Growing economic activities, especially those outside the state sector, required effective financial intermediation.
China’s experience of financial reform has followed a unique path. While strong on establishing institutions and driving asset growth, it has been weak in liberalising markets and improving governance. But why has China followed this path? And what are the key achievements and risks of this approach to reform?
China’s financial reform can be seen as part of a broader ‘dual-track’ economic strategy. At the beginning of the reform period, the government adopted a dual-track reform approach between state and the non-state sectors. To support the relatively less efficient state-owned enterprises (SOEs), the government intervened in the pricing of production inputs. This led to a second dual-track approach, between product and factor markets. Similarly, repressive financial policies resulted in dual-track financial markets, split between the formal and informal sectors.
Under the dual-track strategy, SOEs’ share in total industrial output began to decline, from around 80 per cent in the late 1970s to around 20 per cent in the mid-2010s. Despite various efforts at reform in the 1980s, the state sector’s financial performance deteriorated steadily. In the mid-1990s, China’s SOEs made a net loss.
To staunch the SOEs’ bleeding, the government had to adopt a dramatic reform program known as ‘grasping the big and letting go of the small and medium’ in September 1995. The objective was to focus only on very large SOEs in strategic industries and to release the rest. In the following three years, about 30 million workers lost their jobs and more than half a million SOEs disappeared.
Since SOEs continued to operate in increasingly open and competitive markets, they needed special supports to be able to survive. But financial policies that tried to protect SOEs discriminated against non-SOEs. As a result, and despite China’s very large financial markets, an undersupply of financial services is still common in the formal sector.
Gradually, an informal sector emerged. The two sectors co-exist, with the formal sector mainly serving large companies and wealthy households and the informal sector mainly serving low-income households, and small and medium-sized enterprises. While prices in the formal sector are often highly distorted, the informal sector is relatively market-driven.
While dual-track systems have created numerous forms of inefficiency and risk, they have not prevented the economy from growing rapidly in the past. One important question to ask is whether China engineered its economic miracle because of, or despite, its repressive financial policies.
In the early stages of economic development, financial markets are often underdeveloped and might not be able to effectively channel savings into the right investments. Financial institutions are often vulnerable to instability and fluctuations in capital flows. Under these circumstances, repressive financial policies can actually have a positive effect on economic growth.
In the 2000s, unlike previous decades, financial repression had a negative impact on economic growth. This reflects the view that state intervention in capital allocation can prevent funds from flowing to their most efficient uses. In this environment, repressive policies eventually hinder financial development, increase risks, reduce investment efficiency and hold back economic growth.
The emergence of digital finance in China is a response to the undersupply of financial services caused by financial repression. Not only does digital finance serve groups of customers that have long been neglected by the traditional financial industry — by forming a parallel market, it is also a means of back-door liberalisation, where interest rates and fund allocation are determined by the market. The average peer-to-peer (P2P) investment rate now settles at around 10 per cent, compared with 3 per cent in the Shanghai Interbank Market.
At the same time, digital finance brings with it significant risks. In early 2016, of about 4000 P2P platforms, more than one-third were ‘problem platforms’. This means that they have either discontinued operations or have encountered liquidity difficulties, embezzlement by management or some other form of financial crime. It is clear that digital finance needs to be properly regulated in order to play a more important role in China’s financial system.
After nearly 40 years of economic reform, China’s long march towards an efficient financial system is still only halfway to completion. Although it now has a comprehensive financial sector with many financial institutions that mimic the institutional profile of advanced economies and gigantic volumes of financial assets, market discipline is not enforced effectively.
Many international observers worry about imminent financial crisis, given recent rapid increases in both non-performing loan and corporate leverage ratios. But the probability of an outright crisis remains low in China. The government’s still-healthy balance sheet could buy some time for balance sheet adjustments in state-owned commercial banks and enterprises.
The greatest economic risk for China is growth stagnation. To avoid this, China needs to keep pushing ahead with financial reform.
In November 2013, the Chinese leadership unveiled a program of comprehensive reform. The policies fell into three broad categories: creating a level playing field, freeing up market mechanisms and improving regulation.
Levelling the playing field means allowing private banks to flourish and fostering the development of inclusive finance. While it was justifiable for political and economic reasons to protect SOEs in the initial stages of reform, this policy is no longer an optimal choice.
Free markets are an inherent part of an efficient financial system. If the government wishes to continue to support SOEs, it should do so by using fiscal resources instead of manipulating and distorting financial markets.
Prudent regulation is also vital. Liberalisation can at times lead to market volatility and instability, well-illustrated by the experience of digital finance in China. While these services have added real value by filling an important gap in China’s financial environment, they are also a source of new risks.
Such reforms are easier said than done. They are still subject to economic and political constraints and it is hard to predict how long it will be before these steps are taken. But these policies should help the government complete its mission of building an efficient financial system in China. They may well be the last steps in China’s long march of financial reform.
Yiping Huang is a Professor of Economics at the National School of Development, Peking University and Editor of the China Economic Journal.
Xu Wang is a PhD candidate at the National School of Development, Peking University.
This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Managing China’.