Abstract: In this article, the author points out that strengthening financial services for the real economy is key to increasing national competitiveness, economic growth and people's wellbeing. Making sure that finance continues to serve the real economy will bring huge benefits in the long term.
I. A GLOBAL COMPARISON OF THE UNDERSTANDING OF THE RELATION BETWEEN THE FINANCIAL SECTOR AND REAL ECONOMY
China has always placed much emphasis on the role of the financial sector in serving the real economy and stressed that financial products and services and the financial markets should support the real economy. Many think that other countries share similar policy thinking, however, this is not the case. In fact, few countries are concerned with how the financial sector should serve the real economy. Neither do they emphasize that the financial sector and the real economy should maintain a close tie. It is therefore necessary to make a global comparison and clarify some basic notions.
First, countries have different understandings of the relationship between finance and the real economy. If we rate the level of closeness between the two based on a scale from “zero to one”, then China’s perception of the relation is close to “one” as it emphasizes that finance should keep a close tie with the real economy and the former should serve the latter. On the zero end of the scale, some countries seldom mention such a relation but believe that the financial sector itself can operate separately. Many advanced economies hold this view, particularly in Wall Street where the financial sector is highly mature and more emphasis is put on the sector’s own operations.
Second, the relation between finance and the real economy draws different levels of attention over time. If bubbles caused by excessive speculation burst, people would have more discussions on this topic and tend to strengthen the link between the two; however, after a while, as memories of the last bubble fade, people will become indifferent to this issue.
Third, different groups hold different views. Policymakers, economists and financial experts tend to have varied views on the relationship between finance and the real economy: some emphasize the role of finance in serving the real economy, others much less so. We can also find that China frequently discusses the real economy, whereas in other countries, such a term is seldom used or adopts a different meaning when cited. Moreover, when explaining the basis for policymaking, some countries rarely mention the need of the real economy.
In recent years, especially since the 2008 global financial crisis, the topic on the relation between the financial sector and the real economy has drawn certain global attention and understandings of the relationship vary greatly around the world.
It is fair to say China has done a prominent job in linking the financial sector with the real economy. Since the fourth quarter of 2008, at many international conferences such as those held by the IMF, BIS, etc., China has reiterated that one of the reasons for the global financial crisis is that some overly speculative derivatives were too disconnected from the real economy, which should call for attention. Afterward, at the Central Economic Work Conferences between 2010 and 2013, Chinese leadership emphasized that finance should serve the real economy. In practice, the PBOC introduced a new statistical indicator, i.e. scale of social financing which expands the scope of financing sources to cover more types of financing activities including those carried out by banks, insurance firms, trusts and funds, and on the securities market. Because total financing includes both financing for the real economy and that for the financial sector itself, the latter is subtracted from total financing to calculate the scale of social financing to reflect how much and to what extent the financial sector has served the real economy. The establishment of this indicator demonstrates the importance China has attached to the relation between the two. In comparison, many advanced countries have different understandings and practices. When it comes to discussions about the real economy, in most cases, they (particularly those on Wall Street) would not pick up on the topic; in private, they would say that if I make money in the financial market, then the money is “real” and how come it is not “real economy”. When it comes to potential problems caused by practices and products that are disconnected from the real economy, they tend to stress that these products serve the functions of pricing and hedging against risks.
II. EVOLVING UNDERSTANDINGS OF THE RELATIONSHIP BETWEEN FINANCE AND THE REAL ECONOMY IN CHINA
In China, when the economy was centrally planned, national economic statistics did not use GDP but national income as the indicator, which excludes the service sector and mainly focuses on production and consumption of goods. After the reform and opening up, the GDP indicator and the System of National Accounts (SNA) were introduced.
In the 1990s, there was a period when the so-called virtual economy and real economy were heatedly discussed. At that time, many thought that the financial sector was virtual economy, and China's leadership at that time was quite firm about preventing over-speculation. For example, in a meeting on financial affairs, then President Jiang Zemin talked about the Dutch Tulip Mania, the South Sea Bubble and other earliest incidents of speculation as cautionary tales against risks and bubbles triggered by excessive speculation.
After the outbreak of the global financial crisis in 2008, China explicitly pointed out that finance should serve the real economy but there was no clear consensus on what the real economy was. Between 2010 and 2012, there was an argument that of so many ministries and commissions under the State Council, few of them engaged in the real economy except for the Ministry of Industry and Information Technology and the Ministry of Agriculture. This idea may be influenced by concepts taught in the Soviet Union's textbooks, which categorize all service industries, fiscal and finance, judiciary, and auditing sectors into non-real economy. This is a very narrow definition of the real economy. At that time, we attempted to make some clarifications to emphasize that the relation between the financial sector and the real economy might be more complicated. Some part of the financial sector is a component of the real economy and directly serves the real economy; other financial services and transactions in the financial market might be a little far apart from the real economy; some are even completely disconnected from the real economy.
If the level of closeness between the financial sector and real economy is measured based on a scale from “one to zero”, then three types of financial activities would score “one”: first, payment system. The real economy could not operate without a payment system. Therefore, financial activities related to the payment system can be deemed as part of the operation of the real economy. Second, provision of liquidity for enterprises, especially working capital loans. Companies need raw materials and intermediate goods for production and their finished products need to be stored and transported before being sold. In this process, working capital supports the continuous operation of businesses, and thus it is part of the real economy. Third, financial activities closely related to investment in the real economy. Over time, the real economy needs investment for R&D, upgrade of equipment, technology and products, and building of new factories. Financing services for such investment include credit support from banks, financing from non-bank financial institutions and the financial market, which should all be regarded as part of the real economy.
Indeed, some transactions in the financial market are mainly for risk management purposes while some are speculative activities, which can also be rated. For example, we can rate the level of closeness between certain financial products or services and the real economy based on a scale of zero to one. For IPOs which raise capital for enterprises, if companies spend most of the funds on R&D, upgrading equipment and technology and innovating products, this part of financing obviously serves the real economy and thus could be scaled as close to "one". Some part of financing is used for transactions in the secondary markets or investment in derivatives, which might be disconnected from the real economy to varying degrees and even scaled "zero", meaning complete disconnectedness from the real economy. Such financing should be watched closely and even controlled through policies.
The above analysis shows that views on the relationship between the financial sector and the real economy evolve constantly.
III. THE RELATION BETWEEN FINANCE AND THE REAL ECONOMY: POLICY IMPLICATIONS AND CRITERIA FOR JUDGEMENT
Views on the relationship between finance and the real economy serve as a basis for macroeconomic policymaking. Some of the policies are not directly aimed at clarifying or setting straight the relationship, but they display certain orientations which could vary across countries.
China tends to orient its policies toward “containment” when coping with excessive speculation. There were several times in history when speculative activities went feverish, such as the rush for stock subscription certificates in Shenzhen in 1992, the long-or-short gamble on the government bond in 1995, the stock market surge in 1999, and another one in 2007 when the Shanghai Composite Index burgeoned to almost 6,200. Each time Chinese policymakers have chosen to “cool down” the market in an attempt to curb excessive speculation. This orientation is also seen in the policies in other areas. For example, China has long banned open gambling because policymakers believe this won’t be of help to the real economy. It never allowed bets on horse races. There is no legal gambling house in the mainland, and people are not allowed to engage in gambling activities in neighboring countries either. This orientation is also obvious in education and consumption policies that seek to steer people away from gambling, drug addictions, excessive speculations, and over-borrowing, etc. Education-wise, China has attached huge importance to science, technology, engineering and math (STEM) in graduate and postgraduate education, which is impressive even when compared with other countries or the global average. In contrast, in some other countries, many talents may turn to areas other than STEM as those areas offer more opportunities, partly a result of different policy orientation.
In a long-term view, it's resource allocation that makes the real difference, and we should look at the relationship between finance and the real economy from this perspective. Should we direct scarce resources including people, capital, energy and foreign exchange toward the real economy, or should we channel them to speculative areas that can most easily produce bubbles? This decision would make a difference that can be seen only over the long run.
How do we correctly take stock of the interplay between finance and the real economy, then? To this end, there needs to be a certain set of standards underpinning consistent and scientific judgment of whether finance is truly playing its due part to support the real economy. I hereby propose three standards.
First, is it a positive-sum or zero-sum game? In a positive-sum relationship, the financial sector is supposed to direct investments into the real economy—for example, into listed companies which then step up input in R&D, new equipment, technology and products that increase their market value and shareholder dividends. As a result, the companies and their employees would benefit, there are more varied products, and investors make money—this is a positive-sum game, a win-win or all-win game. In contrast, a zero-sum game is where some of the investors make money only when the others lose. This is more like gambling. Winners only win from losers. Whether it’s a zero-sum game or a positive-sum one could offer a clue to the relationship between specific financial services or market segments and the real economy.
Second, is macroeconomic or regulatory policymaking grounded on the economic fundamentals? Are fiscal and monetary policies formulated based on the fundamentals of the real economy, or are they based on other indicators that do not necessarily reflect how the real economy is doing such as stock indexes, as is the case in some countries? This has sparked many debates.
Third, is there a proper fiscal balance? In a healthy market economy, the three sectors —the government, the business sector and the household sector (individuals)—are supposed to realize fiscal balance: all of them should be able to spend as much as they produce or earn, and their income or expected income should be able to cover their financing costs. However, some of the policies and market practices now have deviated from this principle, especially the highly leveraged excessive financing activities. For example, the subprime crisis in the United States around 2008 was partly attributed to mortgage lending which provided large amounts of loans at extremely low or even zero interest rates regardless of the borrowers' future income and repayment abilities. Such financing activities have been divorced from the real economy.
IV. FINTECH IN SUPPORT OF THE REAL ECONOMY
Technological innovation is an important factor in the interplay between finance and the real economy. For example, many of the discussions on cryptocurrency innovations in China revolve around how they can better serve the real economy. Those innovations which could serve this purpose would receive more attention and resources. Recently, Chinese policymakers have raised doubts over bitcoin mining which consumes so much electric power but does almost no good to the real economy. This is especially the case when some of the cryptocurrencies lose their payment function and become a pure digital asset.
By design, cryptocurrencies should be able to serve as a useful tool to boost the real economy as long as it is intended as a means of payment. Cryptocurrencies, at their current stage of development, are still defective. For example, they enable a limited number of transactions per second (TPS), consume a great deal of internet resources and processing capacities, and some of their features such as decentralization and deregulation remain disputed. But these defects may be solved in the future, and we could wait and see. However, these cryptocurrencies could be made pure digital assets or crypto assets by those who want to reclaim their investments through transactions or make big and quick money amid the fintech boom, and it is unlikely that these cryptocurrencies will restore their function as a payment tool. They have lost their chance and won't be accepted. Thus, we must have adequate understanding of fintech developments and whether they are intended for serving the real economy.
At the same time, we’ve noticed that when we point out that financial technologies also have to pay attention to what they serve, fintech supporters, especially those from the United States, would emphasize the powerful and useful pricing function of financial technologies as well as their hedging function in risk management. For example, some would say Bitcoin can reduce the risk against QE. But they are in fact just looking for excuses, because any kind of commodity, as long as transaction exists, will have to be priced, which gives rise to the function of pricing. What matters is the use of this kind of pricing. Similarly, everything has a hedging function, and it always hedges against the opposite of it, just like every adjective in the dictionary has its antonym. Therefore, though some financial technologies have pricing and hedging functions, it does not mean their existence is meaningful to the real economy.
V. FINANCIAL SERVICES TO THE REAL ECONOMY SHOULD VALUE LONG-TERM RESULTS
The relationship between finance and the real economy can affect the competitiveness of a country, its economic growth and the well-being of its people in the long term. Having finance serve the real economy can generate huge benefits in the long run. Comparing the changes in the scale of the Chinese and American economies and their global share in recent years, it’s easy to draw some conclusions.
Before reform and opening-up, it is difficult to compare the size of the two economies because China adopted a Material Product System as opposed to the SNA applied in the United States and other Western countries. These are two very different statistical accounting systems. But generally speaking, it is widely believed that the economic gap between China and the United States had kept widening during that period. Of course, some people have doubts about this, because international comparisons are usually priced in the US dollar, which is affected by exchange rates, prices, and other incomparable factors. Therefore, some people advocate using PPP (purchasing power parity) for international comparison. However, this is also a rough method.
About 15 years after China adopted the reform and opening up, China's economy and people's living standards greatly improved. The gap between China and the United States should have been narrowed. At that time China also switched to SNA, making the comparison more convincible. However, we have observed that until 1994, the economic gap between the two countries still widened. One of the most important reasons for this is the exchange rate. At the time of the Third Plenary Session of the Eleventh CPC Central Committee, the RMB exchange rate against the US dollar was about 1.8. When China unified its dual exchange rates in 1994, the RMB exchange rate against the US dollar fell to about 8.7. Therefore, although the economy has grown substantially, when it was measured in the US dollar, the gap between the two countries continued to expand.
About 10 years after China implemented the exchange rate reform in 1994, the RMB exchange rate began to stabilize and appreciated slightly. Therefore, between 1994 and 2004, the economic gap between China and the United States gradually narrowed statistically, but the degree of reduction was not as obvious as imagined. Two factors need to be mentioned here: one is that China encountered high inflation in the mid-1990s; the other is the Asian financial crisis that broke out in the second half of the 1990s and lasted until around 2003. The latter had a great impact on the Chinese economy: economic growth slowed down, and the financial system fell into a period of extreme difficulties. It was also against this background that China launched policy campaigns to "get state-owned enterprises out of trouble in three years" and "have the laid-off employees reemployed”.
The economic gap between China and the United States quickly narrowed in 2004-2018. During this period, the United States suffered a subprime mortgage crisis caused by serious financial separation from the real economy and excessive speculation, which in turn triggered the global financial crisis. The US economy tumbled and took about 10 years to recover. In those 10 years, China successfully avoided big mistakes (though some small mistakes were made). Therefore, the economic gap between China and the United States was greatly reduced. In 2004, the GDP of the United States stood at approximately US$12 trillion, six times of China’s US$2 trillion. Fast forwarding to 2018, ten years after the financial crisis, the US and China each recorded a GDP of approximately US$20 trillion and US$14 trillion, and the US economy is only about 1.5 times that of China. During this period, the RMB exchange rate against the US dollar remained at 6-8, but the economic gap between the two countries narrowed significantly.
What conclusion can we draw from it? To me, when economic activities are excessively speculative, it is like young people taking drugs. They may feel excited and good at the time, but are doomed to a crash afterwards, which is also rather costly to recover from. This may be a very important reason for the significant reduction in the gap between China and the United States.
As we all know, in recent years this narrowed gap has caused tension in international relations to a certain extent. On the surface, the tension is directly triggered by factors such as geopolitics and diplomacy, but fundamentally it is highly related to the changes in the economic strength of countries. To some extent, the different paces of economic growth are resulted from the differed relationship between finance and the real economy, and is also related to the policy orientation of various countries. Therefore, not only should China continue to emphasize the importance of this issue and put the financial sector at the service of the real economy; internationally, countries around the world including the United States, should also reconsider the importance of this issue and devote more research on it, so together, we can develop a healthy relationship between the two in order to promote sustainable long-term economic development. Some time ago, I heard a saying from an entrepreneur that long-distance running is about endurance instead of speed, as over-enthused sprints may cause injuries that hamper stamina in the long term. What he said can also apply to the relationship between financial technology and the real economy. In short, when observing and analyzing financial services to the real economy, we must pay attention to sustainability and long-term results.
The article was based on Zhou Xiaochuan’s keynote speech delivered at the “Plenary Session V: Finance Serves the Development of the Real Economy and Innovation of Science and Technology” at the Lujiazui Forum on June 11, 2021. The article first appeared in the 115th edition of Comparative Studies. The views expressed herewith are the author's own and do not represent those of CF40 or other organizations. The English version has not been reviewed by the author.
