into its financial system. It s just too much of a push of liquidity into the system. It s going to create too many pressures. So really to move ahead with financial reform, there needs to be currency appreciation to reduce the amount of foreign currency intervention, to reduce the scale of BOP inflows into China. Having more flexibility in the currency and particularly appreciation of currency will also mean that you don t need to use reserve requirements as they are used now, purely as a tool to sterilize the foreign currency intervention, that you ll actually be able to use monetary tools in a way to exercise monetary policy rather than offset the reserve accumulation, and so that will give you a greater scope for an independent monetary policy. And I m going discuss in order to liberalize the financial system, you re going to need to have an independent and strong monetary policy along the way in order to contain this expansion of credit the system is normally, naturally going to facilitate. And so we see this as a really important prerequisite to moving ahead with financial reform. [00:10:58] The second thing is the monetary framework. As I said, right now a lot of monetary framework is exercised through the use of quantity controls on credit to restrain monetary aggregates. As you can see, inflation moves around quite a lot in China, and interest rates really don t move very much in response to inflation. That s because the counter-cyclical forces of monetary policy are really driven by quantities and not by interest rates, and interest rates are not used very actively. In addition, as I said before, reserve requirements are much more linked to sterilizing foreign currency intervention than to actual use of monetary policy. So it s a strange monetary policy framework. It s something that s not common, particularly not common in an economy this size. So, our view is that first steps in order before you begin the process of liberalization is that you have to absorb the liquidity in the system. Right now, there s an enormous amount of hidden liquidity in the system. It s not reflected in market prices because, as I said, interest rates are regulated in the economy. If you start liberalizing now with all of that liquidity sitting in the system, it s going to turn into loans, and it s going to create overheating pressures and asset bubbles. So first of all, you have to absorb the liquidity, and you do that by issuing central bank paper and driving up interest rates. If you look at central bank paper interest rates, like at the one-year interest rate right now, it s very, very close to the deposit rate. What you need to do is push that interest rate higher and higher, in order the banks become short liquidity, and they start making appropriate decisions on liquidity management and the allocation of credit. So that s the first step. [00:12:35]

6 The second thing is you re going to have to start thinking about a different monetary policy framework. If you re going to give up quantity controls direct quantity controls, if you re going to have a more flexible exchange rate, and you re going to do it at a time when you re reforming the financial system, the monetary aggregates become very unstable. You you re going to have to move towards a different kind of system that neither targets the exchange rate nor monetary aggregates as the nominal anchor. And our view is that there should be kind of a hybrid system that looks at has clear targets on growth, inflation and financial stability, and that uses a combination of monetary tools, particularly interest rates and macro prudential tools, in order to achieve those targets, but particularly a lot more reliance on indirect instruments of monetary policy, open-market operations. And as part of that, it would be important also for operational autonomy for the central bank. [00:13:24] So the third step is improving regulation/supervision. Along with giving banks more ability to set interest rates, more freedom to allocate credit, there needs to be a very strong regulatory and supervisory environment. We ve seen here in the U.S. where regulation and supervision didn t keep up the pace of financial innovation, didn t keep up with the intermediation that was happening. You ended up with huge problems. So it s really there s been huge progress in China in the last several years on regulation and supervision, adopting international standards, having very professional regulatory bodies. So and there s a lot that still needs to be done. So I m I ll just point a few a few of these aspects. I think one thing that s going to be very important is to have a coordinating body that coordinates all of the financial regulators because you re going to see increasing moves out of the banking system and into a nonbank system, into the securities markets, into corporate debt markets, and so you re going to need to have a holistic view of financial regulation driven by a central coordinating body at a very high level. [00:14:25] The second thing is, on crisis management framework, you re going to need to have the tools to handle problems as you liberalize, the problems that arise. So that s going to mean things like being able to take over weak institutions and have an orderly exit process, which currently doesn t exist, having a formal deposit insurance scheme. These are the sort of normal tools we see in market economies that China still doesn t have in place having emergency liquidity support facilities at the central bank that are automatic for banks that temporarily hit liquidity constraints, but don t have solvency problems. So all of these things will be necessary to manage the process of liberalization as it moves along. The fourth thing is the market development, and I m not going to talk in detail about that. But market development in China in addition to moving ahead with reform of the banking system and the financial system, it ll also be important to build a very well-regulated and healthy nonbank financial intermediary system. Currently there s a number of problems in the financial system. Money markets don t work very well; you can see a lot of volatility in money markets. Corporate bond markets are very segmented with exchange-rated and interbank bond markets. Securities markets need a lot of work in terms of improving liquidity. All of these are fairly technical things, though. The main point I want to make on market development is it will be very important that, as you move ahead with market development, it moves in parallel with the liberalization in the banking system. If you move market development faster, you will have more ability to intermediate outside the banking system, and you don t change what s happening in the banking system, which is sort of what s happening now. You run the risk that

7 funds migrate out of the banking system and into the nonbank system, and then you undermine your banking system as a result. So it s very important as I said, a sequenced and coordinated strategy that you move all the aspects of financial reform along together at a similar pace. Finally, interest rates. So once you have a flexible exchange rate, you have a coherent monetary framework linked to growth inflation and financial stability, you ve absorbed the liquidity that s currently resident in the banking system through open-market operations, and you ve got a good set of regulatory and supervisory structures, then you can move ahead with liberalizing interest rates. If you do it before that, the risk is, as you liberalize interest rates, twofold: The banks will start competing heavily for funds, compress their margins, and then the banks get into trouble or you get a surge of credit into the economy as the banks use all the liquidity that they have on their balance sheets and start lending it. So liberalizing interest rates comes somewhat later in the schedule, I think, than many people think, but I think there s a lot of preconditions that need to go in place before you start doing that. [00:17:15] In terms of how to liberalize interest rates, I would focus more on the deposit rate ceiling, so we think which is, I think, is not a view in China, but we think what you want to do is, as you liberalize interest rate(s), you also want to raise the cost of the capital, you want to tighten monetary conditions. So it seems natural that you should raise the deposit rate ceiling, you tighten monetary conditions in order to absorb the liquidity, to drive interest rates up, and as you do that, the long-rate floor that they currently have on banks will just become less and less binding. The banks will start pricing loans more and more above the floor, and eventually the long-rate floor won t matter. Once you get interest rates close to equilibrium, deposit rates higher, eventually you can start removing the deposit rate ceiling too. And as I ve said, all the whole game as you move along this process is to tighten monetary conditions, restrain credit growth, raise the cost of capital that has to be a part of the whole process. And then the final aspect of this sort of broader financial reform plan is capital account liberalization, and we see this coming fairly late in the game. Certainly there s a lot that can be done right now on liberalizing on internationalizing the renminbi, and there s a lot of progress being made. But real capital account liberalization, where you allow more and more flows coming in and out across the capital account, will have really have to wait until you have a financial system that s much more price-based, you have a good monetary framework, you have a good regulatory framework. They do have the tools right now in terms of QDII/QFII tools where they can gradually open up holes in the capital account and allow flows to come through. As usual, we think you open up the longer-term, non-debt-creating flows first. You leave the portfolio flows till later. But it but you know, it you can t move ahead with capital account convertibility until you sort out the broader financial system. [00:19:08] So that s I kept within 15 minutes, which is pretty good. That s unusual for me. (Laughter.) But I m going to turn it back to Doug, and I d like to hear from Yukon and Nick as well. MR. PAAL: Well, that really was a rather breathless tour through the (laughter). I remember when I was in the Navy, when they gave us instructions like this, they took several weeks to (inaudible, laughter). I think that is just I think we d agreed that Nick would go second? Yeah.

8 NICHOLAS LARDY: Well, I very much share Nigel s assessment of the situation and the kind of strategy moving forward. So I thought I would spend a few minutes of to talk a little bit more about the political economy aspects of the question, why haven t the Chinese started on this earlier, why have they waited so long, what are the what are the constraints on undertaking the kind of reform program that we just heard laid out, I thought, very, very well. [00:20:10] And I begin by noticing that China was beginning a process of interest interest rate liberalization in the late 1990s. It continued it through But there has been very, very little progress since then. The whole process essentially came to a halt. Wen Jiabao has talked about interest rate liberalization. It was an objective that was spelled in the 11 th Five-Year Plan that is coming to an end. It s also an objective that s very clearly identified in the 12 th Five-Year Plan. So this is something they started on, then paused a rather long pause and now they re talking more about doing it, but it s very hard to see that any real progress or anything concrete has happened since late And so I d like to talk just very briefly about, you know, why they won t move on the exchange rate, why they won t move on interest rate liberalization. And I think that there are a couple of common explanations in the political economy literature on China people talk about all the time. And one is that there s this misalignment of interests between the central government on the hand and localities on the other. And we see this in many, many domains. So the central government announces policies but you don t get the follow-through at the local level. [00:21:35] We d see this, for example, on intellectual property rights protection. China has a great system of laws and regulations on these subjects, but they re not enforced at the local level. The local levels are interested in the employment and the tax revenues and so forth that are generated by firms that are pirating intellectual property. You periodically have crackdowns that are orchestrated from the central level, but once these are over, it s back to business as usual in the provinces and nothing really much happens. I don t think this framework really tells us very much about why China hasn t moved ahead more on the exchange rate and interest rate liberalization. These are two policy ends. I mean, you don t need boots on the grounds at the local level to reform the interest rate structure, reform the whole process of setting interest rates, or the exchange rate. These are these are policy instruments that are entirely controlled at the central level. And once they are changed, I believe there ll be a very substantial reaction at the local level because most of the activities that these prices affect are in the private sector. Nigel mentioned property development. I m in the school of thought that says, interest rate repression, these very low deposit rates has led a large number of households to invest in multiple houses because the return on housing has been very, very high over the last five or six years, whereas return on bank deposits has been negative. But once you change you know, once you change the interest rate policy and the real return to deposits goes up and the advantage of housing, owning housing over other kinds of financial instruments disappears, the housing market is going to correct and local government officials, party secretaries and so forth, at the local level, may be very unhappy about this. They re going to you know, construction activity will decline or grow at a much slower rate. They re going to lose tax revenues. The revenue from the leasing of land will dry up. But I don t think there s

9 anything they can do about it because you re not local party officials can t people can t force people to buy their third of fourth house if they don t want to own one. [00:23:55] And all of the property activity is undertaken by private companies. If you go back 15, 20 years ago, most construction was undertaken by state-owned companies; that s not the case today. Eight percent of all the construction activity is carried out by private by private firms. So they will respond to price signals like a change in interest rates. And it s the same thing on the exchange rate. The dominant source of exports from China or the growth of exports in China today is coming from private firms. Foreign-funded firms are still important. They are also very profit-oriented. And state firms which, back in the mid- 90s, accounted for about two-thirds of Chinese exports, now only account for about 15, 20 percent of China s exports. So, again, this is an area where private-sector activity dominates. So if the currency appreciates and exporting becomes less profitable, these firms will scale back their activities. If the exchange rate appreciates more, they ll exit from the businesses. And there will be a response. China s export surplus, I believe, would diminish and resources would be gradually allocated into other sectors of the economy. And if we read the reports that the IMF has put out, there are very substantial prospects for increasing employment in the service sector so this need not have a very large effect on employment overall. So this idea that the structural problem here is that central government can t align the incentive structure at the local level to make sure that its mandates are carried out, I don t think applies in the policy that we re addressing this morning. [00:25:41] I think the alternative explanation, which is either that, you know, China is a much more consensus-based political system and they can t get agreement on reforms in these areas or, you could put it another way; you know, you have weak central leadership that can t is subject to conflicting advice on the issues that we re talking about I find that much, much more persuasive. I think the problem, quite frankly, has been that in the in the Hu Jintao-Wen Jiabao era, we ve had no significant market-oriented reform initiatives. We have an increasingly market-driven economy, I think, but it s really running off momentum of earlier reforms rather than a response to significant new initiatives that have occurred under the under the current leadership. So and I think also it s very clear that we see lobbying against the kinds of reforms that we re talking about this morning. The ministry of commerce, a lot of other special interests have repeatedly given terrible advice to the top leadership about what the consequences of exchange rate appreciation would be. In the Spring of 2010, for example, when they were debating whether or not to go off their fixed exchange rate policy, which they finally did do in June of 2010, the spokesman for the ministry of commerce said, the most important thing is exchange rate stability. And he said that it would be two to three years before China recovered first of all, he said there were going to be deficits in the trade account as they went through 2010 and that it would be two to three years before China recovered to the level of exports that it had prior to the global financial and economic crisis. In the reality, as

10 we move through 2010, there was only one month in which there was a trade deficit. China s exports expanded for the year as a whole by more than 30 percent that s about three to four times the growth of global trade that year and China s exports in 2010 were up way above the previous peak. So you got the ministry of commerce, consistently over a period of years, forecasting doom and gloom if the exchange rate changes, and the results usually conclusively prove that the advice that they gave is wrong, but they still seem to be quite influential in the in the determination of exchange rate policy. [00:28:11] That s why even since the policy change in 2010, the currency, while appreciating a little bit against the dollar about 6 percent has continued to depreciate on a on a real trade-weighted basis, so we don t see the kind of adjustment in the exchange rate that I think Nigel correctly points out is more or less a precondition for moving ahead with interest rate liberalization and a number of other reforms that are very important to this overall rebalancing agenda. So I m not very optimistic that the situation s going to change. I think this system has become more financially repressive over the last year as you saw from one of the diagrams. Real deposit rates are declining very, very rapidly over the course of The implicit tax in the household sector is going up. It s very unlikely that consumption gains are going to be significant, just like they were not too significant last year. [00:29:13] The current leadership, which has shown very little appetite for fundamental economic reform is, quite frankly, running out the clock. They don t want to do anything before And we ll have to wait and see what the new leadership that comes in in 2012, what their appetite is for moving ahead along the very sound path that I think has been outlined this morning. But I fear that, as is frequently the case, it will take them a year or two to figure out what to do. So we re maybe looking at another two or three, four years in which the situation, in my view, deteriorates. We get a continued buildup of liquidity in the banking system, which is adverse for the kinds of economic reform that we re talking about. We re still seeing massive increases in the buildup of foreign exchange reserves, even though the trade surplus has come down. The tax on households, the implicit tax on household is going up. And the kind of distortions, excessive investment in the property market, is, if anything, accelerating. China now has a level of property investment that s in the first half of this year, about 9 percent of GDP up from 4 or 5 percent before financial repression really got going. This is an astronomically high level. If you go back and look at Taiwan, for example, in its period of very rapid growth and urbanization, the average rate of investment and housing was 3 percent and the peak was 4 percent. India has gone from 3 to 5. But China is at 9 and rising rapidly, in my judgment, with not much end in sight, given the kind of financial distortions that have taken hold in this system over recent years. So, on that MR. MR. : (Inaudible) 10 percent of GDP (inaudible). : GDP. MR. LARDY: The percent the investment figures in housing are a percent of GDP.

11 MR. : Thank you. MR. LARDY: So, on that happy note, I ll I will (laughter) surrender the floor and turn it over to Yukon. (Off side conversation.) [00:31:32] YUKON HUANG: I m sitting here between two experts on the financial sector. And I begin by saying, I agree with both of them in terms of their analysis. And I m going to bring you, however, a slightly different perspective of what s been happening in China. And it s it may explain a little bit about why China isn t going to move very rapidly on some of these issues. But it may also cause you to think a little bit differently about the question of imbalances and growth in China. And then, at the end of this, you ll probably be as more confused than you began. So let s begin. And let me begin by taking a historical perspective of where this all came from. And it came from Deng Xiaoping. And I call him the unbalanced reformer. And what did Deng Xiaoping do 30 years ago? He basically said, I want to concentrate production, exports, economies of scale, specialization along the coast. But Deng Xiaoping, 20 years, 30 years ago, basically said, I got a problem. I don t have any money. So how am I going to do this? And if you look at the fiscal system, you basically see that the budget revenues in China are collapsing as they move from the socialist system to the market system, hitting only about 10 percent of GDP by the mid- 90s. And yet, China and Deng Xiaoping had these glorious ambitions of increasing investment infrastructure along the coast. [00:32:52] So he said to himself, can I get this from the budget? And the answer is, you couldn t get it from the budget. And you couldn t get it from the budget because incomes are too low to tax household incomes; the sales tax, too costly to administer, too cumbersome to actually implement. And actually, if you put it into the Chinese system, it s a very regressive tax, and then the revenues accrued to localities are very hard to manage. So the beginnings of financial repression and some of the problems that Nigel and Nick are talking about essentially began with the view of, why don t I use the banking system to get resources? I keep interest rates low. I give households few investment alternatives. The banks get all this money. And there are only a few big banks; I ll tell them where to spend it. I ll tell them to spend it on industry infrastructure. And this is turns out to be a progressive tax system because by offering low interest rates, basically are taxing the richer households more than the poor. So they start off by saying, this is actually a better a better system raising money. It s more progressive, I have more control, and instead of using the fiscal system, I use the banking system as very, very efficient. Essentially, that s the China story: extraordinarily efficient channeling of resources, supplemented by incentives, tax policies, export especially export zones along the coastal areas; pour all the money into those coastal provinces; allow 200 million migrant workers to move to the coastal areas; and bang, you get it extraordinary rapid growth. It goes from 4 or 5 percent of GDP to 10 percent.

12 Now, the interesting thing about this diagram is the spatial nature. Growth, stagnating, accelerates to an average of 10 percent, which is this red line, but led by the coastal areas because Deng Xiaoping wanted to put all his resources along the coast. And this is the Tiananmen period. [00:34:54] Aside from the Tiananmen period, what is extraordinary in China is that over the last 20 years, growth has never fallen below 8 percent a year. There s no country in the world that has that kind of stability in terms of rapid growth. And then, look what s happening today. Regionally, the coastal, central, inland regions are not converging. And the western region is actually growing faster than the coastal region. So this is an extraordinary divergence and convergence to a very rapid growth, and that s basically Deng s strategy of growth acceleration. And it led to this rapid increase in investment financed by financial repression, but this dramatic decline in the rate of consumption. So this is the so-called image of China s unbalanced growth strategy. And it carries a very negative image because it looks like consumers are being repressed, it looks the economy is overinvesting. But what we ve already seen right now, of course, is it s growing extremely rapidly because of the strategy. Now, let s look at the declining consumption of GDP in China. And this is the black line. This dramatic decline in consumption share of GDP is at the heart of the unbalanced growth strategy. But if you look at Japan, Taiwan, Korea, back in their industrialization phase, you see that China s declines essentially the same. So the real question is, is China s decline a sign of inefficiencies any more than decline in Japan, Taiwan and Korea was a sign of inefficiencies? Well, the first thing you realize is the decline is more or less the same, but what is really different about China is that its absolute level was so low to begin with and obviously, if it began so low, it ends relatively low. So what is really strange about China is why this curve was so low to begin with rather than the decline, which is actually quite normal. [00:36:44] Now, I ve argued in other papers that part of the reason that line is so low is statistical discrepancies, which explains about half the decline. But there is a real part of the decline which is real. And consumption as a share of income fell over the last decade because savings out of disposable income rose and people consumed less, and disposable income out of the GDP fell, and therefore disposable income, household disposable income, if it falls as a share of GDP, people have less money and they consume less. Now, are these problems what I m going to show you is that some of these are really inefficiencies and problems, but some of these changes actually are quite good and quite beneficial, and the consequences are much more complex but probably better understood from a spatial and structural perspective. Let me begin by looking at savings rates. This is the increase in savings rates in the economy as a whole, and these are the increased savings rate of households. Now, the increased savings rates in China is not a problem of rural households; they re actually falling. So the first thing we realize, there s a spatial issue. The increasing savings rate in China is due to the increased savings rates in the urban households. So to the extent that Chinese are consuming less and saving more, it s an urban phenomenon.

13 [00:38:02] And as Nigel and Nick and others have mentioned, part of the reason that they re saving more is, they re worried about the social welfare system and the long-term security, and therefore, they re saving more, even though the government s actually strengthening social security. So this has a perverse effect of saving more. But there s another reason why urban savings rates have really soared, and actually it s actually more important, but no one ever talks about it. And it s very simple: You have 200 million migrants living in the coastal areas. Their savings rates are approximately 40 percent of their income. The saving rates of others, the people who are entitled to live in these places is 20 percent. And so as you go from zero migrants to 200 (million) migrants, and you look at the numbers, it turns out that explains half the increase in urban savings rates. And what s the solution? The solution is that you have to actually allow them to live there and be formally registered and have hu kou, and then they ll start spending more in line with others. But right now, they have no incentive to spend; they just save. So that s one of the problems in there in terms of the imbalances in the savings rates. Now, the other problem is that disposable income has been falling as a share of GDP. And if disposable income falls as a share of GDP, then consumption as a share of GDP falls because you basically consume out of your household income. And this is a major factor. Now, the interested thing about this fall which many people have written about it turns out that this fall is very strange in China. This fall in disposable income is totally explained by the decline in disposable income in one region in China, and that s the west. Now, everyone s image of China is the coastal provinces. So when they talk about consumption falling or the share of consumption falling, they tend to think about the coast. But, actually, the share of disposable income falling as a share of GDP is explained by the fact that in the far west, it used to be almost 90 percent of the GDP in the western regions was going to households. It fell to 50, whereas in the other three regions, it s been gradual. And this particular regional decline explains about 60 percent, 70 percent of the decline in household income as a share of GDP. Now, that s very, very strange. And then, when you would say, why did it start only 10 years ago? How come it didn t occur before? And it was because of China s develop-the-west strategy, and it was because of the surge in commodity prices. Rapid growth, which we saw in the earlier diagram in the west, basically meant that GDP growth was very rapid, but the share of labor income in the west was actually falling dramatically. But there s a very strong spatial aspect. Now, why did the shift the industrialization process, the rural migration why did this lead to a reduction in consumption? It, of course, led to a reduction of consumption because household income fell. [00:41:04] Now, this is logically what s happening in China: over time, people moving out of agriculture, so agriculture becoming less important. Services are becoming more important. Industry is becoming more important. That s what you would expect and that s true. Now, this is household the labor share of income in each of these sectors. Agriculture is 90 percent. In construction, it s about 70. In services, it s about 55. In industry, it s more, like, 45.

14 Now, as people move out of agriculture into industry and services, they move from agriculture and they re moving into industry and services, the labor share of production, the share the households get out of GDP falls. And that s sort of counterintuitive, but when you think about it, it s quite obvious. You have a farmer moving from a rural area. He s paid very little, he s growing his farm, but all accrues to him. He goes to industry. He makes twice as much. But of course, he s contributing to an industry which generate a lot of profits, so a large chunk of those profits accrue to capital to land to rent. [00:42:10] So as China rapidly grows, invests, industrializes, labor s share of income declines, and so does consumption of GDP declines. And that, I think, is a positive issue and positive development. That s part of the reason why China is growing very rapidly, but the consequence is this imbalance which is seen very negatively. Now, the other thing which is very strange in China is the labor s share in industry is declining. In most countries, labor s share of industry doesn t decline; it goes up. Wage rates, wage unions, bargaining powers increases wages. So why is labor s share in industry declining? And the answer is because the private sector is getting more important in China. The public sector is overstaffed and they pay more. Private companies are not so richly staffed and they pay less. So as the private sector in China gets more important and becomes more dominant in industry, the great irony is that labor s share of income in industry falls. But this is probably a desirable outcome because it s becoming more private, becoming more efficient. So these are kind of very strange things happening in China. And when these things, this transition from agriculture and industry, when industries, private sector becomes totally dominant or stabilizes, you re going to find that household income will start to turn up and consumption will turn up. This is going to take a long time. Now, I wanted to show you two things. This unbalanced growth strategy has problems, of course. It creates tremendous inequalities: Gini coefficient is soaring; the urban-rural income ratio is soaring; the regional disparities are soaring. But one thing which is not a problem, which people focus on, is that consumption, household consumption per capita, in China, the red line, is the highest in the world growing: higher than India, higher than the upper-middle income countries, higher than Korea, Brazil, and obviously much higher than high-income countries. [00:44:08] So although it s an unbalanced strategy where it creates a lot of inequities and disparities, it s not a strategy that actually represses consumption, as consumption is growing incredibly rapidly. Now, one final point I would make is, this is a real problem for the, what I would call, try to get reform in China, because there are many leaders who actually don t think that financial repression is a problem. It leads to rapid growth, tremendously high increases in consumption; imbalances are structural and spatial, difficult to deal with, and it causes a lot of ambiguity in China in terms of, do I need to change, do I not need to change, and that is a big issue in China. Thank you.

15 MR. PAAL: Thank you, Yukon, and thank you, Nick, for your commentaries. You ve to an extent I hadn t expected, you ve really thrown fat in the fire on what is the what is the problem. And I d like to ask you, what is the problem and what does it means for the U.S. as we go forward? Nick has suggested that the ambitious sequenced reforms that Nigel has laid out, after very careful and thorough study, may be held up for next three or four years by the transition in the leadership and the bottlenecks that we have all seen in Chinese decision making. And Yukon, I think you re suggesting that it s not as bad as we think it is, that we can get through this. I d be interested to start off the Q&A, before I turn to the audience, and any comments you have on the relevant MR. LARDY: Can I make a comment? MR. PAAL: Yes, please. MR. LARDY: Well, my comment, Doug, is I think you need to check the water in this building. I used to have these debates about financial repression with Mr. Kaidel, who was also a big proponent of financial repression, thought it was wonderful. And now Yukon s the same thing Vikram, you better watch out. [00:46:03] MR. PAAL: Go ahead. MR. CHALK: On two things. One, on the prospects of reform: I guess I share with Nick the concern that, particularly with the political transition, it won t move ahead, Partly, as Nick said, I think, because it s become a consensus-driven system of making decisions, and this is a big, big reform. It s hard to imagine that big reforms, like, say, Deng s reforms, could happen today in China. You need decisiveness. You need a real clear path of where you want to go. I think our concern is that we see this sort of over-reform program as being, you know, something on the order of five years it s going to take to get through this. It s not a quick fix. It s going to take many years to build the institutions, to build the monetary policy framework to unwind this very complex system that they have right now. And so our concern is not that it s going to be a problem today, but if they don t start investing today in this project, in five years time it s going to be too late. And that s when the pressures will really build up, and that s when they re going to have a big problem. [00:47:11] And then just a comment on what Yukon said: I agree. I mean, the natural process of urbanization, moving people off the land, we expect that to reduce labor income to some extent. I think the problem in China, though, is that it s being kind of supercharged in a way because the cost of capital is so low. That means that industry becomes much more capital-intensive than it should be for an economy as endowed as China is with labor, which means that the returns to labor from production are much, much lower than they would be if relative prices were correct, in some sense, in China. And it really, as Nick says, this really is a system that is designed to tax hired souls and to tax labor, and use that tax to subsidize corporate investment, subsidize banks and subsidize sterilized intervention. That s the distortion of

16 relative prices that I think is the problem. I don t think it s necessarily a problem that, you know, the urbanization process leads to a production function that s less labor-intensive because there s less agriculture in the production. [00:48:12] But the problem is that the distortion of relative prices makes it way, way too capital-intensive, which is why we worry now that you could see an external rebalancing in China, but driven entirely by investment. And that s a risky proposition because the cost of capital is too low and becoming increasingly low in real terms. That just facilitates more and more investment, and at some point you have to hit the end of the road with that. At some point that investment leads to excess capacity, leads to all sorts of environmental problems. It leads to nonperforming loans in the banking system. And that s not a healthy model of development. It s not an imminent problem, but it s a problem if you look, say, five years out. MR. HUANG: Yeah, it s not actually that I recommend financial repression. (Laughter.) I m basically sort of, like, going through and saying, what choices does the government have to get resources going back over the three debt gates? And for many countries with really weak fiscal systems, they basically have to resort to the banking system. And this is true for many of the East Asian countries, not just China. Now, even today, although the fiscal system in China is much stronger, its collection of revenues as a share of GDP is about 10 percentage points lower than most lower middle-income countries. So its fiscal system is still relatively undeveloped. Because ideally, it should be funding some of these things they fund through the banks, through the budget. So my view would be actually that the financial repression issue is not likely to be solved unless they get the fiscal system in hand strong enough, and that gives them the confidence to actually fund a lot of these things that they re funding through the banks funding it through the budget. And if they did it through the budget, some of these things they probably wouldn t fund because it would become more transparent and some of these things are problems. Through the banks, they re not so transparent. So I guess in terms of sequencing, I actually think it s very I actually agree with Nigel and the fund s recommendation in terms of financial reforms. But I think it s very difficult for the Chinese to actually do that unless they have confidence that they have the kind of control or resources to do the things they want to do. Because we know they will do that, and that s, I think, a big problem in China. [00:50:29] MR. PAAL: I m no economist, as you know. But I have been around long enough to have seen a lot of crises develop. And what you re describing in China reminds me of a few points at which rapidly growing economies that relied heavily on low-cost investments access to capital reached a point where it didn t work anymore, and they became either they fell into a period of static growth, such as Japan s been in for almost two decades, or experienced real crises, such as Southeast Asia in 1997, and Taiwan and Korea in their own ways. But you guys are too sober to predict a big crisis for China, you re too responsible. But I think we ought to have that in mind as something that may accompany this period of transition in China.