2007-1 canada in china Bank Reform in China What It Means for the World Donald J.S. Brean, Rotman School of Management, University of Toronto ISSN 1706-919X – print ISSN 1706-9203 – online © Copyright 2007 by Asia Pacific Foundation of Canada. All rights reserved. Canada in Asia may be excerpted or reproduced only with the written permission of the Asia Pacific Foundation of Canada. March, 2007 canada in Bankchina Reform in China What It Means for the World Donald J.S. Brean, Rotman School of Management, University of Toronto Canada in Asia Publications Series This paper is produced as part of the Asia Pacific Foundation’s Research Grants Program. The Canada in Asia Publications Series provides support for scholars to produce analysis and commentary on contemporary policy and business issues in Canada’s relations with Asia, written for a non-specialist audience. Established scholars and researchers are invited to submit proposals for original papers that are suitable for the Canada in Asia series. Full details are available at <http://www.asiapacificresearch.ca/grants/ 2007_08/publications.cfm> — 4 — introduction Banking in the Context of China’s Economic Reform The world watches as China, formerly a closed and otherwise would have been over the past number of crippled state, steadily transforms itself into an economic years because China is a major provider of credit. It is a powerhouse. The combination of sheer size and curiosity in international finance that a country with per spectacular growth has China on course to become the capita GDP of $1,500 lends US$1 trillion to the rest of world’s largest economy by 2020. Opening up cautiously the world. to international trade and foreign investment in the China’s voracious demand for industrial commodities 1980s, China has rapidly emerged as the world’s factory, — oil, copper, and nickel for example — explains much out-competing other nations in low-cost production of of the increase in traded commodities prices over the manufactured exports of increasing sophistication – past 10 years, reversing a century-long decline. As a from textiles and toys to cameras, computers and cars. commodity exporter, Canada is enjoying the global China today not only manufactures every conceivable commodities boom. The effects are also felt in the gizmo, it now designs gizmos to come. new-found strength of the Canadian currency, of course. With the expansion of China’s economic power, the Within China, the nation-in-transition faces new extent and complexity of China’s involvement with the economic and social challenges that include worsening rest of the world has likewise increased. China is the income inequality, massive internal migration, a world’s second-largest recipient of foreign direct shattered “iron rice bowl,” political corruption and a investment (FDI), behind only the United States. Modern fragmented fiscal system that fails to facilitate the new technology and management acumen accompanies the relationship between the private sector and the state. inflow of capital, moving China further up the learning Larger, angrier and more frequent demonstrations curve of international business. More recently China reflect a degree of social unrest that is especially has been involved in a significant amount of outward troubling in a country that formally places “social foreign direct investment. So far China has kept its harmony” above all else. sights mostly on foreign mining, oil and gas, sectors that are naturally important to Canada. China, “the mysterious East,” is a country of contradictions. It has the technical wherewithal to Global inflation has been kept in check by the double launch satellites yet in remote parts of the country life influence of China’s production efficiency on product is virtually unchanged from centuries past. China prices. For instance the 50% fall in the price-index of seems forbidding and secretive, yet Beijing will host the consumer electronics over the past 10 years and 40% international spectacle of the Olympics within less than drop in the price-index of textiles are directly attributable two years. China seems intent on following its own to China’s exports. Meanwhile China has acquired a agenda on economic dealings with the rest of the large hoard of financial paper issued by countries that world, sometimes defiantly, yet it is now a full member buy China’s low-cost goods. of the World Trade Organization and has properly China’s foreign exchange reserves have topped US$1 reclaimed the “China chairs” at the International trillion. China’s ability and willingness to accumulate Monetary Fund and the World Bank. this paper fortune has allowed industrial nations, This monograph deals with banking and finance, a including Canada, to enjoy non-inflationary consumption. perplexing but increasingly crucial aspect of the made- US interest rates and interest rates related to US rates, in-China version of economic reform. For most of the such as those in Canada, have been lower than they — 5 — period of reform that is now approaching 30 years, First is the “population dividend” that China seems to China has moved steadily and successfully toward be enjoying. People born in the 1950s and 1960s are functioning markets — for agriculture, for goods for the backbone of the Chinese economy. It has an domestic consumption and export, for labour and for exceptionally high ratio of young working people to capital. All the while, however, China’s market-building retirees. The financial implication is an extraordinarily program has had to contend with a financial sector high national rate of “deposit” or savings that flow with features of the old central planning regime. That directly into the banking system. China’s savings rate is bank-centric system continued as a state-run plan- close to 45% of income.2 financing mechanism with a bias toward state-owned enterprises (SOEs). China’s deliberate move to markets Second, the opening up of China to international trade was not accompanied by similarly serious reform of the and foreign investment has attracted huge inflows of banking system. What does this imply for the importance FDI that augment internally generated investment. On of finance for the transition itself and, more important average, over recent years 60% of FDI from than the historical point, what would continued Organization for Economic Cooperation and weakness and inefficiency in banking mean for the Development (OECD) nations to non-OECD nations sustainability of China’s economic modernization? It has gone to China. Multinational corporations generally could be ominous. have well-honed financial relations with the global banking system and hence the production efficiency of A disturbing recurrence in economic development, foreign investment in China is unlikely to be dubbed Goldsmith’s Law, relates financial fragility and compromised by weakness in its banking system. economic instability. Goldsmith’s unsettling finding is that, in most cases, economic transition from heavy- Finally, China’s monetary policy seems to shrewdly handed statism to a decentralized market economy and compensate for structural problems in finance. The a burst of extraordinary growth sooner or later comes high savings ratio belies a disappointingly low rate of 1 transfer of savings to investment, indicating that the crashing down in a financial crisis. Weak financial banking system in China is woefully inept in its institutions, inexperienced central banking, inefficient intermediation function. At the same time, China’s intermediation, volatility in monetary aggregates, lack money “velocity” — a standard measure of the efficiency of confidence and the spectre of capital flight combine of money circulation, for instance from savings to to undermine and destroy hard-won economic gains. investment — is exceptionally low. If velocity is low and Inflation, soaring interest rates, mounting bad loans, pools of cash are stagnating, the compensating internal runs on banks and external runs on the currency monetary policy is to inject more cash into the system. that torpedo the exchange rate — these make up a In fact in China “M2” (circulating cash plus bank destructive turbulence that is the dark side of economic demand deposits) is 150% of GDP which is growth built on a shaky financial structure. extraordinarily high by international standards (in the China may yet break Goldsmith’s Law. The boom-bust US M2 is 70% of GDP). cycles have diminished in amplitude. Inflation is low. Is a debilitating financial crisis in China a serious risk? The currency is strong. Exports are booming. Tax revenue To anticipate a more detailed response to this nagging is rising. Meanwhile, as far as banking itself is concerned, question, my answer is that China’s remarkable China is engaged in a broad campaign of financial economic advances are unlikely to end in financial institution building, albeit relatively late in the reform conflagration. China has both the policy insight and the program. It is intriguing to ask whether China has resources to allow it to act early and forcefully to any devised a template for transition that allows it to deal threat of financial instability. In global finance, a trillion with a weak financial system without substantially dollars of foreign exchange buys a lot of strength and compromising the forces for growth. A few uniquely credibility. In short, the concern about banking in China Chinese factors may explain economic gains achieved is not the apocalyptic story. The problem is not that without sophisticated finance. — 6 — banking is precarious but rather that it is inefficient and incapable of doing all that could reasonably be expected of banking in China’s emerging complex industrial society. It will take some time to rid the system of the fundamental inefficiencies but the reform process is well underway. Meanwhile China suffers capital misallocation, poor risk management and weak link- ages in macro-monetary mechanisms. Addressing the shortcomings could create enormous value for China’s economy.