Abstract: The Chinese economy is about to experience major transformations. With the miraculous growth over the past decades becoming history, it is ushering in a new normal featuring continuously declining growth, improving income distribution, a more balanced structure, and accelerating industrial upgrading. Technological progress is the fundamental force driving long-term economic growth, and China needs to step up related efforts; meanwhile, another major challenge facing the country is how to boost financial innovation, which is of great significance to promoting industrial upgrade and preventing systemic financial risks.
I. THE CHINESE ECONOMY: THREE MAJOR REVERSALS AND ONE CONUNDRUM
2008 was a very important year in the past four decades of economic reform in China, not just because of the global financial crisis (GFC). More importantly, it was around 2008 when the macroeconomy in China experienced several major changes, or reversals.
With the miraculous growth coming to a plateau, the Chinese economy has ushered in the “new normal” which is “new” mainly in terms of three major reversals.
First, China’s fast economic growth came to a halt, and has continued to slow ever since.
China maintained an annual GDP growth of almost 10% until 2008 when the rate significantly slowed down amid the GFC’s blow. It once recovered to above 10% in 2010 thanks to the strong stimulus package introduced, but failed to remain there; instead, it has continued on a downward ride ever since, falling to below 7% in 2016 and 2017 and never climbed back up again.
Second, China’s economic structure “rebalanced” in 2008, reversing the previous serious imbalance.
Before 2008, any discussion of the Chinese economy would touch upon the issue of structural imbalance, when growth was mainly driven by investment and export. After 2008, however, China’s economic structure began to rebalance, with investment rate declining and current account surplus narrowing, and consumption emerging as an important pillar sustaining economic growth.
Third, the financial system was no longer “relatively stable”, with systemic risks looming large.
We used to say proudly that China was one of the major emerging economies without any systemic financial risk. But we don’t have that confidence now: in recent years, financial risks have been haunting various parts of the Chinese economy, and a financial crisis is no longer something that is beyond the bounds of possibility.
How should we understand these reversals in the Chinese economy that happened around 2008? And why was the Chinese economy experiencing both high growth and structural imbalance at the same time before that?
The latter was the conundrum that I was hoping to address when I came to work at Peking University in 2009. Another way to state this conundrum is: why are people holding widely diverging views as to the future of the Chinese economy?
Some are very optimistic, while others are much less so. Put simply, those who look at growth tend to be optimistic, while those who look at structural imbalances are more pessimistic.
In fact, both make sense; or rather, these are two sides of the same coin. What exactly has given rise to this phenomenon?
II. UNDERLYING REASONS BEHIND CHINA’S ECONOMIC REVERSALS
If we were to describe the Chinese economic reform over the past four decades with one word, it would be “marketization”. China’s market-oriented reform has many important features. For example, it was no “shock therapy”, but progressive; another is what I would describe as “asymmetric”.
On one hand, China opened up its product market with adequate competition, where the prices of agricultural and manufacturing products and services were all determined by the market mechanism and the balance between supply and demand; but on the other hand, the factor market was far from liberalized, where government intervention still prevailed in all production-related factors including capital, labor, land, energy and water.
Such intervention was most obvious in the financial sector. Even today, over 40 years after reform and opening-up started, the biggest problem with the financial system in China is still “financial repression” with a heavily intervening government. Characteristic of China’s financial reform these decades is that the market mechanism has yet to fully play its role despite the enlarging scale of the financial sector.
At the start of reform, China only had one financial institution, which is the People’s Bank of China, the central bank. Now, the country has an enormous financial system, with the four major state-owned commercial banks listed among global top 10 every year, boasting the world’s second largest stock market in terms of market value as well as the third largest market for bonds.
But at the same time, the Chinese government is still intervening in the interest rate, the exchange rate, fund allocation or even cross-border capital flows while controlling large financial institutions. Economists from the International Monetary Fund (IMF) has conducted special research on the level of financial repression across countries, and China ranked number four among the 91 countries with available data.
A bit more special is the labor market. Many believe that the government does not intervene in the labor market, and wages are determined by the market. But this is not necessarily the truth. Partly due to the household registration (hukou) system, the Chinese population had a very low mobility over a long period of time, and most population movements were heavily subject to government intervention.
A special group that has managed to break the restrictions of the hukou system and move was migrant workers. But for a very long time, migrant workers were not treated equally as city dwellers. Even if they worked at the same place doing the same jobs, their wages could be only one-third of those paid to local workers or even less. In other words, the hukou system has in effect pared down labor costs in city industries.
Back in the early days of reform and opening-up, the Chinese government established four special economic zones in the southern part of the country, providing them with many preferential policies to attract foreign investment such as tax exemptions, free land use and cheap funds and energies. These policies themselves were a kind of market distortion. While promoting economic activities, preferential policies meant that factor users were not paying due costs in accordance with market-based prices. For a long time following this move, many places across China were competing with each other in rolling out various preferential policies. As a result, “factor market distortions” prevailed.
Such distortions are mainly seen in two aspects: first is the lower costs of factors; second is the preference for large and state-owned enterprises (SOEs) in factor allocation.
In other words, in the past when the Chinese economy was underdeveloped, it was natural that the production cost was low. However, as the Chinese economy matured, the distorting policies in the factor market has helped sustain and reinforce China’s low-cost advantage.
The reason behind such distorting policies is the “dual-track” reform approach: the Chinese government was supposed to help sustain the state-owned department while creating conditions for the non-state sectors to thrive.
In essence, such distorting policies were reallocating household and business income to subsidize exporters, producers and investors.
For example, let’s assume that the bank deposit interest rate is 1%, which should have been 3% without repressive financial policies, then where has the money gone? With a low deposit rate, banks can lower their lending rate, which in essence is a type of transfer payment from depositors’ accounts to borrowing businesses.
As a result of such income reallocation, export and investment boomed, economic growth gathered momentum, but consumption only became more and more sluggish. That’s why running parallel to China’s growth miracle was worsening structural imbalance.
III. CHINESE ECONOMY GOING FORWARD: MAJOR TRANSFORMATIONS PENDING
As said above, I explain the coexistence of fast economic growth and acute structural imbalance in China in the first three decades of reform and opening-up with “asymmetric marketization”.
But the story did not end there. We made a bold prediction: China’s growth miracle would one day be consigned to history.
China’s miraculous development was owed to both a low basis which provided huge space for growth and effective reform and opening-up policies. The asymmetric marketization, or the distortions in the factor market, amplified the low-cost advantage of Chinese products in the past.
But while enabling fast growth, such distortions have also resulted in an unbalanced economic structure.
China’s economic growth relied heavily on investment. Such reliance peaked in 2009 when investment accounted for 45% of GDP. But investment back then translated into production capacity years later, when consumers just did not have enough money to spend on the products that came out, giving rise to overcapacity that added to the strains facing the economy.
China was lucky because in those years, globalization was widely applauded, and it had good relations with the United States. The American people were spending, with a very low savings rate, while China was producing, and so a large proportion of Chinese products were exported to the international market, especially to the U.S. That led to increasing trade surplus for China, and widening trade deficit for the U.S.
That trading system was unsustainable. We knew it was doomed to fail. Many countries were happy when China started reform and opening-up, because that was good for the entire world in general back then. But as the Chinese economy expanded day by day, especially when it surpassed Japan as the world’s second largest economy in terms of total GDP in 2010, troubles came, because large and small economies have very different impacts on the global market.
An economy as large and fast-growing as China was taking bites out of the market shares of other countries, and in time, throwing them into employment troubles. As seen in recent years in the international market, any commodity that is highly demanded by China would become expensive, while prices in a market dominated by made-in-Chinas always tend to fall. China is having increasing influence on the global market.
Therefore, the economic growth model that China once had was unsustainable whether in terms of the investment efficiency, the economic structure, or adjustments in the international markets. The miracle is doomed to become history.
At that time, we saw two changes: First, the labor market shifted from a severe surplus to a shortage of labor, and the wages of workers have increased significantly since 2005. Second, there were also efforts from the government to promote the market-oriented reform of production factors and to redress the various distortions in the past, such as allowing the market to determine interest rates.
If the above analysis is valid, that is to say, the distortions in the factor market is an important cause of China's rapid economic growth as well as structural imbalance, elimination of the distortions will greatly affect the Chinese economy. Therefore, we made a judgment at that time: China's economy is about to face a major transition from economic miracle to normal development.
In this process, we predict that the following four changes may occur:
First, economic growth rate will continue to decline. As China loses its previous low-cost advantage, costs will rise and a decline in economic growth is inevitable.
Second, income distribution will improve. An important reason is that in the past, wages were suppressed, but they may rise in the future. Generally speaking, the poor rely on wages and the rich rely on investment returns. If wage increases squeeze the space for investment returns, although it may put some pressure on economic growth, it is still a good thing from the perspective of income distribution as it will narrow the gap between the rich and the poor.
Third, economic structure will become more balanced. As the proportion of residents' income in national income rises, consumption goes up accordingly, and the economy's dependence on exports and investment will decline.
Fourth, industrial upgrading will continue to accelerate. The previous low-cost advantage is hard to sustain, not only because the economy has grown and costs have gone up, but also because the distorting policies in the past have been eliminated and costs have further returned to normal.
The costs of China's manufacturing sector have risen at a much faster pace than other countries with the same level of development, which means that Chinese enterprises that used to be competitive in low-cost industries will lose their competitiveness overnight. The costs will only grow higher in the future, and the only way to deal with it is to improve technology, efficiency, and brand, so that the industries can move up the value chain.
IV. TODAY’S CHINA URGENTLY NEEDS FINANCIAL INNOVATION
These days we are hearing a lot and in many occasions about how "the future has come". Regarding China's economy, my view is that the miracle is in the past, but the future has yet to come, and it is still on the way. During this transition, a series of factors, such as the gradual elimination of factor market distortions, have combined to bring about fundamental changes to the economy.
Today’s Chinese economy are facing very different challenges, one of them being the "middle income trap." With continued economic slowdown in recent years, we often see scholars, entrepreneurs, and officials discuss when the growth rate will reach the bottom and go up again, but it is impossible to know where this "bottom" is.
I think it’s highly possible that China will get out of the middle-income trap, but it is too early to say for sure whether and when this might happen. One of the major problems facing China is industrial upgrading, which lies in technological innovation. Some scholars say that China is able to make theoretical innovation, but not technological innovation. I paid visits to many places and found that companies in China are good at applying technological innovation. Many can directly use existing technologies to move up the industrial chain.
However, a major challenge in this new era is to have "financial innovation".
The emergence and application of new technologies often rely on financial support. Every industrial revolution occurred not only because new technologies triggered changes in the industry, but also because of financial revolution. For example, the information industry revolution and the emergence and popularization of the Internet were all driven by the development of the capital market.
Now China faces two financial challenges.
The first challenge is whether the old financial operations are suitable for supporting technological innovation.
The second is whether China can put the growing financial risk under control.
When these two challenges are mixed together, financial innovation is needed, not only to support the growth of and innovation in the real economy, but also to prevent systemic risks.
China now has one of the world’s largest financial systems with the supply of broad money (M2) far exceeding that of the United States. When discussing China's economy, few worry about the imbalance of the economic structure as the most talked about has turned to whether the leverage ratio is too high. Excessive leverage is definitely a problem that can cause financial difficulties.
What China urgently needs is to provide tangible financial support for technological development and innovation. From the perspective of China's long-term economic development, innovations in food delivery or shared bicycles alone cannot support the sustainable growth of the overall economy. The fundamental force for long-term economic growth lies in technological development, or in other words, industrial upgrading. In this regard, China still has a long way to go.
V. FOUR CHALLENGES FACING THE FINANCIAL SECTOR IN THE FUTURE
While making financial innovation, we must be vigilant about systemic risks. Today China’s systemic risks are higher than before, behind which I think there are many reasons.
First, slowed growth in combination with industrial upgrading means the deterioration of business balance sheets at the micro level , so financial risks are easy to occur.
Second, industrial upgrading means that a considerable number of enterprises will be knocked out. This process may trigger new financial risks, an inevitable result of the continuous decline in the growth rate.
In the past, the government undertook all the losses, which secured short-term financial stability, but renderer the financial system more unstable in the long run. One of the direct results of such a government safety net is moral hazard. If there is always someone to underwrite losses, financial practitioners will pay no heed to risks and expand wantonly. Now China should have some local risks exposed, break the promise of “rigid payment”, and let the market decide which to go bankrupt and which to default. But it is really difficult to judge where to start the process.
In terms of breaking the rigid payment, China has done the most successfully in the stock market. But in the rest of the financial markets, policymakers face a tough choice as they weigh the possibility of causing systematic risks when breaking rigid payment.
The banking sector is a good example. What is the purpose of the deposit insurance system introduced a few years ago? When a bank is in trouble, it can go bankrupt or get merged, whichever suits the situation best. As long as a savings account does not exceed 500,000 yuan, the deposit insurance system can cover the losses. People won’t have to panic and the government does not need to “put out the fire”. This is a good mechanism, but in practice the deposit insurance system has been in operation for three years and has not really dealt with a single case. Were all the banks in China running so well in the past three years that no risks were seen at all? Everyone has his or her own answer. The difficulty lies in how to deal with this issue. Although it has not happened yet, banks with poor operations will eventually go bankrupt, and this general direction will not change.
Third, excessively high leverage ratio means there is really too much money in the market.
While China still remains at an undeveloped stage, the country has more broad money supply than the United States. Why does China issue so much money? It’s mainly because financing is dominated by banks. Money supply in China also features a special acceleration mechanism that stems from the government’s tendency to cover all the losses. When the government asks the central bank for help, money supply goes up.
If all the funds can stay in the bank quietly, too much money won’t be a big problem. After all, this has been the case for many years, during which banks provided funds to support economic growth. But now that there are too much money but insufficient investable assets, the central government is particularly worried about the emergence of systemic risks. One of the reasons is that financial risks transmit among different sectors, from the stock market to the bond market, and pass between wealth management products, Internet finance, and the real estate market, and through capital outflows.
The fundamental problem reflected behind this is that with so much capital in circulation, there must be channels for investment. Therefore, when the funds are aimed at a certain market, whether it is a financial market or a commodity market, bubbles always emerge, because there is indeed too much money. This is a systemic problem and it will take a long time to resolve. In the final analysis, the macro problem is that there are abundant funds but insufficient investment targets. China must let this kind of risk gradually manifest itself and then reduce the risk.
Finally, there is the financial supervision system.
In the past, the regulatory system featured one central bank and three regulatory commissions, each of which had its own purview. The structure seemed to be stable and effective. Newly established financial institutions must obtain licenses and thereupon be supervised by the license-issuing authority. However, with the increasing blurring of boundaries between financial products, people saw a problem with this supervision method. For example, when a commercial bank sells insurance products, and insurance companies sell wealth management products, who is to supervise such businesses?
There are problems with separate supervision of different lines of financial businesses. What’s more complicated is that some of the newly rolled-out financial services have problems with obtaining licenses, for example, shadow banking and Internet finance. As cross-sectoral businesses, emerging businesses and all-round banks gain popularity in the financial sector, the old supervision methods were on longer effective, so the transformation of financial supervision has become rather important.
In summary, the Chinese miracle has become the past and there will be no return to a grow rate of 10% in the old days. However, even if the growth rate drops to 6% or even 5%, it’s still remarkable development as long as it is high-quality growth.
The Chinese economy is moving towards a new era, but there are still doubts about whether the transformation can be successful. The key to this is the replacement of old growth drivers with new ones, which hinges on the government’s resolve to refrain from intervening whenever signs of weak economic performance are seen.
There was an interesting phenomenon that the new economy and the old economy often move in opposite directions.
The old economy was driven by nothing but investment, such as investment in infrastructure, real estate, etc. When the government provided support for such investment, these sectors would go up and the economy would be stable. However, the new economy would go down as a consequence. This is because the resources in the society are limited, and the old and new economies compete with each other for resources.
In the process of nurturing the new economy, financial innovation has become indispensable and vital. Absent financial innovation, industrial upgrading will encounter huge obstacles, and it will be difficult to prevent systemic financial risks.
Therefore, in the next step, whether China can successfully surpass the miracle and enter a stage of lower speed but higher quality and more balanced growth, financial innovation is of vital importance.
This is an excerpt of a new book under CF40, Value of Finance: Reform, Innovation, Regulation and Our Future (CITIC Press Group, December 2021). In this book, Professor Huang Yiping shares his understanding of the underlying logic of the Chinese economic and financial system, and takes stock of the trends going forward.
