ESSAYS ON ISSUES THE FEDERAL RESERVE FEBRUARY 2008 OF CHICAGO NUMBER 247a

Chicag o Fed Letter

China up close: Understanding the Chinese economy and fi nancial system by Michael H. Moskow, vice chairman and senior fellow for the global economy, Chicago Council on Global Affairs, and former president and chief executive offi cer, Federal Reserve Bank of Chicago, and Cathy Lemieux, senior vice president, Supervision and Regulation

In March 2007, the authors paid a weeklong visit to and , . In this article, they summarize some of the most striking impressions from their visit concerning the Chinese economy and financial system.

The specifi c occasion for our visit to and the signs of this success were visible China in March 2007 was a series of throughout our visit. lectures on that Michael Our trip highlighted some major differ- delivered to three leading Chinese uni- ences between macroeconomic policy and versities: Tsinghua University, Fudan central banking in China and in the U.S. University, and the Central Party School We were also struck by some of the chal- of the Communist Party. The broader pur- lenges China faces as it continues to pose of the trip was to enhance mutual modernize its economy and improve its understanding between U.S. and Chinese There are major differences business processes and the functioning offi cials concerning economic and fi nan- of its fi nancial markets in the context of between macroeconomic cial conditions in both countries.1 its existing political system. These chal- policy and central banking As part of the visit, we met with offi cials lenges include corporate governance, in China and in the U.S. of government agencies, including the market infrastructure, and economic People’s (the central effi ciency. Finally, we address some issues bank), the China Securities Regulatory that may affect China’s future economic Commission, and the Shanghai Metro- development, including concerns about politan Government Financial Services unmet needs of certain population seg- Offi ce. We also met with senior represen- ments and the environment. tatives of leading manufacturing com- panies (BorgWarner, Caterpillar, and Macroeconomic policy and central banking General Motors) and fi nancial services companies (Citigroup, Deutsche Bank, Economic growth in China has been very JPMorgan Chase, Northern Trust, and different from that in the U.S. Since eco- Tianan Insurance). Finally, we visited nomic reform began in 1978, China has two key fi nancial markets: the Shanghai averaged gross domestic product (GDP) Stock Exchange and the Shanghai growth of almost 10% per year—the Futures Exchange. fastest in the world over this period. Not only is China’s growth much faster than China has made huge progress in achiev- that of the U.S., but it has also been large- ing high rates of economic growth, lifting ly driven by investment. Investment rep- hundreds of millions of people out of pov- resents approximately 40% of GDP in erty, developing its manufacturing sector, China, compared with about 20% in the producing impressive rates of savings and U.S. The downside of this impressive investment, and building export growth. investment performance is that the It has been an amazing success story, consumption sector in China is under- bank deposits are also maintained at classical “socialist” economy, private own- developed, with signifi cant unmet needs. artifi cially low rates. Nonetheless, the ership of the means of production is domi- In per capita terms, China is still a lower- increases in foreign reserves are not nant in China and may represent as much middle-income country, with 130 million fully neutralized. Over the last fi ve years, as two-thirds of the economy. China’s econ- Chinese falling below international pov- Chinese M2 (the broad money supply, omy (including its so-called state-owned erty lines.2 Moving toward a growth path which includes cash and bank deposits) enterprises) represents a continuum of that relies more on domestic consump- has been growing above 15% per annum, various mixes of public and private owner- tion demand is part of China’s current while real economic growth has averaged ship. In addition to the complex and ever- fi ve-year plan. China also wants to pro- about 10.5%. shifting boundary between the public and mote faster development of the service private sectors, the relative power of the Against the background of China’s fast- sector, including the small- and medium- central government versus the provincial growing economy, it is diffi cult for the sized enterprises that are so important to governments shifts over time as well.

Corporate governance China has a complex political economy that represents a hybrid Observers accustomed to a U.S. or Western of private ownership and state control. European context note a number of weaknesses in corporate governance at Chinese fi rms. Chinese offi cials them- the U.S. economy. To increase consump- to evaluate the economy’s selves have identifi ed embezzlement by tion of goods, such as televisions, refrig- maximum potential pace of noninfl ation- majority shareholders and the neglect erators, and washing machines, China ary growth—in other words, a sustain- of duties by directors as fundamental has completed rural water and electri- able level that would be associated with issues. In addition, many senior execu- fi cation projects. Another positive sign a strong, but not overheating, economy. tives of Chinese companies come from is that consumer are increasing. Unlike more-developed market econo- government, and many reportedly re- mies, China is reluctant to raise domestic China’s central bank also functions quite tain a political mind-set. As we observed interest rates to slow its domestic growth. differently compared with the U.S. model. on one occasion, a phone call from the To do so might mean attracting more Unlike our Federal Reserve System, the Communist Party can put all “business capital infl ows, which would, in turn, re- People’s Bank of China is not politically as usual” on hold. We were also told the quire further money issuance to stabi- independent. It reports directly to the party retains considerable control over lize the exchange rate. This is why the State Council, which serves as China’s human resource decisions at many fi rms, Chinese central bank instead raises lev- cabinet as well as its highest executive such as hiring and compensation. Finally, els of bank reserve requirements (the body. Monetary policy in China aims at the Chinese legal system lacks the range amount of money a bank is required to limiting the appreciation of mainland of civil and criminal penalties for corpo- keep on its account at the central bank) China’s offi cial , the rate malfeasance that we have in the U.S. on an ongoing basis to slow the expan- (RMB),3 while keeping economic growth sion of money and . A key challenge is the continuing role at a sustainable pace and infl ation under of state-owned enterprises. The stake that control and preserving a fragile banking Over the long run, such practices as the government holds in these fi rms has system. In contrast, the Federal Reserve’s setting higher reserve requirements been reduced sharply. In addition, gov- monetary policy has a dual objective of and asking to buy low-yield bonds ernment is making a transition from com- maximum employment and price stability. could have a distorting effect on banks’ plete control to providing direction. balance sheets and the overall economy. There is large and ongoing demand for However, many companies are hybrids— Also, under this system, China must im- RMB because China runs a high current publicly traded on the stock exchange pose capital controls (restrict the fl ows account surplus—nearly $330 billion but still majority-owned by the govern- of capital transactions between residents expected for 2007.4 To maintain RMB at ment. It is very diffi cult to implement and nonresidents) to avoid a massive in- the desired level, the Chinese central Western-style corporate governance in fl ow of speculative portfolio investment bank issues RMB to meet this demand, such a context. For example, what exactly that would cause the currency to appre- thereby increasing the money circulat- does “shareholders’ rights” mean when ciate and put pressure on its export sec- ing in China. To keep economic growth the largest shareholder is the government, tors. These capital controls also prevent and infl ation under control, the central with at least a 51% stake? a run on domestic banks that are not offer- bank sterilizes its foreign exchange mar- ing yields that would match those offered According to one expert we spoke with, ket interventions; i.e., it buys back some by international fi nancial markets. China’s state-owned enterprises are hin- of the RMB that it issued to buy dollars. dered by the structural problems that In particular, it does so by selling low- A hybrid political economy characterize its bureaucracy in general.5 yield government securities to state- China has a complex political economy In particular, senior offi cials are often owned banks. So far, banks have been that represents a hybrid of private owner- required to do jobs for which they are able to absorb those low-yield bonds in ship and state control. In contrast to a unprepared. For example, one offi cial part because the interest rates paid on was directed by the central government economy. One of these barriers is a heavy supplied by their employers. Finally, there to privatize several hundred state-owned emphasis on high employment. This are gaps in education. While literacy is fi rms within two years, even though he leads to jobs being defi ned very narrowly high overall, many Chinese do not have had never privatized a business before and other ineffi ciencies, such as a govern- access to the high-quality education they and had very little idea how to proceed. ment policy of splitting road construction need to thrive in today’s global economy. In addition, many senior government contracts into two-mile increments to China’s rapid industrialization and over- offi cials are moved from one assignment support small construction companies. all rate of economic growth have had a to another too quickly, which limits Another barrier is the reliance on older severe impact on the environment. Its their effectiveness. accounting systems that focus on fl ows of pattern of growth has been highly energy- Chinese offi cials are taking steps to im- funds, not earnings. Similarly, lending to intensive, with a heavy reliance on coal. prove corporate governance. For ex- a state-owned enterprise does not require Coal provides about 70% of China’s ener- ample, the China Securities Regulatory analyzing whether the company will be gy needs, and in 2006 the country con- Commission has hosted meetings to pro- able to repay the in the future. In sumed more coal than the U.S., Japan, mote better governance practices. In the past, managers have been compen- and the UK combined.7 In addition, addition, the sated for completing projects and for high rapid industrialization has led to water has implemented strong governance employment, but not for profi tability. shortages and urban congestion. China’s rules for listed companies. These include leaders plan to relocate 400 million peo- requirements that one-third of corpo- Looking toward the future ple to newly developed urban centers rate directors be independent and that Looking ahead, the Chinese economy between 2000 and 2030. All these envi- the role of chairman be separated from will face challenges in correcting imbal- ronmental impacts have led observers to that of chief executive offi cer. ances stemming from its current pattern question whether China’s high rates of of economic growth. We have already economic growth are sustainable. On the It should be noted that these same cor- mentioned the challenge to balance con- positive side, the government is increas- porate governance issues exist in a num- sumption and investment. Unmet needs ingly open to acknowledging environ- ber of other countries where partially and the societal costs of growth, such as mental problems and developing state-owned enterprises are publicly health and environmental concerns, will interim solutions. traded. However, they are especially acute also need to be addressed to sustain in China, which is still in a transition At the Communist Party’s recent twice- China’s high rate of economic growth. toward a market economy. a-decade National Congress, held in So far, China’s economic growth has been October 2007, China’s leadership out- Market infrastructure very uneven across regions and provinces. lined goals for the next few years that As in other developing countries, China Drastic differences in the rate of devel- addressed some of the imbalances and faces several challenges in creating a opment remain between urban and ru- concerns we have just mentioned. strong fi nancial market infrastructure. ral areas. Average disposable per capita It was only very recently that bankruptcy income in rural areas is less than one- Charles L. Evans, President; Daniel G. Sullivan, laws covering private fi rms went into ef- third of that in urban areas. Disparities Senior Vice President and Director of Research; Douglas fect. In addition, although stock markets are even worse in the poorest rural areas. Evanoff, Vice President, fi nancial studies; Jonas Fisher, Economic Advisor and Team Leader, macroeconomic were reopened in the early 1990s, China’s There is also a geographical dimension policy research; Richard Porter, Vice President, payment stock market capitalization as a share of to these gaps—most investment is on the studies; Daniel Aaronson, Economic Advisor and GDP is very small compared with that east coast. Formerly, people were not Team Leader, microeconomic policy research; William Testa, Vice President, regional programs, and Economics of other developing countries. allowed to move from one region to an- Editor; Helen O’D. Koshy, Kathryn Moran, and other to get better jobs, which enhanced Han Y. Choi, Editors; Rita Molloy and Julia Baker, Financial markets are still in the early Production Editors. the power of the regional governments. stages of development. China’s corporate Chicago Fed Letter is published monthly by the bond market is small relative to GDP and Social welfare programs—pensions, Research Department of the Federal Reserve Bank of Chicago. The views expressed are the is dominated by large state-owned enter- health care, and education—are poten- authors’ and are not necessarily those of the prises. In addition, even profi table small- tial sources of unrest. Pensions cover only Federal Reserve Bank of Chicago or the Federal and medium-sized businesses fi nd it hard city workers, who make up approximately Reserve System. to borrow from Chinese banks.6 China’s 28% of the population. Chinese offi cials © 2008 Federal Reserve Bank of Chicago Chicago Fed Letter articles may be reproduced in market offers a narrow acknowledge that pension funds are ba- whole or in part, provided the articles are not range of products, with a very limited sically insolvent. Affordability of health reproduced or distributed for commercial gain and provided the source is appropriately credited. secondary market. Finally, fi nancial in- care is also an issue. There is a huge gap Prior written permission must be obtained for novations, such as trade in derivatives, between health care in the cities and in any other reproduction, distribution, republica- tion, or creation of derivative works of Chicago Fed are being introduced only slowly. the rural areas, where the former system Letter articles. To request permission, please contact of free clinics has disintegrated. The vast Helen Koshy, senior editor, at 312-322-5830 or Effi ciency majority of the rural population is now email [email protected]. Chicago Fed Letter and other Bank publications are available A number of barriers stand in the way uninsured, but most urban residents have on the Bank’s website at www.chicagofed.org. of greater effi ciency in the Chinese some kind of health coverage, which is ISSN 0895-0164 Chinese leader Hu Jintao indicated that the central government’s initiatives re- revenues, peasants and workers contin- growth will continue to be the top pri- lated to narrowing income gaps, im- ue to be excluded from positions of ority, with the government’s goal being proving environmental protections, and power in the Communist Party.11 to double per capita GDP by 2020 and creating a stronger social safety net.9 “basically eliminate” absolute poverty. Conclusion After the National Congress, the govern- However, the government will also try China continues to engineer high rates ment announced new antipollution reg- to reduce the impact of growth on re- of economic growth, using an economic ulations for the export industry. Export source consumption and on the envi- system that has never been seen before manufacturers that violate China’s pol- ronment. Hu proposed a restructuring in history. However, the country faces lution laws would be forced to close for of the economy to emphasize technol- enormous challenges because of its sheer one to three years. In the past, such com- ogy rather than heavy industry, services size, its rapid rate of social and economic panies have only received small fi nes. A rather than manufacturing, and con- change, the confl icts between its tradi- signifi cant portion of China’s air pollu- sumer spending rather than exports. tional political and cultural institutions tion is due to the production of goods Hu also said the government will raise and the dynamism of the market, and for export.10 minimum wages, expand health care the massive unmet needs of its popula- and the social safety net, and stimulate Despite such reform efforts, one analyst tion and the environment. China’s lead- job creation in the private sector.8 has expressed skepticism about the prom- ership has been focusing intently on ises made at the National Congress about these challenges and is studying how In addition, a new group of top offi cials, broadening prosperity, expanding the so- other countries are addressing similar whose experience in local government cial safety net, and increasing education issues. Clearly, the solutions must fi t could help Beijing strengthen its author- subsidies. He noted that, despite recent the unique circumstances in China. ity over local interests, emerged at the increases in social welfare spending, National Congress. Up to now, local made possible by surging government governments have thwarted many of

1 Many of our conclusions derive from a mix- 3 The renminbi is the name of the currency, 20070901faessay86503/elizabeth-c-economy/ ture of personal observations and interviews while the is one unit of the currency. the-great-leap-backward.html, accessed on with experts who were speaking “off the November 1, 2007. 4 A country has a current account surplus record,” so specifi c sources cannot be pro- when its exports of goods and services ex- 8 Andrew Batson and Jason Leow, 2007, vided in many instances. However, where ceed its imports. “China puts growth atop agenda,” Wall Street possible, we have provided publicly avail- Journal, October 16, p. A4. able sources for our most signifi cant points. 5 John L. Thornton, 2006, “China’s leadership We would like to thank Steven VanBever gap,” Foreign Affairs, November/December, 9 Andrew Batson and Jason Leow, 2007, “Hu’s and Benoît Mojon, both of the Federal pp. 133–140. big challenge: Getting provinces on board,” Wall Street Journal, October 23, p. A6. Reserve Bank of Chicago, for assistance 6 Janet L. Yellen, 2007, “China’s banking with this article. sector,” Asia Focus, Federal Reserve Bank 10 Jane Spencer, 2007, “China shifts pollution 2 U.S. Central Intelligence Agency, 2007, The of San Francisco, March. fi ght,” Wall Street Journal, November 1, p. A15. World Factbook, report, Washington, DC, 7 Elizabeth C. Economy, 2007, “The great leap 11 Willie Lam, 2007, “Hu Jintao’s hollow available at https://www.cia.gov/library/ backward?,” Foreign Affairs, September/ pledges,” Far Eastern Economic Review, publications/the-world-factbook/geos/ October, available at www.foreignaffairs.org/ November, pp. 27–29.

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