Abstract: China's economy is shifting from an input-based to an innovation-driven model, posing a challenge to the financial system. To reduce financial risks, the financial system should be transformed and financial regulation should be enhanced as soon as possible.
Ⅰ. THE ECONOMY IS IN TRANSITION, BUT THE FINANCIAL SYSTEM IS NOT
The Economic Observer: You said in 2017 that China was at a huge risk of a systematic financial crisis. At that time, China’s GDP grew at the rate of 6.5%. Things have changed in the past several years. Have you changed your assertion?
Huang Yiping: No, the risk is still there.
First, I want to make clear that a systematic financial crisis in China, if it occurs, will be different from the one that happened in the US. China is more likely to suffer from crisis-related efficiency damage, inefficiency in capital allocation, or stalled growth. But it doesn’t rule out the possibility of other types of financial crisis, such as the default of real estate developers last year, which could have led to a comprehensive crisis. When compared to typical market economies, though, Chinese government’s participation in the financial system provides greater security.
China's financial system is distinguished by its size, breadth of control, lax regulation, and bank dominance. Such a financial system will inevitably lose efficiency in capital allocation, but it is well suited to supporting an input-based growth model, in which savings are effectively converted into investment, thereby propelling economic growth.
Wide control is a two-edged sword: it slows financial efficiency, but it has a positive impact when neither the market nor the regulator is well-prepared for a fully open market. Overall, China’s financial system has been effective over the past several decades.
But why do we face greater danger now? We have two problems. The first is a slowing economy. It is difficult to maintain the old development model. Some industries are at stake. The other problem is that financial stability can't continue to rely on the government and rapid economic growth. China's economy is shifting from an input-based model to an innovation-driven one, posing challenges to the financial system. If financial regulators are unable to keep pace with the changes, we will see an increase in systematic financial risks.
In fact, we've seen financial risks everywhere since 2015, beginning with the stock market and progressing to the forex market, shadow banking, Internet finance, bonds market, and local financing platforms. Even though we haven't seen any systematic problems, we must remain cautious. To reduce financial risks, the financial system should be transformed and the financial regulatory framework should be enhanced as soon as possible.
The Economic Observer: You've repeatedly warned against falling into the middle-income trap. Do you believe China has passed the trap?
Huang Yiping: There is little doubt that China will overcome the middle-income trap. According to the World Bank, a country is considered to have a high-income economy if its GDP per capita exceeds US$12,535, which China is expected to achieve within the next one to two years. However, the essence of the middle-income trap is whether innovation can prevent economic growth from slowing or even stalling, and the general international experience is that the critical point is at US$15,000 per capita GDP, or around 30% of the per capita GDP of the leading country, the United States. China's challenge remains that, in order to maintain sustainable growth, the economy must transition from input-based growth to innovation-driven growth, and the latter places a greater emphasis on the private sector. The success of private enterprises determines the future of China's economy to a large extent. The fundamental challenge that China faces is that the economy needs to be transformed, but the financial system has not been transformed.
The Economic Observer: How to conduct financial reform through market-based means?
Huang Yiping: There are numerous market-oriented approaches to financial reform, and we can begin with three. First, finish the market-based interest rate reform, the goal of which is to achieve market-based risk pricing or to set the price according to the risk. Second, to make financing easier for private enterprises, build a diverse financial system that includes capital markets, commercial banks, and new types of financial institutions such as digital finance firms, with each specializing in their own field. Third, rather than eliminating the informal financial sector, regulate it. They provide financial services to the real economy and complement the formal financial sector, even though they pose some financial risks and should be better regulated. Furthermore, market-based financial reform necessitates some supporting policies and systems. For example, financial institutions frequently discriminate against private enterprises when granting credit, but this is not a problem with these institutions; elimination of such discrimination requires a genuine achievement of ownership neutrality at a higher level. There is also a need to strengthen property rights protection.
The Economic Observer: The relationship between innovation and regulation is delicate. People often think of it as an “either or” question. There seems to be a vicious circle where too little regulation leads to anarchy, which triggers a drastic tightening of regulation, which in turn snuffs out innovation. So, how do we find a happy middle ground between regulation and innovation?
Huang Yiping: That is the result of immature regulation. Consider peer-to-peer (P2P) online lending. The first P2P platform was launched in 2007, but the first interim regulation document did not come out until 2016. There was a nine-year regulatory void, for which the regulators were to blame. Some small and medium-sized banks have been exposed to risks in recent years as a result of negligence on the part of management and boards of directors, but it also has something to do with regulators. Risks emerge in areas where regulations are inadequate.
I’ve been urging a regulatory overhaul. China does have a complete system of regulatory framework, bodies, agents, rules, and procedures in place, but when it comes to mitigating financial risks, we fall short. Regulators are reluctant to stand in the way of innovation, but when something goes wrong, they all rush to the fore, scrambling to snuff innovation out, which is what we call “campaign-style regulation” or “regulator competition”. It isn’t good governance.
The Economic Observer: What constitutes an overhaul of the financial regulatory system?
Huang Yiping: The first step is to establish what financial regulators should do. Financial regulation should be reformed in order to ensure 1) full and fair competition, 2) rights and interests of customers, and 3) financial stability. The issue now is that regulators are tasked with a variety of other duties, such as financial development, macroeconomic adjustment, structural adjustment, and supporting market entities as seen in 2020. It’s difficult for regulators to determine what they are responsible for. These tasks, particularly financial development, should be removed from the purview of regulators. The second step is to grant full authority to regulators so that they can solve problems as they arise. Third, create a system of accountability for practitioners and government officials.
Ⅱ. HOW TO FINANCE INNOVATION
The Economic Observer: Is financial support to the real economy dwindling?
Huang Yiping: Let's start by looking at the incremental capital-output ratio, or ICOR, which indicates how many new units of capital input are needed to produce each new unit of GDP. China’s ICOR has risen from 3.5 in 2007 to over 7.0 today. This is a clear sign of decreasing financial efficiency. One of the manifold reasons is that private enterprises have become pivotal in the economy, but they face a difficult financing environment.
Since 2013, the Chinese government has been deeply concerned about the financing difficulty faced by private enterprises, and a policy is introduced almost every two or three quarters to alleviate the problem of deficient financial support to the real economy, as well as the difficulty and high cost of financing for private enterprises. We saw an immediate improvement in statistics after the introduction of each of these policies, but if we conduct further research, we will discover that the actual effect is far from ideal. I'm afraid the reason for this is that the policy measures put in place do not pay enough attention to basic financial rules and do not fully prescribe the right medicine.
Private enterprises actually face two financing problems, i.e. difficulty in accessing financing and high cost of financing. Difficulty in accessing finance encountered by private businesses reflects the problem that the channel between money supply at the macro level and financing at the micro level was blocked. Even if expansionary policy increases market liquidity, it is still hard for money to flow to private enterprises that urgently need the finance. Just like the case of deleveraging - it is supposed to reduce the overall leverage ratio, but has in fact reduced the leverage ratio of private enterprises while increased that of state-owned enterprises. The difficulty of private enterprises in accessing finance lies in the fact that banks neither conduct rational risk management of private enterprises nor can adopt market-based risk pricing, so they lend money only to state-owned enterprises. This is why the financial sector fails to support the real economy.
The Economic Observer: How can financial innovation support small and medium-sized enterprises (SMEs)?
Huang Yiping: During the Covid-19 pandemic, banks provided loans to SMEs. In 2020, SME loans increased by 30 percent. This is a policy with Chinese characteristics. Lending to SMEs is risky for banks, and it is even more so during the pandemic. Therefore, the lending is policy-based instead of completely market-based. But if it leads to a higher non-performing loans ratio of banks, whether the consequence should all be borne by the banks is worth discussion. In my view, fiscal funds should also bear some of the consequences.
I suggest establishing a special-purpose platform where the central bank provides liquidity to commercial banks which then offer loans to SMEs, and fiscal funds carry the losses. In the face of default, both fiscal departments and commercial banks should take the consequences together. Despite my repeated proposals, the suggestion was not adopted. In the end, the responsibility of resolving bad loans all falls on banks.
That will lead to the issue of moral hazard. For example, banks do not perform well on their own businesses, yet they blame it on policy-based loans in 2020. I do not oppose the measure in 2020 that asked banks to offer more loans to stabilize the economy. But who is going to bear the burden of default? Such problems will persist in the future, and banks should not always be the one to take on all the consequences.
The Economic Observer: Large enterprises have been late in paying SMEs. What is your view on this issue?
Huang Yiping: Longer payment periods are an issue of liquidity crisis. Thus the management of cash liquidity will become more important. The total accounts receivable of SMEs is around 14 trillion RMB, which is similar to the scale of loans provided to SMEs in 2020. In other words, almost all lending offered by banks to SMEs are withheld by large companies instead of flowing to the accounts of SMEs, which to a large extent offsets the policy support for SMEs. Extended payment is essentially large companies exploiting small ones by taking advantage of their market position. This is against the government’s efforts to develop inclusive finance and will affect not only the operation of SMEs but also the stability of macro economy.
The Economic Observer: Since policy-based lending does not fundamentally address the financing problems facing the SMEs, are there any other solutions available?
Huang Yiping: First, market-based risk pricing must be implemented to let the market decide the interest rates of loans and perform the function of capital allocation. Currently, the interest rate of policy-based loans to SMEs is rather low, making such lending unprofitable for commercial banks in the long run. But the banks have to comply with the regulatory requirement, so in the end they either lie about meeting the requirement or suffer great risks.
Second, we should improve measures of risk management. The difficulty of lending to SMEs lies in the lack of means to manage risk. Therefore, financial innovation should first find ways to solve the problem of risk management. For example, big data can be utilized to assess the repayment capacity of enterprises; relationship lending allows loan officers to offer loans after acquiring comprehensive information about a company; more approaches that can be employed to evaluate credit risk include a combination of debt and equity financing, and high-tech sub-branch that provides high-tech banking services.
Another type of innovation is digital supply-chain finance. Nowadays banks provide consumer finance that determines the amount of credit based on consumer behavior. Lending to SMEs follows the same logic of individual loans. In the future, via supply chain finance, the amount of credit to SMEs can be raised substantially.
The newly established Beijing Stock Exchange also mainly aims to finance SMEs. But it still faces the challenge of how to conduct SME risk assessment. The securities market might also utilize big data to evaluate the growth and investment potential of these companies.
The Economic Observer: We need a financial system that can support innovation and technological advancement. How different is this financial system from the existing one?
Huang Yiping: Currently, as China’s financial system is dominated by banks, how the financial system should support innovation and how banks should support SMEs overlap to a large extent.
Compared with banks, the capital market can play a better role supporting innovation, is more specialized in investment, and equity investment better suits the need of innovative companies. The successful development of the capital market relies on political, cultural, legal, and historical factors, among others. Objectively speaking, I am a little disappointed with China’s capital market. It is short of support for corporate financing and residents’ investment, and cannot reflect the economic fundamentals.
Banks can also support innovation. For example, German and Japanese banks serve as the main driver of innovation. But as China’s economic development enters a new stage, the growth model should shift from extensive growth driven by factor input to growth driven by innovation. The financial model has to change too. That is why it is important to discuss financial transformation now.
The Economic Observer: In today’s context, why should we regulate the platform economy?
Huang Yiping: The platform economy is a new thing. The greatest advantages of platform economy include extensive outreach, fast computing, and personalized services. It has become an essential driver of China’s economic growth. However, some of the features of the platform economy are double-edged. For instance, economies of scale can improve efficiency but also tend to create monopolies; platforms create many opportunities for flexible employment but may harm the interests of workers; big data analysis can reduce information asymmetry on the platform but might also undermine information transparency for other participants. The purpose of strengthened regulation of platforms since 2021 is exactly to let development and regulation go hand in hand.
The Economic Observer: What principles should we apply to the regulation of the platform economy?
Huang Yiping: I think the principle is balancing the relationship between innovation and stability.
Given the current level of China’s economic development, China’s platform economy is performing quite well, ranking the second in the world. But China’s platform economy mainly enjoys market advantage instead of distinct technological edge. In the past few years, the productivity of digital economy platforms seems to have declined. This is due to many factors, of which an important one is that China’s platform economy is separate from the international market. While increased efficiency gives these companies a market advantage, in the long run, the separation tends to result in unfair competition. That’s why strengthening regulation and governance of platforms is imperative, but several things need to be considered in the process.
First, it should be made clear that the purpose of stricter regulation is to realize orderly development of platforms so as to pursue the goal of common prosperity, rather than crack down on the platforms. These platforms are innovative enterprises that contribute a great deal to economic growth and job creation. Regulators should rely more on day-to-day responsive regulation and avoid campaign-style regulation. In new and emerging sectors, it is hard to make a quick judgment on some issues. Take the “either-or” type of arrangement (imposed on merchants by e-commerce platforms in China) for an example. Though it may sound bad, exclusive agreements are justified in economics, such as exclusive distribution contracts signed between a supplier and a distributor that guarantee the distributor the exclusive rights to sell the supplier’s products in a certain territory. I am not saying that the “either-or” obligation is right. Rather, my point is that, in the process of platform governance, we need to go deep into the issues. The traditional approach is not fit for platform governance. Is it reasonable to crack down on platforms when they become too large? To answer this question, one should not ignore the fact that one of the key features of the platform economy is economies of scale. There is a concept in economics called “contestability”, according to which judging whether a platform exercises monopoly depends on the entry threshold for potential competitors. For instance, in 2013 Alibaba accounted for 92 percent of the e-commerce market share, while in 2020 the figure was only 42 percent. If we look at market share alone, it was necessary to adopt anti-monopoly measures. But in fact, with the growth of Pinduoduo, JD.com, WeChat, and Douyin over the years, Alibaba’s market share has been gradually taken away by its rivals, suggesting that the e-commerce market was highly contestable and Alibaba was not a monopoly back then.
High contestability does not mean there is no need for anti-monopoly policy. However, policy should prioritize improving contestability and reducing the entry barrier, which might make more sense than the traditional anti-trust approach.
III. WORK TO DO IN 2022
The Economic Observer: How do you see the economic condition this year? What should be the policy priorities for this year?
Huang Yiping: As the Central Economic Work Conference put it, this year we should prioritize stability while pursuing growth, which highlights the crucial role of macroeconomic policies. Of course, structural policies are also important, such as the crackdown on the tutoring sector and regulation of the platform economy, carbon emissions, the real estate sector, etc. These structural policies aim to help achieve high-quality growth, but they should be conducted in a gradual way to balance short-term and long-term objectives and to avoid causing great downward pressure on the economy in the short run. The priority this year should be stabilizing the macro economy and enabling finance to support the stability of the real economy.
The Economic Observer: Many people believe that economic growth should be driven by consumption. Of the three major drivers of growth (i.e. investment, consumption, and export), what do you think is the appropriate ratio between consumption and investment?
Huang Yiping: Internationally, investment accounts for 20 to 40 percent of GDP. In Japan and the four Asian Tigers, the average investment share was around 35 percent during high-speed growth. In other countries, the figure is generally over 20 percent. America has a relatively low investment share, while in China, the ratio remained over 40 percent for a long period of time. That wasn’t an issue during the period of rapid growth.
Whether consumption can drive growth is highly controversial among economists. Some scholars think that consumption-led growth is ridiculous, because after spending the money away, there is nothing left to boost growth. Some scholars believe that in the past consumption was too weak to drive growth. In my opinion, it is necessary to maintain a proper ratio between investment and consumption in order to ensure stable economic growth.
More investment and less consumption tend to result in excessive production capacity. If products cannot be sold, there is no return on production, making economic growth unsustainable. Why does China not yet have the problem of overcapacity? This is because our products have been exported abroad without creating an overstock. But the aim of production is not to earn foreign exchange but to meet people’s growing demand for a better life. Moreover, export growth is unlikely to remain as high as it was in the past. So it is important to count on the rebound of consumption.
The Economic Observer: Why is consumption relatively weak?
Huang Yiping: First, people’s income hasn’t increased rapidly. The share of labor income is too high while that of capital income is too low, which will be a great problem in the era of aging population. Second, income distribution is not equal. There is an economic concept called “propensity to consume”, which refers to the proportion of total income that consumers tend to spend rather than save. Usually, the poor have a higher propensity to consume but they don’t have much money, whereas the rich have a lower propensity to consume yet they have a lot of money. Unequal income distribution thus reduces the overall demand for consumption. Third, the social welfare system is not robust enough. China has done a good job in controlling the pandemic and bringing production back on track. But people’s income has nevertheless been affected. Without a robust social welfare system, people will refrain from spending.
The Economic Observer: How do you think of the consumer goods market?
Huang Yiping: In the long run, after solving the three problems mentioned above, China’s consumer goods market will have great potential. Compared with other countries, consumption as a share of GDP in China has considerable room to grow. This year, China’s total retail sales have exceeded those of the US, making China the world’s largest consumer goods market. Even if the growth rate of retail sales declines, the market will remain the world’s largest and the fastest growing one. With a massive consumer base of 1.4 billion, the Chinese market is attractive to producers around the world. However, at the current stage, the market still faces great challenges.
The Economic Observer: Compared with traditional money, what changes will digital RMB bring about? What are the positive implications and challenges for the dual circulation strategy after the launch of digital RMB?
Huang Yiping: At present, the biggest role of digital RMB is to improve payment efficiency. In the short term, I don’t see the need to exaggerate its role. From the perspective of average consumers, there is little difference between digital RMB and Alipay or WeChat Pay. Compared with Alipay and WeChat Pay, digital RMB is more reliable as it is issued by the central bank, cheaper, and more inclusive with features such as offline payment and convenience of use for the elderly. As for the reason why the central bank launches digital RMB, I think the central bank’s focus is on the inclusiveness of mobile payment, not necessarily on the internationalization of RMB, as RMB is not yet an international currency.
This article is abridged from the interview with Huang Yiping published on The Economic Observer’s WeChat blog on February 11, 2022, written by reporter Zheng Yuxin and Wenduo and reposted on CF40’s WeChat blog on February 21, 2022. The article is translated by CF40 and has not been reviewed by the author. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
