While China remains an engine of growth in an increasingly unsettled global economy, it also faces many challenges, including high inflation, the potential of a housing market bubble, and volatile global liquidity conditions. Shifting to a growth model that relies on domestic demand is no easy task—China would need to strengthen its social safety net, raise household income, enhance productivity, and invest in human capital.
Financial reform is a prime candidate to engineer such a transformation. Nigel Chalk, the International Monetary Fund (IMF) mission chief for China, gave his views on the importance of financial reform, its role in rebalancing China’s economy, and the risks of an uncoordinated approach. He was joined by Carnegie’s Yukon Huang and Nicholas Lardy of the Peterson Institute for International Economics. Carnegie’s Douglas Paal moderated.
Sequencing Essential: A Roadmap Needed
Liberalizing the financial sector will be as important to China’s future growth as state-enterprise reform was during the 1990s, said Chalk. Yet financial liberalization is a risky process, requiring carefully sequenced steps to avoid the crises that overtook reform efforts in Argentina, Chile, and Mexico. Chalk outlined the steps in order:
- A stronger exchange rate: Allowing the renminbi to appreciate would reduce the liquidity pressures generated by capital inflow, enabling the People’s Bank of China to take a more proactive and independent monetary policy.
- Rethinking the monetary framework: After absorbing hidden liquidity in the system, China can move toward a new monetary framework, with a greater reliance on indirect monetary instrumentsand open market operations to achieve objectives for growth, inflation, and financial stability.
- Improved regulation and supervision: China should establish a financial stability committee equipped with procedures for intervening in (and exiting from) weak institutions in the event of a crisis.
- Developing the financial market: Expanding bonds, money markets, and equities will give households a wider array of financing and investment options. Non-bank channels of financial intermediation should also be strengthened.
- Liberalizing Interest Rates: Only after absorbing liquidity and creating indirect instruments for monetary policy should China liberalize interest rates.
- Capital account liberalization: With the bulk of financial reforms in place, China can gradually dismantle controls on capital flows and internationalize the renminbi.
Political Challenges to Reform
Any effort to reform the financial sector will require Chinese leaders to confront entrenched interests, Lardy pointed out. In this respect, China’s recent track record is not encouraging.
- Stalled reforms: Interest rate liberalization began in the 1990s and was a stated objective of the 11th Five Year Plan. Yet, very little progress has been made in the decade since then, and reforms are once again featured in the 12th Five Year Plan, Lardy said.
- Central, not local, leaders to blame: Despite the increasingly prominent role of the private sector, no significant market-driven initiatives have emerged under the Hu-Wen administration, Lardy said. Local leaders have little say over interest rate policy, and would not be able to resist reforms aimed at absorbing excess liquidity or correcting a real estate bubble. If interest rates rose, private firms—which are responsible for the vast majority of the country’s exports and construction—would simply adapt accordingly.
- Influential opponents lobby for the status quo: The Ministry of Commerce (MOC), for instance, argued for “stability” in maintaining the country’s exchange rate and claimed in 2010 that it would be two to three years before exports returned to pre-crisis levels. Although exports actually expanded by 30 percent last year, the MOC has proven influential in shaping exchange rate policy, Lardy explained.
- A Delayed Transition: The current leadership is reluctant to undertake any new reforms before the 18th National Party Congress in 2012. The new leadership, however, will likely spend one to two years consolidating power, meaning that it will be three to four years until serious reforms are introduced, Lardy said. In the interim, liquidity will continue to build up, foreign exchange reserves will accumulate, and excessive investment in the property market will accelerate.
The Complex Origins of Economic Imbalances
Economic imbalances have actually served China’s interests for much of the reform period, Huang observed. Although distortions in the economy have indeed emerged, reformers must look beyond misleading statistical indicators if they hope to devise an effective response.
- Imbalance by Design: With little hope of squeezing revenue out of the country’s cash-strapped budget, Deng Xiaoping, the architect of China’s economic reforms, relied on financial repression to mobilize resources to support growth in China’s coastal regions. Imbalances were at the heart of China’s original strategy for reform, and have spurred investment and rapid growth for decades, explained Huang.
- Misreading consumption: The decline in China’s ratio of consumption to GDP is not unique, as Japan, Korea, and Taiwan all experienced similar phases during industrialization, Huang said. While China’s absolute level of consumption is significantly lower than that of the three countries at a similar stage in their development, half of this difference can be attributed to flawed sampling procedures that don’t incorporate informal activities, non-cash transactions, and housing services.
- An Urban Phenomenon: The other half of the difference between China’s level of consumption and those of its peer nations can be traced to a rise in savings out of disposable income, and a drop in the household income to GDP ratio. Increased savings can be explained by the migration of 200 million workers to country’s urban centers, Huang argued. Unable to access the social welfare system due to the country’s restrictive hukou, or household registration system, they save nearly 40 percent of their incomes. Hukou reform will thus be vital to stimulating consumption.
- Productivity Gains Flow to the State: China’s falling household income to GDP ratio looks dire, but actually reflects a commodity-fueled boom in the Western region, Huang said. While the western development program has brought rapid growth to the region, returns on investment have accrued to the state, producing a lower household income to GDP ratio.
- The Private Sector Emerges: Similarly, labor’s falling share of income in industry is the result of an expanding private sector, where wages are lower than that of state enterprises, Huang added. Given that the private sector is more efficient—and that wages will increase as private industry gains a dominant share in the economy—this indicator actually masks a trend that is a net positive.
All the speakers agreed that China is reaching a state of development where financial sector reforms are important in dealing with the macro-economic policy challenges facing the country in the coming years. Thus more interest rate flexibility, gradual liberalization of the capital account and institutional reforms are a priority. However, given the nature of China’s growth strategy and the historical legacy of how policies have evolved, whether the policy makers would act on the needed reform agenda is uncertain.