China’s GDP figures calls for financial reforms. Opens opportunities for FinTech
When reading the news today you could learn that China is due to report its slowest GDP growth since 2007. I argue that part of this slow economic growth can be resolved by reforming China’s financial sector ( along side other policies such as boosting domestic consumption etc). Reforming the financial sector would allow China to unlock the currently foregone economic growth, caused by a dysfunctional allocation of resources within the economy.
To do so, lets start with the beginning. A discussion of the Chinese financial system cannot be complete without first accounting for the role of the State. This is warranted by the omnipotent function of the CCP in Chinese economy – it is at the same time “the regulator, the financier, the banker, the business man, the guarantor and the employer.”
However, not all banks are state-owned. Indeed, Chinese banks have faced successive waves of reform. The start of this gradual process began in 1978 with the end of the monobank model, whereby only the People’s Bank of China (PBOC) could allocate credit within the economy.
This inclination of the State to control banks is not surprising. However, state interference causes problems not only with credit allocation in the economy, but also of accountability. Finally, the distortion generated by the state can contribute to a future financial crash. Indeed, part of the blame for the Asian Financial Crisis of 1997 was this ‘crony capitalism’, whereby loans were made on political considerations, as opposed to commercial sense.
Chinese banks today are in a hybrid position between making loans based solely on commercial logic on the one hand (and thus benefiting the non-state sector) and following directions from the CCP that may only be based on political/personal motives, on the other.
This conflict in policy of loan allocation is also seen at the regulatory level. The PBOC – which was made responsible following the 1995 Central Bank Law for the stability of the financial sector – has a clear line in requesting that banks increase the availability of loans to Small and Medium-sized Enterprises (SMEs).
However, the China Banking and Regulatory Commission (CBRC), created in 1997 after the AFC, is more focused on individual institutions. As a result, it gives instructions that banks should be careful in establishing the ability of companies to service their debt so as to avoid Non-Performing-Loans (NPL).
In 2008, as RMB 4 Trillion made its way in the economy due to the stimulus package, the policy of the CBRC prevailed with the majority of financing going to State-Owned Enterprises (SOEs). Banks preferred to make credit available to SOEs because they felt safe knowing that those loans were implicitly guaranteed by the State. As a result, less than half of the stimulus program went to SMEs.
Yet, even this regulatory “turf war” was a smoke-screen hiding the influence the State really has. The latter is so deeply-rooted that Violaine Cousin has argued: “as a result of the strong influence the State Council has on PBOC and CBRC, they cannot be fully made accountable for their policies and actions even though staff can get penalties and fines for misconduct.”
The importance of this quote, but also of the facts illustrated above, for now remain unappreciated. But they will be crucial should a crisis hit the formal banking sector in the country. Indeed, behind banks’ decisions and regulators’ (in)actions invariably stands the CCP. This total control over the financial system would limit, if not deprive, the party of scapegoats (bankers/regulators) that could channel public anger in case of a meltdown.
The consequence of the direct exposure the CCP has to critics is not just a moot point. In fact, because of the unspoken social contract between the people of China and their Party, banks have become the “essential and indispensable tool for the Leninist party State” to attain the targeted economic growth necessary for its continued legitimacy. However, the corollary of this is that if economic growth was to stop (because of a banking collapse, for example) and bring with it unemployment, it is likely that the Party would rapidly lose the confidence of its citizens.
The CCP is therefore in a situation where it must strike a balance. Maintaining sufficient economic growth will necessarily imply financial reform to better allocate savings into the financial system. Yet, it must also be able to prevent the liberalization process from creating various asset bubbles that would affect the real economy if they were to burst. This dilemma is reflected at the top of the CCP in the form of Ex-Premier Wen Jiabao’s demands for reform and PBOC Governor Zhou Xiaochuan’s concern about financial stability.
So far, the decision was to compromise. Violaine Cousin’s book Banking in China refers to an analysis conducted by McKinsey Global Institute, in 2006, which estimated that the foregone GDP growth was 13%, resulting from an inefficient financial sector. The exact figure is subject to debate, but the fact remains that a well-functioning financial system and economic growth are linked, as is reflected by a body of work called “Finance and Growth”
From the political risks analysed above, it transpires that this “sub-optimal” growth level is the result of a conscious choice. The factions that are prone to liberalization and the ones that prefer stability have “settled for a compromise: a slightly lower rate of growth, but more stability which do not put the financial resources unnecessarily at risk.”
At the time, this decision made sense. China’s GDP increase was always boosting double digits, and as such – the liberalization of the financial market was neither a priority, nor a necessity. However, since 2007 the growth rate has been declining, pushing newspapers to each year write an article reporting that this year’s increase has been lower than the previous. The latest data, confirms a growth rate of bellow 7,5%, or in a more catchy press title way such as the one of CNN money: “China is poised to report its slowest growth since the financial crisis”
This matters because we are now at levels below 8%. Those figures have been considered the minimum growth rate to keep the required social stability in the country. It is accepted that the validity of this number is subject to debate and some commentators such as Micheal Pettis argue that the risk of falling bellow this minimum is a “myth that should be discarded.”
It should be clear that I am not participating in this technical discussion, which is “what exact growth rate does China need to maintain?”. Instead I highlight the overall point that must be taken is that China’s economic expansion is decreasing, and so is the ability of politicians to not engage in reforms that would allocate financial resources efficiently, even if this brings some risks. Therefore, the foregone cost of not engaging in financial reform can no longer be avoided.
Well-devised, policies that liberalize the banking sector should stimulate economic development and boost employment in China. This use of financial liberalization is not novel. Indeed, even in the US, deregulation was expected to both support growth, but also increase job prospects in that sector. However, the latest crisis has shown the negative effect of inadequate regulation, which destroyed more jobs than those saved and created in the 80’s.
This is why reform must be highly targeted and precise. Even more so, because every change within that sector will affect a fragile economic, social and political equilibrium in which the system is now resting.
However this takes time and until regulators and politicians put their act together and reform the inefficiencies of certain state own banks and the financial system in general, a large number of FinTech companies will enter the Chinese market and leverage of the vast opportunities offered to them (e.g low paying deposit accounts , limited personal/SME lending ).
Note: This article is an extract from “A Crack in the Great Wall. Too-big-to-fail them: a societal perspective” a paper written in 2012 which is being updated to reflect the more recent developments.
