Manual Recovering Financial Systems: China and Asian Transition Economies

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Recovering Financial Systems - China and Asian Transition Economies-
  1. Transition Economies: An IMF Perspective on Progress and Prospects -- An IMF Issues Brief
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  4. Recovering Financial Systems: China and Asian transition economies - Edited by Mariko Watanabe

After this round of reform, the SOE sector shrank significantly. Its profitability also improved markedly because most of the remaining SOEs are gigantic and enjoy certain degrees of monopoly. Problems of the so-called soft budget constraint and relative inefficiency, however, continued. The loss making by the SOEs around the mids caused at least two types of macroeconomic consequences, one was fiscal and the other was financial. The government almost suffered a fiscal crisis. The proportion of government revenues to GDP declined from 36 percent in to the trough of 11 percent in This decline was partly a result of the decentralization policy.

Transition Economies: An IMF Perspective on Progress and Prospects -- An IMF Issues Brief

SOEs, the dominant contributor to government revenues, not only contributed less over time but also demanded subsidies from the government. Although the private sector grew rapidly, most of the private enterprises were small and medium-sized enterprises SMEs paying little tax. Many foreign-invested firms enjoyed preferential policies such as tax exemption and tax concession. As a result, some local governments were unable to cover their overheads. To alleviate the fiscal stress, Beijing introduced a new tax-sharing system in Under the new system, some taxes such as the income tax and customs duty went directly to the central government, some such as the resource tax and stamp duty went to local governments, and others such as the value-added tax went to both the center and localities.

The new system helped strengthen tax collection and increased the revenue share of the central government. Gradually, the proportion of tax revenues to GDP recovered to around 21—22 percent. The banking sector also suffered severely, as the average bad loan ratio of the Chinese banks reached 30—40 percent around Bonin and Huang Fortunately, there were no bank runs, as the banks also had a blanket guarantee from the government.

From that time, the Chinese government adopted a series of measures to revamp the banking sector. In , it established four asset management companies AMCs to resolve the bad loans. In , the authorities established the Central Huijin Investment Company to inject capital into the banks and other financial institutions. Other banks took the same steps in the following years. All these problems highlight a key difficulty in implementing the dual-track reform approach — many of the SOEs are unable to survive without external support.

One logical solution to this problem is for the government to provide fiscal subsidies to protect the SOEs. However, as the fiscal revenues declined rapidly relative to GDP throughout the s, it became clear that the government would not have enough funding to support the SOEs. One alternative is through state intervention in factor markets in favor of the SOEs, both in terms of pricing and allocation of production factors.

For instance, if the government could instruct the banks to continue to allocate large volumes of cheap credit to SOEs, then SOEs could survive even if their performance continues to deteriorate. On the one hand, the government almost completely liberalized markets for agricultural, industrial, and service products, which allowed producers to identify market demand and profitable opportunities.

With an open trade regime, Chinese industries can also easily participate in international competition. On the other hand, markets for production factors — including labor, capital, land, and energy — remained heavily distorted, and the government continued to intervene in their allocation and pricing. These distortions in the factor markets ensure that SOEs receive needed inputs at favorable prices.

They are de facto subsidies. For instance, SOEs are often in privileged positions when purchasing energy products from the state power grid or the state-owned oil companies. The private enterprises would either not be able to acquire enough inputs or have to pay higher prices. The asymmetric liberalization approach between product and factor markets functions as a necessary policy instrument to support the dual-track reform between the state and nonstate sectors.

Repressive financial policies played an essential role in distorting factor markets and were important instruments to subsidize SOEs. Without those policies, the less-efficient SOEs would have been eliminated by competition a long time ago. Repressive financial policies also led to segmentation of the financial system into a formal sector and an informal sector. In the formal sector, the authorities depress costs of capital and allocate funds in favor of the SOEs. This has simply pushed a lot of non-SOEs out of the formal sector and caused the funding costs in the informal sector to be exceptionally high.

Therefore, China has developed a very large financial system, and undersupply of financial services remains a very serious challenge, especially for the private enterprises. This is also why, in recent years, shadow banking and fintech industry expanded very rapidly. To a large extent, these developments were responses to financial repression in the formal sector. On the surface, those policies did not prevent the economy from achieving rapid growth and financial stability.

But the fundamental question remains: Did the Chinese economy achieve those successes because of, or despite, the repressive financial policies? The answer to this question might help us understand the mechanisms through which repressive financial policies affect economic and financial performance. It could even help us think about policy choices for China today and for other developing countries. In an earlier study, Huang and Wang tried to quantify the impact of financial repression on economic growth in China during — by constructing a financial repression index.

They first looked at the three-decade period as a whole and found a positive impact — that is, financial repression promoted economic growth. They then looked at three subperiods, separately, and found that, while financial repression promoted economic growth in the s and s, it became a drag in the s.

According to their study, if there had been full financial liberalization, real GDP growth would have been reduced by 0. But growth would have been increased by 0. The positive effect discovered for the s and s was consistent with the reasoning by Stiglitz In early stages of economic development, financial markets are often underdeveloped and might not be able to channel savings to investments effectively.

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Also, financial institutions are often immature and vulnerable to fluctuations in capital flows and financial stability. State intervention in forms of repressive financial policies can actually promote economic growth through support to confidence and effective conversion of saving into investment.

Today, China is the only major economy in the world not experiencing a serious financial crisis. This is mainly because of government ownership anchoring investor confidence despite various risks that occurred during the past decades. For instance, without a relatively closed capital account, the Chinese economy would have been more seriously harmed by both the Asian financial crisis and the global financial crisis. The negative impact of financial repression on economic growth found in the s is in line with analysis by McKinnon State intervention in capital allocation might prevent funds from flowing to the most efficient uses.

Protection of financial institutions and financial markets might also encourage excessive risk taking due to the typical moral hazard problem. Therefore, repressive financial policies would eventually hinder financial development, increase financial risks, reduce investment efficiency, and slow down economic growth. This should be easy to understand.

For instance, if the less efficient SOEs continue to take in more and more financial resources, then efficiency of the overall economy would decline steadily. In a relatively recent study, Huang, Gou, and Wang examined the same question by using a cross-country dataset for the period — Similarly, they also found different impacts of financial repression on economic growth at different stages of economic development. Statistical analyses reveal that the growth effect of financial repression is insignificant among low-income economies, significantly negative among middle-income economies, and significantly positive among high-income economies.

Furthermore, for the middle-income group, repressive policies on credit, bank entry, securities market, and the capital account significantly inhibit economic growth. These empirical results suggest that the mechanisms through which repressive financial policies affect the economy and the financial system are complicated. The negative McKinnon effect and the positive Stiglitz effect of repressive financial policies on economic growth probably exist simultaneously in any economy Huang and Wang The net outcome in an economy depends on the relative importance of these two effects Huang et al.

And the relative importance of these effects also changes under different economic and financial conditions.

For instance, in early stages of economic development and reform, the contribution of financial repression to economic growth, through maintaining financial stability and converting saving into investment, is greater than its cost in terms of inefficiency and risks. Therefore, we should observe the Stiglitz effect. As the financial system matures, the negative impact of financial repression in terms of reduced capital efficiency and increased financial risks could outweigh its positive contribution.

Then we should observe the McKinnon effect. The recent transition from the dominance of the Stiglitz effect to the dominance of the McKinnon effect suggests that repressive financial policies have become a main drag on economic growth. There is probably a mixed set of factors responsible for this growth slowdown. Cyclical factors could include sluggish global economic recovery and weak Chinese export growth. Trend factors could refer to slower growth, on average, in more advanced economies. In the meantime, financial repression still favors less efficient SOEs in resource allocation and further impedes economic growth.

This points to the urgent need to further liberalize financial policies. Were China to have completely abandoned government intervention at the beginning of the reform, the financial system would, most likely, have experienced dramatic uncertainties and volatilities.

Repressive financial policies probably still caused some efficiency losses, but the benefits were far greater. Equally important is that, even during that period, the level of financial repression was static. Financial liberalization continued, which should also generate significant efficiency improvement and strong momentums for growth. Economic and financial performance deteriorated markedly in China, especially after the global financial crisis in After a sharp rebound of GDP growth to Economists are divided on what caused this persistent slowdown — some speculate it to be a part of cyclical fluctuation, while some others believe this is a trend change.

The most plausible explanation is probably the so-called middle-income challenge. Many of the industries that supported Chinese economic development for several decades, especially the labor-intensive manufacturing sectors, are no longer competitive. In order to continue with robust economic growth, China now needs to develop a large number of new higher tech and higher value-added industries that are competitive at high costs.

Therefore, what is happening in China is not just slowdown of growth, but a paradigm shift in development. The ratio was 3. Rapidly declining capital efficiency is truly worrisome. It might be related to the hangovers of the big stimulus package that the government implemented before. But misallocation of financial resources became an even bigger issue after the global financial crisis. As economic uncertainties stay at the escalated levels, the private enterprises deleveraged, while the SOEs leveraged, partly protected by the repressive policies and partly facilitated by the macroeconomic policies.

But these led to sharp deterioration of corporate leverage quality Wang et al. An even more worrisome development is the steady rise of financial risks. At the macro level, there are at least three sets of factors contributing to the recent rise of SFRI. First, persistent growth slowdown led to significant deterioration of corporate balance sheets, which added to financial risks.

In particular, in the past, the Chinese economy grew at very rapid and stable growth rates. The authorities were able to resolve or, at least, to hide temporarily from any financial risk factors, even if they did occur. However, that is no longer possible. Second, the government could no longer guarantee everything.

In the past, the government could shield the economy from any major financial shocks. For instance, the state ownership ensured that there was no bank run in the late s, even when one-third of banks were nonperforming. This is no longer possible, partly because the potential liabilities are much bigger today. More importantly, government liabilities, especially borrowings by the local governments and their affiliated investment platforms, have already become a source of financial risks.

Finally, the segregated financial regulatory regime could no longer keep financial risks under control. But when shadow banking transactions grew, regulatory gaps quickly emerged — for example, who should be responsible for regulation of banks selling insurance products? Even worse, a lot of fintech companies started businesses even without applying for a license.

In addition, the fact that all regulators are responsible for both financial regulation and industry development could create conflict of interest situations for the regulatory officials. The Chinese financial system also became inadequate in serving the real economy. On the one hand, Chinese households receive little returns to their financial assets.

Total household financial assets rose from Unfortunately, the households have very limited options for investment. Currently about 69 percent of their financial assets are in bank deposits, 20 percent in securities products, and 11 percent in pension and insurance products. The proportions of total household financial assets in bank deposits were much lower in other countries, such as 53 percent in Japan, 36 percent in Western Europe, and 14 percent in the United States. On the other hand, as the growth model shifts from mobilizing inputs to relying on innovation, the traditional bank-dominated and highly repressive financial system is no longer appropriate.

Innovation and industrial upgrading are much more uncertain and risky than simple expansion of manufacturing capacity. They require technical expertise and flexibility in providing financial services to support economic development. All these suggest that whatever financial system that worked in supporting economic growth and financial stability has probably hit its limit.

Further reform and adjustments might be needed in order to support continuous economic development. Discussion so far points to needed changes in at least the following three areas. One is to develop multilayer capital markets. And this may remain so for a very long time. But it is now critical to increase the role of the capital markets. This is necessary for providing asset-based income for Chinese households. Direct finance is also critical for supporting innovation and industrial upgrading.

Two is to let market mechanisms play a decisive role in allocating financial resources. The negative consequences of government interventions have become clearer.

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And three is to improve the regulatory system to prevent systemic financial crises. The Asian economies started out, on balance, from more favorable initial conditions than the European economies. Compared with the latter, their political situation at the start of reforms was more settled; their economies had larger agricultural sectors; they were less integrated with the CMEA system; and they had a stronger memory of a market-oriented system particularly in Indochina.

On the unfavorable side, the dominance of agriculture meant that per capita incomes were low with the attendant problems of rudimentary infrastructure and weak administrative capacity and these countries were initially more isolated from the international community. As in the European countries, the initial years of the transition in Indochina were associated with a burst of severe inflation.

Tight macroeconomic policies were successful in reducing inflation to moderate levels. There was only limited use of exchange rate pegs as a nominal anchor to reduce inflation; instead the monetary frameworks were varied, and in the case of Laos relied on Fund-supported programs to enhance credibility. China adopted a gradualist approach to stabilization.

Though inflation never rose above thirty percent, the country has gone through cycles of low inflation followed by resurgence of inflationary threats. These cycles have more to do with surges in aggregate demand than with changes in the exchange rate regime. In sharp contrast to the experience of the European countries, output growth remained positive in the aftermath of the stabilization programs. The resilience of output is attributed to the favorable supply response in the agricultural sector. Important institutional reforms in agricultural land use and ownership helped secure the favorable response.

Privatization As noted above, economists generally agreed on the need for speed in carrying out liberalization and stabilization. But on privatization of large enterprises, there was a debate on whether to have a rapid transfer of assets from the state to the private sector or to adopt a more gradual approach. Advocates of rapid privatization called for eliminating state ownership by giving assets to citizens, for instance through vouchers that gave their holders the right and means to purchase state-owned companies on sale.

They were motivated by considerations of fairness, a desire to give ordinary citizens a stake in the economy. They also perceived a need to seize the window of opportunity that had opened for privatization before the state bureaucracies regrouped and resisted the process. Others advocated a more gradual scaling back of state enterprises as new private sector firms emerged in the economy.

They were in favor of the privatization of enterprises through the sale of assets to those likely to work on improving the performance of the companies. Hungary followed this gradualist approach to privatization, and it appears to have proved more conducive to genuine restructuring of enterprises.

By contrast, experience has shown some of the pitfalls of the rapid privatization approach. But there was no genuine restructuring of enterprises, either because the investment funds lacked the capital to develop them or because the funds were in turn controlled by state-owned banks that did not impose hard budget constraints. The weak growth performance of the Czech Republic in the lates, relative to other CEE countries, is attributed in part to its weak enterprise reforms.

Rapid privatization fared even worse in Russia. However, contrary to expectations, insider privatization did not lead to self-induced restructuring of firms. It was hoped that secondary trading would introduce outside ownership, and that transparent methods would be used in the second wave of privatization of remaining firms still in state hands. Neither hope was fulfilled. Insiders were wary of relinquishing control; workers feared the cost-cutting that might occur under outside control, and managers found it easier to keep enterprises alive by lobbying the state for subsidies than to foster competitive performance through involvement of outsiders.

The second wave of privatization, in particular the so-called "loans-for-shares" scheme, was non-transparent and systematically excluded foreign investors and banks in favor of parties with ties to government interests. Overall, the experience of the transition economies suggests that privatized firms tend to restructure more quickly and perform better than comparable firms that remain in state ownership, but only if complementary conditions are met.

These conditions include the presence of hard budget constraints and competition, effective standards of corporate governance, and an effective legal structure and property rights. In contrast to the mixed experience on privatization of large enterprises, the privatization of small-scale enterprises has been generally successful and has been completed in all but five countries. The move to a market economy required substantial amounts of finance to facilitate the reallocation of investment into productive sectors, modernize antiquated machinery, enhance public infrastructure, and provide financing for emerging firms.

But, it was difficult, in the initial years of transition, for governments in these countries to raise the requisite capital. Rather, external assistance on a much smaller scale was provided primarily by the international financial institutions, the European Union, and individual countries. Another factor contributing to a capital scarcity was that private capital fled the countries in response to the uncertain circumstances at the start of transition.

However, once the direction of reforms was clearly established in many CEE and Baltic economies, private capital returned quickly. Russia's experience stands in sharp contrast. Several years into its transition, Russia is still experiencing massive capital flight.

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Though inflation has been brought under control, Russia has lagged in the implementation of structural reforms. Inequality in incomes has increased, not surprisingly, over the period of transition. A commonly-used measure of inequality is the Gini coefficient for income, which takes on values between zero and one; a value of zero would indicate perfect equality of incomes. Pre-transition Gini coefficients were around 0. Post-transition Gini coefficients have increased, ranging from 0. Countries with better growth performance--as measured by cumulative GDP growth in the first eight years of transition--experienced a smaller increase in inequality, as shown in Figure 4.

The fact that the increase in income inequality has been modest in many countries does not mean that the process of transition has not generated winners and losers. The case of Poland proves this point. Poland did experience a substantial increase in inequality of labor earnings.

But social transfers played a role in mitigating this shift, so that the rise in income inequality was far more modest. Interestingly, the transfers were targeted at the people who had lost or stood to lose the most from the transition. These people tended to be middle class rather than the poor; that is, they were not the ones who would have been targeted had the goal been to help those whose absolute need was the greatest.

But they may have helped the reform effort by bolstering political support for the reforms among the people most likely to block them. This brief discussion of inequality is by no means a complete account of the often wrenching social changes under transition. For instance, one major aspect of the increase in inequality is the deterioration in the relative position of retirees although this was not the case in Poland.

With the demographic pressures facing these countries, this is a very hard problem to address in the framework of existing pay-as-you-go pension systems. The pension reforms in most of these countries will improve the situation, but this will unfortunately be too late for the current generation of retirees.

Furthermore, several other social indicators have deteriorated in some of the transition economies. However, efforts at structural reform have been weak and privatization has been often mishandled. What is the way forward for Russia? There is a range of answers to this question reflecting differences of opinion about the reform process in Russia. One vociferous view is that the reform approach taken in Russia, particularly with respect to privatization, was fundamentally flawed in emphasizing radical reform over gradual institutional development.

To Joseph Stiglitz, for instance, the failure of rapid privatization in Russia "was not an accident, but a predictable consequence" of the absence of competition policies and the institutional and legal infrastructure needed to support a successful reform effort. Stiglitz suggests that Russia could learn in this regard from the "enormous success of China, which created its own path of transition, rather than just using a blueprint or recipe from Western advisors". An opposing view, associated with some Russian observers and policymakers such as Boris Fedorov and Andrei Illarionov, is that the reform strategy was the correct one, but never implemented, in part because of the leniency shown by the advanced market economies and international financial institutions.

For several years, the Russian government and Russian society as a whole turned out to be effectively spoiled, as they have been granted unearned financial assistance. As a result, Russian economic policy has not only been inconsistent, but it has seriously diverged from the economic policy conducted in a majority of countries in transition. In a similar spirit, Fedorov's "recommendations for the West" are not to grant Russia "concessions, but rather apply the rules as you would to any country.

Recovering Financial Systems: China and Asian transition economies - Edited by Mariko Watanabe

Western capital should flow to the private sector, not the government. Only this will help to change the country, create jobs and increase efficiency. While acknowledging that greater attention ought to have been given to institutional reforms, the view from the IMF is that the basic strategy pursued in Russia was sound but derailed by special factors. What is needed is not a fundamental change in reform strategy, but a decision by the political authorities "to renew reforms and improve governance. Can the power of vested interests be overcome?