Source: Bloomberg

As China’s growth slows, its banking system is coming under greater scrutiny. The general perception outside the country is that negative real interest rates are causing financial instability, repressing consumption and encouraging excessive investment in capital-intensive industries.

Amplifying this perception was Premier Wen Jiabao’s much- publicized recent statement that the big four state commercial banks -- Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. -- have a monopoly position and earn excessive profits while neglecting small private companies and catering to the interests of large state enterprises.

Although this storyline has a degree of validity, some aspects of it are more myth than reality. Those myths risk diverting attention from the real nature of the banking system’s problems.

MYTH: Negative real interest rates are a problem specific to China.

REALITY: These days, negative real interest rates are a global norm. Real interest rates for savers are more negative in the U.S. (-2 percent) than they are in China (-0.5 percent) given recent inflation and benchmark one-year deposit rates.

What makes China’s form of financial repression unique is not negative real interest rates per se but the restricted investment choices -- reinforced by capital controls -- for household savings. The authorities strictly limit how much cash individuals can take out, review the purpose and origins of bank transfers and regulate investment options. As a result, government can more easily capture household savings for its own spending.

MYTH: Negative real interest rates explain low consumption in China.

REALITY: Such rates are a relatively minor factor in explaining the 15 percentage point decline in the share of consumption to GDP in China over the past two decades. Most of this decline is due to the industrialization process as workers move from agriculture to industry. In the process, household income typically declines relative to GDP, causing the share of consumption to fall.

The same phenomenon occurred in other rapidly industrializing economies including Japan,South Korea, Taiwan and even the U.S. a century ago. In these countries, consumption as a share of GDP fell by 20 to 40 percentage points over several decades.

Household consumption in China has notably grown by more than 8 percent annually over the past two decades. This is higher than any other major economy. The goal is to maximize sustainable growth in consumption over time and not its share of gross domestic product. The concern that consumption has been repressed is thus misplaced.

MYTH: China’s big four state commercial banks enjoy a monopoly position and earn excessive profits.

REALITY: The four banks now command about 45 percent of banking assets, but this compares with 75 percent two decades ago. And while reporting high profits, these banks will inevitably be forced to take major write-offs by the defaults from the 2008 stimulus program.

So the big four neither enjoy more of a monopoly position nor earn excessive profits. The real problem is the limited presence of other financial intermediaries and the rudimentary nature of bond and equity markets, both of which poorly serve the needs of small private companies and local governments.

MYTH: China’s low interest rates encourage excessive investment in capital-intensive industries.

REALITY: Given China’s unusually high savings rate of about 50 percent of GDP, interest rates might actually fall in a fully liberalized financial system. Regardless, the government’s intentions, and not low interest rates, drive the investment pattern in China.

In an economy of China’s size and diversity, the industrial structure would normally span the full range of light to heavy industries. The buildup in heavy industries has been triggered not by low interest rates but by an overly ambitious effort to rapidly rebuild its depleted capital stock in the post-Mao period.

Despite high investment rates, China’s capital stock in relation to the size of its economy has been below average for middle-income East Asian countries. Together with the strategic push for rapid urbanization, this has driven growth in steel, cement and heavy construction machinery.

MYTH: Reforms will allow the banking sector to play a more prominent role in the economy.

REALITY: Bank deposits as a share of GDP are abnormally large in China because the government has been using credit expansion to drive demand and households have limited investment options. In a reformed world, the banking footprint will shrink and other financial services will increase to serve more diversified interests.

MYTH: Reforming the banking system means improving its governance and regulatory framework.

REALITY: This thinking misses the point. Weaknesses in the banking system -- as serious as they may be -- are less important than the inadequacies of the fiscal system in serving the needs of a state-driven economy. Government expenditures account for only 27 percent of GDP in China compared with about 35 percent in other middle-income economies and more than 40 percent in Organization for Economic Cooperation and Development countries.

When reforms began decades ago, government revenue and the profits of state enterprises had collapsed and the only feasible option to secure resources for investment was to tap household savings deposits. With an increasingly sophisticated economy, China’s leadership needs to move away from having banks as the main instrument for funding public expenditures.

Thus the key to reforming the financial sector begins by getting the fiscal system to take on the responsibilities it should normally have. This would encourage more accountable and transparent practices, and reduce the likelihood of waste and corruption.

This article was originally published in Bloomberg.