Zhou Xiaochuan made waves with his call for an alternative to the dollar as the world's currency of choice. That recommendation, as well as China's push for a greater voice in reforming international economic institutions, have placed renewed focus on China's financial sector. Does it jeopardize the country's growth prospects?
That question was the subject of the ninth debate in Carnegie's "Reframing China Policy" debate series, featuring Albert Keidel, senior associate in the China Program; Nicholas R. Lardy, senior fellow at the Peterson Institute for International Economics; and Paul Saulski, senior counsel in the Office of International Affairs at the U.S. Securities and Exchange Commission. James A. Leach, the John L. Weinberg Visiting Professor of Public and International Affairs at the Woodrow Wilson School, Princeton University, moderated the debate.
China’s Financial System Is Evolving Appropriately
Keidel argued that the pace of China's financial-sector reforms is commensurate with its relatively low level of per capita GDP. Citing the advice of respected economists such as Friedrich List, he cautioned that implementing market-based reforms in the absence of sound market conditions can, and generally does, produce disastrous results.
While acknowledging that China's financial system is partially repressed – the government intervenes to ensure that banks make sufficient funds available for investment in public works – Keidel noted that it has highly competitive elements. For example, Chinese firms decide how to re-invest retained earnings.
China's financial system is more accurately regarded as a hybrid. Keidel argued that the high degree of state intervention can be attributed, at least partially, to the belief that entrepreneurial individuals should receive a higher return on their investment than those who just passively deposit their money and wait for it to accrue interest.
Keidel noted that experimentation with different financial practices will be crucial if China is to foster greater firm transparency and eliminate accounting regularities.
He concluded his opening remarks by observing that China's high current account surplus is properly ascribed not to its exchange rate, but rather, to the enormous increase in liquidity in the United States during the 1990s.
Financial Repression Distorts China’s Growth
Lardy disagreed strongly with Keidel. He argued that the real interest rate for firms has declined sharply in recent years, and is now highly negative. The consequences of that reality are two-fold: (1) the share of China's output that goes to profits has increased significantly, while (2) the share that goes to wages has decreased significantly.
The interest that wage earners accrue on their deposits is very low, which is one of the reasons why per capita household income in China suffers; Lardy cited data showing that household interest income has declined by 60% over the last decade. A parallel dichotomy has emerged; in recent years, the share of Chinese investment going to manufacturing has grown steadily, while the share going to services has decreased steadily.
The results, he explained, is that China's emissions of environmental contaminants have grown and job growthhas stagnated, resulting in depressed wages and rising capital earnings. Lardy stated that it would be prudent to re-initiate the market-based reforms of its financial sector that it stopped in Fall 2004.
“A Definite Maybe”
Saulski took a more nuanced position, arguing that his answer to the debate question was a "definite maybe." He said that the final verdict would hinge on whether China accelerates financial-sector reforms and develops institutions that are needed for sound capital markets to flourish. If China is to grow long-term, it will have to adopt a new model whereby capital is allocated more efficiently.
He noted that all countries that have initially relied on government intervention to develop their financial sector have had to transition to a market-based system at some point. To its credit, Saulski said, the Chinese government has taken important reform-oriented steps: for example, it passed a securities law in 2007 that would allow the Chinese Regulatory Commission to crack down on insider trading, market manipulation, and other such abuses.
Questions & Answers
Leach opened the discussion period by asking whether it was appropriate for the United States to be lecturing China, noting that the former had demonstrated terrible judgment even though it possesses a highly sophisticated financial system. Where China built its financial strength on the back of U.S. treasury bonds, the United States primed itself for disaster by purchasing trillions of dollars worth of credit default swaps.
Lardy followed up on Leach's observations by noting that China could not conceivably introduce sophisticated financial instruments when its basic interest rates are not even determined by supply and demand. He reiterated the danger of distortions in China's financial system. Since July 2005, the yuan has appreciated by 20-24%; half of that appreciation has occurred in the last year alone. No other country has ran a current account surplus worth ten percent of its output in consecutive years, or accumulated nearly $2 trillion in foreign reserves.
Other questions addressed the future of the Sino-American economic balance, the likelihood that special drawing rights will be implemented, and the concrete financial-sector reforms that China must implement.