Financial repression has a significant and negative effect on economic growth, and repressive financial policies often lead to both domestic and external economic imbalances.
Yet recent research suggests that there is a non-linear relation between financial repression and these negative outcomes. Governments can use financial repression to allocate limited financial resources, skew relative prices and provide capital to preferred sectors. Scholars have shown that this type of financial policy has helped economic growth in China, and have linked this positive relationship to a prudent and gradual approach to liberalisation. But these findings also show that the impact of financial repression turned from positive during the first two decades of reform to negative in the 2000s.
If the negative effects of financial repression are to be redressed, the Chinese financial system must undergo a series of reforms. These include interest rate controls, credit controls and reserve requirements, barriers to entry and state ownership in the banking sector, capital account restrictions, regulations and supervision in the banking sector, and security market policies.
Repressed interest rates are the most often cited repressive financial policy used in China. Very low deposit and lending rates have resulted in an implicit tax on net lenders. Combined with China’s high household and corporate savings rate, repressed interest rates have reduced the cost of sterilisation (manipulation of the remnimbi to insulate from the foreign exchange market), allowing for a significantly undervalued renminbi for most of the past decade.
Because the state controls the domestic banking sector, state-owned enterprises are the major beneficiaries of repressive interest rate policies. Though SOEs might be receiving less of the total lending than before, it is clear that the banking system is still filled with preferential treatment of certain enterprises. Supporting the view that the government is still very much controlling credit, the IMF recently published a report claiming that the Chinese government’s role in credit allocation is partly responsible for causing a build-up of contingent liabilities and possibly affecting the much needed reorientation toward domestic demand and new sectors for economic growth.
China’s banking sector is also in need of greater privatisation and supervision. China’s four major banks have all undergone initial public offerings but remain under majority state control. Of the other 13 major banks classified as joint-stock commercial banks, 11 are controlled by national or local government organs. Significant steps have been taken to improve the regulatory framework and supervision of China’s banks. Yet the autonomy of the China Banking Regulatory Commission is challenged because the banking system is used so extensively by the government to pursue its economic policy and to facilitate a high level of credit growth. Reforming the banking sector in China will be difficult because it would result in a significant loss of control over capital allocation in the economy. Yet it constitutes one important way to improve overall efficiency in the financial system.
Another area for reform is the capital account, which is undergoing gradual liberalisation. Even when compared to other developing countries, China has relatively low levels of capital account convertibility. The People’s Bank of China has released a report that provides a road map for capital account liberalisation. Such signals are consistent with the trend toward internationalising the renminbi, which has been gathering pace since 2010.
While China has taken steps to develop its securities markets, it is still far from having well-functioning capital markets. For instance, the bond market is yet to become a central part of the financial system. The domestic stock market has grown significantly in size over the past decade, but is still far from developing into a mature and well-functioning market. The fact that foreign investors’ access to this market remains very limited proves as much. Supervision of the stock market is also weak, and the supervisory body, the China Securities Regulatory Commission, is in need of considerably more resources.
Sequencing will be crucial to the successful liberalisation of the Chinese financial system. Although capital account liberalisation is important, a complete opening up of the capital account should come only after other financial reforms. Interest rate restrictions play an important role in fuelling the banking system with cheap capital, so a sudden and comprehensive liberalisation of the capital account could generate a massive outflow of capital. Before a complete reform of the capital account can take place three preliminary reforms need to be implemented. These are interest rate liberalisation, exchange rate flexibility, and strengthening of supervision and regulatory practice in the banking system. There is also a need for sufficiently developed domestic capital markets, because they provide incentives for further commercialisation of domestic banks, enable absorption of large capital inflows and reduce the risk of currency mismatches.
Financial repression is certainly not the only factor causing imbalances in China’s economy, but less repressive financial policies could go a long way to mitigating these imbalances. Financial liberalisation would allow the Chinese economy to reduce its reliance on investment and heavy industrial development while freeing resources for the expansion of the service sector and consumption. Repressive financial policies have outlived their usefulness; paced liberalisation of the financial sector ought to be the best way forward.
Anders C. Johansson is Director of the China Economic Research Centre at the Stockholm School of Economics.
This article is a digest of Dr Johansson’s chapter in Huw McKay and Ligang Song (eds), Rebalancing and Sustaining Growth in China, available in pdf here.
This article was first published on eastasiaforum.org. Reproduced with permission.