Paul Armstrong-Taylor. Debt and Distortion. Risks and Reforms in the Chinese Financial System

Transcription

1 Debt and Distortion

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3 Paul Armstrong-Taylor Debt and Distortion Risks and Reforms in the Chinese Financial System

4 Paul Armstrong-Taylor Nanjing University Nanjing, China Debt and Distortion ISBN ISBN (ebook) DOI / Library of Congress Control Number: The Editor(s) (if applicable) and The Author(s) 2016 The author(s) has/have asserted their right(s) to be identified as the author(s) of this work in accordance with the Copyright, Designs and Patents Act This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. Printed on acid-free paper This Palgrave Macmillan imprint is published by Springer Nature The registered company is Macmillan Publishers Ltd. London

5 Pref ace As China s economy and financial system have grown, so too has the importance of understanding their development. Unfortunately, the Chinese financial system is unique, complex, and rapidly changing, all of which aspects make it a challenging subject to grasp. Almost every day, a new financial problem is revealed, an innovative product released, or a critical reform announced. Even for someone who follows these developments closely it can be hard to keep up. Surely, only a fool would write a book, a medium with unavoidable lags between creation and publication, on such a rapidly shifting subject. A shortage of such fools may explain the lack of such a book. Perhaps I am such a fool because this is such a book. But before you close it, let me explain why I believe that a book, specifically this book, can offer something that other media cannot. While a book cannot deliver commentary on daily events, it does offer a chance to step back and see the broader trends and forces that might be obscured by a focus on the latest news. If it can t show the trees, it can offer a map of the forest. To construct such a map, I focus on a few key underlying distortions that can explain much of the Chinese system s uniqueness, complexity and rapid evolution. Most of China s financial problems are manifestations of such underlying distortions, most Chinese financial innovations are attempts to bypass or exploit these distortions, and most of China s financial reforms are attempts to correct these distortions. These distortions have been around for a while and, unless addressed by reforms, will not go away soon. They will continue to shape China s financial system and drive reform for many years. Writing a book on these distortions is, I hope, not entirely foolish, and reading such a book may be of value to even a wise reader. v

6 vi Preface This book should be of interest to anyone who wants to understand the broad trends in the Chinese financial system. This might include business people, financial professionals, government officials, regulators, and those generally interested in world affairs. Even those who do not intend to work with China directly can benefit from understanding how changes in China will impact the rest of the world, and I believe this book can provide that understanding. The book is written at a level that should be accessible to those without specialized knowledge of China or finance, but even those with such knowledge will, I hope, learn something. This book is not intended to provide practical business or legal guidance, but could provide a valuable complement to such guidance. Finally, I would be remiss if I did not acknowledge the help of a number of people without whom this book could never have been written. A book on such a wide-ranging subject as this cannot be written without leaning on the work of others. Much of what I know about China s financial system has come from reading the work of others. There are too many to list individually, but the bibliography should give an idea of the scale of my debt. I was fortunate that Peter Baker, my editor at Palgrave Macmillan, was willing to walk a new author through the unfamiliar process of writing and publishing a book. I am grateful for his patience. The Hopkins-Nanjing Center has been a lot more to me than an understanding employer. My time at the Center has been rewarding on both a personal and professional level. My colleagues have helped me enormously with this book, among so many other things. I have been fortunate to have had the opportunity to teach some talented and motivated students, and my discussions with them, both in and outside the classroom, have helped me develop many of the ideas in this book. In particular, I would like to thank Antoine Cadot-Wood for sharing some difficult-to-find statistics and Sean Linkletter for feedback on an early draft of this book. Finally, I would like to thank my family for their support from the other side of the world. I fear I am not the most filial of sons. Of course, any errors are my sole responsibility. Nanjing, China Paul Armstrong-Taylor November 15, 2015

7 Contents Part I Current Economic Model 1 1 Growth Model 3 How Did China Grow So Fast? 3 Why Can This Growth Not Be Sustained? 6 2 Financial Risks 11 Minsky s Theory of Financial Crises 12 Japan 13 USA 16 China 19 3 Financial Repression 25 What Were the Effects of Financial Repression? 27 Transfers Wealth from Households to Firms and Government 27 Excessive Investment 28 Depressed Consumption 29 Inefficiency 30 High Asset Prices 31 Why Did Investors Not Move Money from Deposits to Other Investments? 32 Shadow Bank Products 32 Stocks 33 Bonds 34 Real Estate 34 vii

8 viii Contents International Investment 35 What Would Be the Effects and Risks of Liberalizing Interest Rates? 35 Deposits 36 Loans 37 Asset Prices 39 4 Government Guarantees 41 Role of Financial System in Managing Risk 42 Government Guarantees and Moral Hazard 45 Effect of Government Guarantees on Financial Risk 47 Solvency Risk 47 Liquidity Risk 49 Systematic Risk 51 5 International Distortions 55 Undervalued Currency 55 Problems 55 Restrictions on International Capital Flows 58 Advantages of Closed Capital Accounts 59 Disadvantages of Closed Capital Accounts 60 6 Overview 63 Part II Domestic Reforms 65 7 Banking 67 Liberalizing Interest Rates 67 Competition for State-Owned Banks 70 Better Incentives for Bank Officials 73 Improved Risk Management 75 8 Shadow Banking 81 Trust Companies and Wealth Management Products 84 Purpose 84 Risks 85 Benefits 86 Reforms 87 Informal Lending and the Wenzhou Crisis 88

9 Contents ix Wenzhou Model 89 Wenzhou s Financial Crisis 89 Lessons from Wenzhou 91 Wenzhou Reforms 92 Loan Guarantee Firms 94 Purpose 94 Risks 95 Reforms 97 9 Stock Markets 99 Advantages of Equity over Debt 99 Immaturity of China s Stock Markets 101 Volatility 101 Corporate Governance 104 Capital Controls 107 Government Intervention 108 Unlocking the Potential of the Stock Market 110 Reduced Government Involvement 110 Corporate Governance 112 Capital Controls Bond Markets 117 Bonds over Banks: Market Forces and Liquidity 117 Characteristics: Large but Illiquid 118 Risks: Challenges to Banks and Government Control 121 Reforms: Finding the Middle Path Local Government Debt 125 Causes, Scale, and Characteristics 125 Conflict Between Central and Local Governments 125 Centralization of Tax Revenue 126 Distorted Incentives 127 Scale and Characteristics of Debt 129 Local Government Debt: A Nexus of Financial Risk 131 Solvency and Liquidity Risk 131 Links to the Financial System 133 Links to the Real Estate Market 133 Risks to the Broader Economy 135 Balancing Local Government Debt Reform with Economic Growth 135 Stock and Flow Problems 135

10 x Contents Development of Local Government Bond Market 138 Funding Gap 140 Implications of Reform Real Estate Market 145 Does China Have a Real Estate Bubble? 145 How Would a Real Estate Crash Affect China s Economy? 148 Households 148 Local Government and Corporate Risk 150 Reducing Risks from the Real Estate Sector 153 Reduce Real Estate Risk 153 Insulating the Financial System from Real Estate Risk 155 Part III International Reforms Exchange Rate Liberalization 161 Renminbi: From Undervalued to Overvalued? 162 Pre Onwards 164 Letting Go: Moving to a Floating Exchange Rate 166 Loosening Control over the Exchange Rate 166 Relationship Between Exchange Rate Liberalization and Other Reforms Renminbi Internationalization 169 Benefits and Barriers to Internationalization 170 Trade Settlement 170 Investment and Reserves 172 Short History of Internationalization 174 Challenges of Managing Risk with International Currency 176 Impact of Internationalization on China and the World 179 Domestic 179 Politics 182 International Capital Account Liberalization 185 Treacherous Tides: Risks of International Capital Flows 186 Financial Freedom and Political Commitment: Benefits of an Open Capital Account 188

11 Contents xi Tentative Steps: Progress to Capital Account Liberalization 189 Portfolio Flows 189 Direct Investment 190 Unofficial Capital Flows 193 Policy Laboratories: Free Trade Zones Asian Infrastructure Investment Bank and the New Silk Road 199 Infrastructure Investment 200 Global Financial Power 202 Domestic Rebalancing 203 Conclusion 204 Part IV Politics Political Conflicts over Reforms 209 Conflicts Within the Chinese Communist Party 209 Reform and the Party s Power 209 Reform and the Personal Finances of Officials 210 Broader Conflicts over Reforms 211 Losers from Reform 211 Winners from Reform 212 Greater Influence of Losers Strategies to Overcome Opposition to Reform 215 Anticorruption Drive 216 Anticorruption Drive and Financial Reforms 216 Anticorruption Drive and Legitimacy of CCP 216 Effectiveness of Anticorruption Campaign 217 Effect of Reduced Corruption on Economic Growth 218 Centralization of Power 219 Process and Benefits of Centralizing Power 219 Costs of Centralization of Power 220 Part V Risks and Consequences Domestic Risks 227 Level and Distribution of Debt 229

12 xii Contents Foreign Debt 229 Domestic Debt 232 Quality of Investment 235 Asset Liability Mismatches 238 Liquidity Risk 239 Currency Risk 240 Corporate Governance and the Regulatory Environment 241 Corporate Governance 241 Regulation 242 Ability of Government to Manage Financial Risk 245 Preventing a Crisis 245 Containing the Effects of a Crisis International Consequences of Reform 249 Consequences of Economic Transition 250 International Impact of Financial Crisis 252 Trade Links 252 Financial Ties The Future 255 Exaggerated Pessimism 255 Short-Term Risks, Long-Term Benefits 258 Appendix: Financial Decision Making in the Chinese Government 261 Major Central Government Institutions 261 Chinese Communist Party 261 State Council 262 Central Leading Groups 262 Central Discipline Inspection Committee 263 Ministry of Finance 263 People s Bank of China 264 Financial Regulatory Commissions 264 National Development and Reform Council 265 Index 267

13 Introd uction In 1992, Deng Xiaoping toured China s southern provinces and committed to opening China s economy to the world. This policy transformed China s economy and affected almost every part of the global economy. Whether we look at British supermarkets, Peruvian mines, American universities, or French fashion houses, we see China s influence. Despite their importance, Deng s reforms did not liberate the financial system, and government intervention remained the norm. Interest rates were suppressed to support investment, and the renminbi s exchange rate was controlled to support exports. The financial system remained dominated by the state-owned banks, with foreigners largely excluded, and stock and bond markets remained underdeveloped. In many ways, China remained a planned rather than a capitalist economy. In 2012, twenty years after Deng, Chinese president Xi Jinping embarked on his own southern tour. The symbolism was deliberate. Xi is planning the most radical transformation of China s economy since the early 1990s. Financial reforms are at the core of Xi s vision. Interest rates and exchange rates will be liberated, restrictions on international capital flows will be relaxed, and state-owned banks will face more competition from private competitors, shadow banks, and stronger markets. China, he promised, will become truly capitalist at last. Th ese reforms will impact the structure of the entire economy. Resources will shift from state-owned firms and governments to private firms and households, leading to a shift from investment to consumption. Higher interest rates will reduce capital-intensive infrastructure projects and promote service and knowledge industries that use capital more efficiently. The discipline of the market will dominate while the influence of government recedes. xiii

14 xiv Introduction As China changes, many of the global trends of the last 20 years will slow or reverse, and new trends will replace them. Until now, China has been a trade partner; in the future, it will be a financial one both as a source and destination of capital flows. While past reforms boosted China s manufacturing exports, future reforms will allow service imports. Emerging markets may suffer from China s reduced demand for raw materials, but developed countries will benefit from its growing demand for services. This book takes a systematic look at China s financial system: how it has worked in the past and how it will work in the future, why reforms are needed and what risks they bring, and how these reforms will affect China and what their impact will be on the rest of the world. We will analyze the core forces underlying China s transition and how these forces are manifested in a wide range of areas. Outline of the Book Part I of the book shows how China s existing financial system supported China s impressive growth and why, despite this, it needs to be reformed. China grew through investment and, to a lesser extent, exports, and the financial system was distorted in ways to promote these. High interest rates may have choked off investment, so interest rates were kept low. Rapid appreciation of the renminbi may have choked off exports, so the exchange rate was managed. Risk may have discouraged investment, so the government guaranteed investment. In short, the distortions were not seen as problems: they were part of a deliberate policy to promote growth. As long as the economy was growing at 10 % per year, the costs of the distortions could be absorbed. However, there are limits to investment-led growth. Previously countries have grown quickly for a period of time using a similar strategy, but none have been able to maintain the growth forever. Eventually, good investment opportunities start to run out, and the returns to further investment fall. Maintaining growth requires ever larger investment and ever more borrowing, but servicing that borrowing becomes increasingly difficult. Low interest rates and government guarantees that supported the growth in borrowing and investment in the past now become liabilities encouraging unsustainable increases in debt. With no reform, widespread defaults and a financial crisis are inevitable. Reform, as the Chinese government has acknowledged, is necessary. Broadly speaking, those reforms involve eliminating the distortions of the existing system. However, reform is also risky. Raising interest rates and

15 Introduction xv eliminating government guarantees increases the risk of defaults on existing debt. Discouraging excessive investment, while necessary, will also lead to a slowdown in growth, which carries both financial risks (it becomes harder to service existing debt) and political risks (it reduces the benefits going to vested interests). Reform, then, is both essential and fraught with challenges. The rest of the book explores these themes in more detail and attempts to outline the path reform should, and hopefully will, take. Part II takes the themes of the first part and applies them to particular financial sectors. One of the main points of this book is that the formidably complex web of reforms across multiple sectors becomes much easier to grasp once you see that many of these reforms are reflections of the same basic themes. Understand the themes, and most of the reforms make sense. However, while the reforms across different sectors may rhyme, they do not exactly repeat; applying themes requires care. Furthermore, reforms in one sector affect other sectors. For example, reforming the banking sector will affect the shadow banking sector and vice versa. These interrelations must be taken into account when considering what type of reforms to undertake and, in particular, the order in which reforms must occur. The correct reforms applied in the wrong order can lead to crisis. Part III looks at the international aspects of China s reforms. International reforms, such as liberalizing the exchange rate and freeing capital flows, will have the most direct effects on the rest of the world. However, international reforms must be consistent with, and mostly subsequent to, domestic reforms. Premature opening of China s financial system would be disastrous. Most importantly, China cannot fully open its capital markets until domestic interest rates are liberalized. If it attempted to do so, capital would simply flow abroad to bypass the domestic restrictions, leading to a loss of domestic liquidity and potential crisis. On the other hand, limited opening is possible and may be helpful in increasing the pressure for reform in domestic sectors. An understanding of the Chinese financial system and reforms helps to illuminate several issues that have attracted attention. A reserve currency requires open capital markets and a large and liquid government bond market. China has neither of these things and will not have them for some time. 1 Therefore, there is little chance that the renminbi will become a reserve currency soon. The Asian Infrastructure Investment Bank (AIIB) has been very controversial 1 It also requires a willingness to allow foreigners to accumulate large amounts of domestic assets, usually by running persistent current account deficits. There is little sign that China is prepared to do this, either.

16 xvi Introduction for political reasons, but its economic importance is likely to be minor. China already invests heavily in overseas infrastructure projects and would do so with or without the AIIB. If anything, the AIIB, as a multilateral organization, will place additional constraints on how China directs this investment. China s commitment to foreign infrastructure investment is best seen as a way to extend its investment-focused growth model while bypassing the constraints of diminishing returns in the domestic economy. Part IV looks at the politics of reform. The principal goal of the Chinese government is to maintain power. In addition, and consistent with this, it is cautious and risk averse. Both of these principles are reflected in its focus on stability. These principles combine to create the incentive for financial reform. Failure to reform is likely to end, sooner or later, in a financial and economic crisis. Economic instability could easily lead to political instability and so is to be avoided. Reform is, therefore, essential. However, financial reform brings political challenges of its own. The existing elites have benefited from the existing system. It has brought them political power and financial wealth. Financial reforms threaten these benefits and therefore will face entrenched, powerful opposition. Xi Jinping, China s president and leader of the reforms, understands that to enact his reforms, he will need to subdue or crush this opposition. His extensive anticorruption campaign is designed to achieve these goals. Certain opponents, most notably Zhou Yongkang and his power base, have been publicly convicted of corruption and removed from power. Others may be spared as long as they do not oppose Xi s policies. Some have puzzled over why Xi is loosening control over the economic and financial system while concentrating political control in his hands. Properly understood, this is not puzzling at all. The financial reforms require the centralization of political control. Without this, any reforms would stall as happened under Hu Jintao. Part V looks at the risks and effects of reforms, both domestically and internationally. Reform is necessary but not without risk. Understanding why requires understanding the role of debt. Reforms are necessary to prevent new debt from building up by removing the subsidies that support borrowing. However, removing these subsidies may increase defaults on existing debt. Reform too slowly and the debt will continue to rise; reform too fast and you could trigger a crisis. Finance is an interconnected system: changes in one part ripple through the system and may cause unintended effects elsewhere. For example, developing a bond market allows large companies and local governments to borrow at lower interest rates, but it leads to the loss of customers and interest income

17 Introduction xvii for the banks, which may cause them to take more risk (as happened in Japan in the 1980s). Increasing competition in banking, for example, by allowing Internet banking, might improve efficiency. However, with deposit guarantees, banks must compete on interest rates and may search for higher-return, and therefore higher-risk, projects. Poorly regulated liberalization, therefore, could lead to increased risk. However, China does have some advantages in managing these risks. First, the government retains control over most of the financial system, which gives it more tools than Western governments have at their disposal for responding to problems. The subprime crisis was exacerbated by the refusal of banks to lend to each other. If banks cannot borrow when they need to, they are forced to hoard cash. This sucks liquidity from the real economy and exacerbates recessions. The Chinese government can simply order banks to lend (to each other and to the real economy) and so avoid such a liquidity crisis. Such intervention is counter to the direction of reform but might be temporarily justified to address a crisis. Western governments and central banks used similar tools to intervene during the subprime crisis. If China does suffer a recession or a more serious crisis, it is not clear that the impact on the rest of the world will be severe. Japan in 1990 was similar in many ways to China now. It was the world s second largest economy and was coming off a period of rapid growth fueled by debt. It ran current account surpluses and had a bank-based financial system that was somewhat insulated from the rest of the world. Japan suffered a major financial crisis, after which it barely grew for 15 years, but its domestic problems did not infect the global economy. On the contrary, the 1990s proved to be a time of rapid growth in many parts of the world. My own research suggests that this episode illustrates some general themes: economies like those of Japan and China tend not to transmit their economic problems to the same degree that the US does. While the risks of a financial crisis may be overplayed, the effects of successful financial reforms will be significant. Rebalancing will change China s economy and the way it interacts with the rest of the world. As China moves from investment to consumption, and from construction and manufacturing to services, the composition of its imports and exports will change. Demand for commodities will fall, which will impact economies that have grown on Chinese demand, including many emerging markets; this has already begun. On the other hand, demand for services, such as finance, healthcare, and education, will increase, creating opportunities for economies strong in these areas. Finally, as China opens its financial system, there will be more opportunities for investment to flow into and out of China. Recently, China s outward foreign

18 xviii Introduction direct investment (FDI) surpassed its inward FDI. China as an investor will be a theme of the next few decades. Finally, in Chap. 21, I reflect on China s future. Much of the recent pessimism about its prospects is exaggerated. While growth is certainly slowing and the reforms discussed in this book carry short-term risks, the longterm prospects remain bright. Despite its past successes, China s economy in general and its financial sector in particular urgently need to be reformed. President Xi Jinping has committed to these reforms and, I believe, possesses the political power to overcome the vested interests that stifled his predecessors. Many challenges remain, and the risk of some form of financial crisis within the next 10 years is high. However, on balance, the positive effects of reform will far outweigh any negative effects. Within a decade, China could become a truly market-based economy with stable growth prospects. While some commentators have portrayed China s rise as a threat to the West, it will bring great opportunities. The 1992 reforms created an economy based on investment and manufacturing with a vast appetite for raw materials. This led to a commodities boom that greatly benefited commodities exporters, including many emerging markets and Australia. The benefits to the USA and Western Europe were less clear, however, as Chinese products often seemed to be competing against domestic industries. 2 China s new economy will be based on consumption and services, areas where Western economies are particularly strong. For the USA and Europe, therefore, the opportunities of this second wave of reforms may, therefore, be even greater than the first wave. 2 There were exceptions. Germany s strong economic performance is at least partly based on China s demand for its high-quality manufacturing exports. And, of course, consumers in all countries have benefited from cheap Chinese imports.