Abstract: In writing the preface for Financial Conundrums: A Comparative Study of German Financial System, Li Yang finds that it addresses China’s financial reform headaches by drawing German experience. This problem-oriented work offers feasible reform methods for two of Li’s interested topics, i.e., “finance in service of real economy” and “real estate finance”. In Li’s opinion, if China is to learn something from Germany, housing system and housing finance should be the first lecture.
It took two and a half years for Xiaopu and other researchers to finish the monograph on German financial system after ten drafts. He wanted me to write a few words as it went to press, and I agreed without hesitation.
My readiness comes first from Xiaopu. As an expert of Chinese finance, he has been active at the frontier of Chinese finance practices, studies, regulations and reforms. He is the author of several books, including some sensational ones. This new work marks the latest achievements of Xiaopu and his partners. It surely is a pleasure for me to be one of the first readers and recommend it to you.
Another attraction for me is the topic. As a unique design among the developed economies, the German financial system has always been one of my interests that I wish to study on. Sadly, with miscellaneous works to do, I have put it off for such a long time. Now that I have obtained such a latest research outcome that condenses the wisdom of several scholars, I certainly don't want to let go of the opportunity to learn.
I.
In my opinion, one of the outstanding features of Financial Conundrums: A Comparative Study of German Financial System is the problem-oriented outline. These “problems” are by no means conceptualized doctrines, but rather unsolved institutional problems that have emerged repeatedly in the course of China's financial reform and development for more than four or even seven decades. Those are difficulties that we need to overcome through further deepening reforms.
As the mainstream in the book, the problem orientation could be seen throughout the book.
In the substantial Introduction, these issues are presented and sorted out with the title of “Impressions of German Finance”, as a guide for the whole book.
In the following first chapter, the topic reappears as the eye-catching “German financial conundrum", this time on Germany itself, with a summary of the financial development in Germany since the end of the World War Ⅱ, along with a comparative analysis of the practices and theories of western "mainstream" developed economies like the US and the UK.
After all set, the following nine problem-oriented chapters give a panoramic view of the financial system, monetary policy, and macroeconomic policy in Germany by covering the relationship between finance and the real economy, low leverage, the iron law of price-sustaining monetary policy, the virtuous cycle of finance and real estate market, “l(fā)ess collection of umbrellas on rainy days” by banks and the pro-customer characteristics, financing for SMEs, the complementarity of policy factors and commercial factors, the unique role of credit cooperatives, and the lagging development of the stock market, etc.
Finally, the authors summarize the book into “Ten Enlightenments from German Finance” by reviewing the German financial system from the perspective of China's financial reform, and extracting several aspects that may provide reference for China.
Such arrangements not only help readers to have a gradual grasp of the full picture of the German financial system but also highlight the characteristics of the system. In terms of the layout, the book is a success.
II.
Since it’s a study on German finance with China’s problems in mind, it’s intended to draw lessons from this research, which I believe is another feature of this book.
As known by all, China’s financial reform and development is a journey of learning from developed economies. In my memory, the first lecturer that Chinese reform designers invited was Hong Kong, and the main experience is: in a market economy, “there are more banks than rice shops.” As a result, a wave of large-scale banks (mainly savings houses) and other financial institutions emerged in the mainland of China.
However, Hong Kong is just a city economy. The reformers therefore turned to the neighbor – Japan –to learn and promote large institutions, specialized banking systems, integration of industry and finance, and the main bank system in the 1980s.
However, the rapid development of the economy soon demanded the reformers to look for a more advanced financial system that can not only provide long-term financial support for industrialization, but also improve the capital structure of Chinese enterprises, and motivate for the future-oriented albeit risky venture capitals. They turned to the United States, country with the most developed financial industry in the world.
Needless to say, China’s financial reforms since the 1990s have more or less followed the US in its designs of a capital market (main board), a small and medium-sized board market, and a growth enterprise market, or “real” investment banks, even the governance mechanism of financial institutions.
Unfortunately, in the past 20 years or so, among the many American elements imported to China’s financial system, the country has failed to retain the institutions that it needs most, including “a multi-level capital market” and “high proportion of direct financing”, as well as “a risk investment mechanism". These mechanisms and markets are urgently needed for us, so that we repeat these demands in the financial reform plan time and time again.
In retrospect, more and more researchers have started questioning the rationality of such system: If the reforms have little effect in achieving the top goals after over two decades, should we re-examine whether the goals make sense?
The good thing is new explorations have emerged along two paths.
The first path is to have our thinking rooted in the socialist economic system with Chinese characteristics. China features its unique system and mechanism, and the country boasts a long history and unique culture. What kind of financial system do we need for such a country? In other words, what kind of financial system is more compatible with the socialist economic system with Chinese characteristics and more conducive to the development of the socialist market economic system?
The second path is to learn from other developed economies. In addition to the United States or countries of Anglo-Saxon traditions, China can focus its attention on other market economies with distinctive cultures and traditions such as Germany and Japan.
On the whole, the book Financial Conundrums: A Comparative Study of German Financial System adopts the second path. However, as it intends to address Chinese issues, it also touches upon the core concern of the first path. In this sense, the book is worth reading for people who are concerned about China's financial reform, monetary and financial policies, as well as the development of financial theory.
It is particularly worth pointing out that this kind of comparative study is also desirable in methodology. Different from those comparative analyses that boast certain doctrines or best practices, this book presents institutional arrangements or practices in Germany that worth learning and explores the deeper mechanisms and institutions that enable the creation, development and functioning of such arrangements and practices.
After making such an in-depth analysis, the author has made it very clear about which kind of German experiences we can directly learn from, which require us to create certain preconditions for further implementation, and which are unsuitable for China’s condition. Such an analysis can help us avoid being trapped in predicaments. For example, China had called for more direct financing for over 20 years but received little effect.
For the same reason, I have a stronger desire to learn from German experience after reading the book. China’s financial system is dominated by bank financing, featuring collectivism and social spirit of pursuing fairness, etc. This renders China and Germany more common ground. Based on these national spirits and social backgrounds, it seems it is more suitable for China to learn from Germany in developing its financial sector.
III.
With “China’s problems” in mind throughout the research and writing process, the book Financial Conundrums: A Comparative Study of German Financial System delves deeply into China’s problems of financial reform and development. I believe that every reader will find aspects that interest them. For me, I’m interested in the proposition of “making the financial sector serve the real economy” and the real estate financial market.
1. Making the financial sector serve the real economy
In recent years, “making the financial sector serve the real economy” has become the motto of almost all Chinese documents, conferences, articles and media related to economy and finance. But unfortunately, so far, this proposition has not been well implemented, otherwise it won’t grab the headlines of China’s financial sector development and reform for years. As a book on financial problems, it will certainly touch upon this topic.
As I pointed out a few years ago, the proposition of “making the financial sector serve the real economy” is not as simple and clear as it seems at first sight. A little more study shows that it is actually quite difficult to explain clearly. The problem is that in most people’s mind, the so-called “making the financial sector serve the real economy” is to provide funds for the production and investment activities of enterprises. With this understanding, if the financing needs of enterprises are not met, financial institutions can easily be described as "not serving the real economy".
Nevertheless, people who are not biased and have normal judgement will not agree with such perception. We all know that there are good and bad enterprises; normal economic development is a process where good enterprises survive while bad enterprises are driven out of business. Obviously, financial institutions must take responsibility for blindly funding companies that are doomed to be obsolete during economic development.
Throughout the world, this problem is universal. Therefore, we can see that, the authorities and even the World Bank are endeavoring to find a universally accepted standard that lies between “support” and “not support”. One typical attempt is by designing all types of “l(fā)oan denial rates” (corresponding to “l(fā)oan approval rates”) to draw a line between rational and irrational lending behavior for financial institutions.
However, in practice, even if the design of the index is sophisticated enough with all factors considered to assess financial institutions’ behavior, it is still difficult to reach consensus between lenders and borrowers.
As a researcher, I was in a similar quandary in the end of 1999 when the Asian financial crisis was raging. Under the influence of the crisis, China’s economy went downward and the number of clients with good credit profiles shrank, which made many companies’ loans be suspended, cut off, or even demanded early repayment by banks. Against this background, the monetary authority became the target of criticism in various meetings that discussed the economic situation. As the professional and responsible macro regulator, the central bank always upheld its stance on avoiding financial risks, but it could not immediately find strong arguments to refute the fierce criticisms from various sides.
Under this situation, the central bank commissioned us to do a project -- designing China’s “effective credit demand index”, in the hope that through this index companies that really need credit and can produce products needed by the society (instead of surplus ones) can be identified accurately so as to prevent loans from being misallocating to ineligible companies.
The result of the project is obvious. We just made a statistical analysis of the number and value of loan applications and denials over the past few years. The conclusion is that “in a downward economy, effective credit demand plunge”, while “in an upward economy, effective credit demand gradually increases.” In fact, this conclusion didn’t reveal anything new.
Obviously, we have to find another approach, which is accurate and acceptable by all sides, to depicting the effectiveness of the financial sector’s role in serving the real economy. More and more researchers think that a functional perspective of finance might lead us out of the woods.
As we all know, Robert C. Merton has given a comprehensive illustration of financial functions. In his view, the financial system has multiple functions, including facilitating deposit and investment, payment and clearing, promoting social division of labor, preventing and defusing risks, improving efficiency of resource allocation, coordinating non-centralized decision-making process, reducing transaction cost and so on. Financial functions are diverse, so are financial instruments and activities. The fundamental goal of finance is to function as an intermediary to allocate resources in a market economy. Therefore, “making the financial sector serve the real economy” basically requires that the financial system should function as an intermediary in resource allocation: providing better financial services for the real economy primarily requires reducing cost of circulation to improve efficiency of the financial sector in intermediation and allocating resources, thus helping companies generate more profits.
Analysis in the book unfolds in the same logic. The authors examine the value added of the financial sector to measure the cost of financial intermediation, and take this as an important gauge when assessing if finance plays due roles in supporting the real economy. “The size of the financial sector and its relative size to the real economy demonstrate the importance and influence of finance in the entire national economy. Through this lens, we could observe the relationship between finance and the real economy and assess the level of financialization. Amid the global financialization tide, the financial sector in Germany did not experience dramatic expansion, and it was actually long outsized by those in most other major economies. The financial sector in the United States, the United Kingdom and China once accounted for over 7% in national GDP, but this has never happened in Germany. In 2017, this proportion in Germany was only 4%, 3.6 and 3 percentage points lower than in the United States and the United Kingdom in the same period, respectively, and it dipped further to 3.9% in 2019.”
The book offers very important perspectives, as the authors have straightened out the relationship between finance and the real economy, stressing that the financial sector does not engage in material production; instead, its main function is to support the transformation of the form of capital. Thus, expenses incurred to maintain the functioning of the financial sector could be deemed as “pure circulation expenses” in economic production. Obviously, the lower such expenses and the costs incurred by this sector, the better.
Regarding the topic of finance in support of the real economy, having addressed the financial side, let’s turn to the real economy side. As a matter of fact, this topic has not received heightened attention or triggered heated debates that involve even top policymakers in developed economies including Germany as it has in China. The difference here is that most businesses in developed economies are less dependent upon external financing.
This obviously corresponds with the modern corporate finance theory; or rather, the modern corporate finance theory was developed based on the business practice in developed economies. According to the theory, modern businesses mainly have two channels or means of financing, which are internal financing (profit accumulation) and external financing, the latter further broken down into equity financing and debt financing. The theory assumes that a rational business would first resort to internal financing, followed by debt financing and equity financing. That’s why internal financing prevails in businesses in developed economies.
Documents show that businesses in developed economies have always had a relatively low leverage ratio. Among them, Japanese businesses have the highest leverage which stood at 117.7% in 2000, but it declined to 101.6% by the end of 2019. U.S. businesses have relatively low leverage, which were 64.1% in 2000 and then gradually climbed up to 75.7% by the end of 2019. German businesses have the lowest leverage, 58.8% in 2000, rising slightly to 59.1% in late 2019. Business financing structure is undoubtedly one aspect where China has to improve to put its economic system on par with those in developed economies.
Of course, there are historical reasons why lack of capital and high debts and leverages prevail among Chinese businesses. Under the planned economy system before reform and opening-up, the main source of financing for businesses in China was government grants. Banks provided only liquid funds. Back then, businesses were barely indebted or leveraged. Business profits were incorporated into the government’s fiscal account, and companies barely had any internal source of financing.
After reform and opening-up started, there was a period when China had extreme economic difficulties, with the proportion of fiscal revenue in national income and that of the central government’s fiscal revenue in total fiscal revenue both declining. In addition, state-owned enterprises (SOEs) were experiencing unprecedented reforms. Against this backdrop, the government decided to replace grants with bank loans. As a result, the debt ratio and the leverage ratio of Chinese companies began to surge.
In the late 20th century, facing a heavily indebted business sector, Chinese policymakers implemented reform measures to convert some of the loans for businesses, mainly SOEs, into investments or equities, along with the debt-to-equity conversion arrangement, hoping to pare down the debt ratio and debt costs of the business sector. But the reform did not proceed swimmingly. Chinese businesses continued to have high debt ratio, high leverage and high debt expenditures, making overreliance upon external funds almost inevitable since they had almost no access to internal sources of financing. As a result, the conflict between the financial sector and the real economy are acuter in China than in other countries.
With the above said, Financial Conundrums: A Comparative Study of German Financial System has, in my view, provided much food for thought for China to break through bottlenecks in giving the financial sector bigger play in supporting the real economy. It has offered a two-pronged solution that is both insightful and practical: first, reduce costs of financial intermediation to straighten out the relationship between the financial sector and the real economy; second, establish a sound modern corporate system to enhance businesses’ internal financing abilities.
2. The housing system and the housing finance system
The real estate sector is a pillar for most of the economies in the world, and correspondingly, housing finance is an important part in the financial systems of most countries. Given their prominence, fluctuations in the real estate market and housing finance usually have huge implications for a country’s macroeconomic performance.
Distortions and fluctuations in the housing market and housing finance have even become the main factor behind the macroeconomic turmoil or long-term economic decline since the late 20th century in most countries.
The most typical example would be Japan. In the 1990s, the real estate market slump in Japan plunged the entire national economy into a long-lasting recession also known as the lost 20 years or even the lost 30 years.
Situations in the United States may have been even worse. The Savings and Loan crisis that hit the country in the 1980s and 1990s lingered for over a decade. According to the estimate of China International Capital Corporation (CICC), the public and private sectors in the United States paid a whopping price of 318 billion USD to weather through the crisis that was equivalent to 4.2% of its GDP in 1995. In 2007, while the country was still in the shadow of the Savings and Loan crisis, its housing finance market witnessed the outbreak of yet another disaster—the subprime crisis, which triggered a financial crisis that swept across developed economies, if not the whole world.
We wouldn’t be carrying it too far in saying that the tumults in the housing market and housing finance have been at least one of the culprits in most economic and financial crises around the globe since the 1980s.
However, if there is one country that have stayed immune, it would be Germany. Germany may have been the only major developed economy that hasn’t take any big blow from fluctuations in its housing market and housing finance: its real estate market has hardly triggered any major economic upheaval, while its macroeconomic fluctuations have hardly any big impacts on its house market, either; there has been almost no negative interplay between its national economy and its housing market.
Let’s explore both the housing market side and the housing finance side to figure out why Germany has stayed immune.
In terms of the real estate market, Germany has maintained a high rentership rate and low homeownership rate. As of 2020, the German homeownership rate was only 43% while rentership rate was 57%. We know that only privately-owned housing can be speculated in the market, whereas rental housing cannot due to its nature of property rights and physical property. Therefore, Germany’s “national policy” that makes rental dominate the housing market weakens the relationship between the real estate market and financial system, thus avoiding a mutually reinforcing vicious cycle between the two. In addition, as for the rental housing market, the German government strictly and comprehensively regulates rental prices, which strengthens the management of the real estate market.
By contrast, China’s homeownership rate reached 89.84% in 2020, much higher than the world average of 69%. Given this housing market structure, it is very hard to implement the guiding principle that “houses are to live in instead of being speculated”.
As for real estate finance, Germany also has its own characteristics. The book Financial Conundrums: A Comparative Study of German Financial System gives a concise overview of the German housing financial system: the housing finance market is effectively controlled through a prudent housing finance system; fixed rate is the main approach, which insulates the real estate market from being affected by changes in monetary policies; collateral valuation based on MLV (mortgage lending value), prudent refinancing system design, low loan-to-value ratio and calculation of loan-to-value ratio based on MLV, which can avoid overlapping pro-cyclicality of the financial sector and housing market and stop the spiraling cycle of rising housing prices and increasing mortgage loans.
In Germany, mortgage equity withdrawal is regulated in a unique way. This book even argues that it is exactly the strict regulation of mortgage equity withdrawal that to a large extent cuts off the positive feedback loop between the real estate market and the financial market, thus preventing the real estate market and real estate finance from being the main factors that disrupt the overall operation of the economy and financial system.
Mortgage equity withdrawal (MEW) is increased loans or new loans against the added value of the property given rising home price. Major forms of it include adding collateral, transferring collateral, and home equity loan. In practice, as this type of loan uses leverage, it is an important channel to transmit information and amplify the effect of certain policy between the financial system and the real estate market. Naturally, regulation of such loan can prevent the two markets from influencing each other.
In Germany, although laws and regulations do not ban MEW, the financial system holds a cautious attitude when dealing with businesses related to it. Moreover, if any institution was to issue Pfandbriefe mortgage bond, it should have adequate collateral and when the bond is collateralized by mortgage loan, the mortgage may not exceed 60% of the property’s MLV. This proportion is far lower than that in Spain (80%), Portugal (80%) and Ireland (75%).
This arrangement in effect restrains the issuance of high loan-to-value (LTV) loans. Meanwhile, LTV ratio in Germany usually is 70%, lower than that in the US, Japan, UK and France. In addition, in the German mortgage market, the appraised value of the property used to calculate LTV ratio is lower than the market value which is reflected in MLV. This means that compared to other countries that use the market value to calculate LTV, Germany’s LTV is much lower. Clearly, in the area of real estate finance, Germany adopts a prudent principle.
Overall, it is these multiple restraints that minimize the speculative element inherent in the real estate market. Thus, Germany becomes the only developed country that is not disrupted by the real estate market, which in turn reduces the unavoidable factor of inequality in the market.
When it comes to German real estate finance, the structure of this market is noteworthy. As of 2019, sources of German housing funds include savings banks (32.1%), commercial banks (24.7%), credit cooperatives (23.8%), and building societies (10%). This structure significantly weakens the commercial aspect of real estate finance and helps curb bubbles in Germany’s real estate market and real estate finance market.
On the whole, the success of the German housing system and housing finance system can be summarized as follows: maintaining a majority-renter housing system and upholding a prudent principle in the housing finance market; meanwhile, cutting off the positive feedback effect between the housing market and financial system when designing financial products. In my view, if China wants to learn something from Germany, the housing system and housing finance system should be the first thing to learn.
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