Premier Wen’s recent attack on the Chinese banking system last month has highlighted what was already a very interesting debate on Chinese banks and the Chinese financial system. There is a growing sense that the Chinese banking system is deeply flawed and needs to be reformed.

But why should China reform its banking – hasn’t the financial system been a key component of China’s economic success in the past three decades? Just as importantly, what does financial reform mean – what kind of changes would need to be implemented for a real reform to have occurred?

Before addressing these questions we should be clear that there is no meaningful difference between China’s banking system and its financial system. Commercial banks dominate the country’s financial system and they largely determine pricing even in the informal banking system and in non-bank financial institutions. It also seems pretty clear that much of the funding within that ambiguous thing called the informal banking sector originates in the commercial banks. For example SOE’s seem to be increasingly involved in financing activity, but they are probably doing so largely as a function of the “arbitrage” between the rates at which they can obtain funding from the banks and the rates at which they can lend.

So China’s financial system is, for the most part, its commercial banks, and the key characteristic of the banking system is what we would call financial repression. What is a financially repressed system and why does it matter? In a recent paper (“Financial Repression Redux”, Finance & Development, June 2011) Carmen M. Reinhart, Jacob F. Kirkegaard and M. Belen Sbrancia described a financially repressed system this way:

Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere. Policies include directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some of the banks or through heavy “moral suasion.”

Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases, or the placement of significant amounts of government debt that is nonmarketable. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation,” which refers to government efforts to ensure the health of an entire financial system.

As the passage above implies, most savings in financially repressed countries, like most of the countries that followed the Asian development model, are in the form of bank deposits. The banks, furthermore, are controlled by the policymaking elite, and they determine the direction of credit, socialize the risks, and set interest rates. Financial repression is a way of describing a system in which the rates of return and the direction of investment of domestic savings are not determined by market conditions and individual preferences but rather are heavily controlled and directed by financial or political authorities. At the extreme the financial system is often little more than the fiscal agent of the government.

If the central bank – or whichever institution has the appropriate responsibility – sets at an excessively high level the rates that household savers earn on their savings, it is effectively transferring resources from borrowers to depositors. If it sets the rate excessively low, of course, it does exactly the opposite. In most countries that create the conditions of financial repression – for example the countries that broadly followed the Asian or Japanese development model – interest rates have been set extremely low.

This is very clearly the case for China, as I have discussed many times in this newsletter. Normally under these circumstances we would expect the losers in the system, the depositors, to opt out of depositing their savings in local banks, but it is extremely difficult for them to do so. There are usually significant restrictions on their ability to take capital out of the country and there are few local investment alternatives that provide similar levels of safety and liquidity.

Depositors foot the bill

Depositors, in other words, have little choice but to accept very low deposit rates on their savings, which are then transferred through the banking system to borrowers, who benefit from these very low rates. Very low lending and deposit rates create a powerful mechanism for using household savings to boost growth by heavily subsidizing the cost of capital.

The ones who lose under conditions of financial repression are net depositors, who tend for the most part to be the household sector. The ones who win are net borrowers, and in most countries in which financial repression is a significant policy tool, these tend to be local and central governments, infrastructure investors, corporations and manufacturers, and real estate developers. Financial repression transfers wealth from the former to the latter.

But, as the case of China shows us, the fact that net depositors “lose out” is not necessarily a cause for concern. If the amount of growth generated by the system is so high that households still experience rapid growth in their incomes even as their share of GDP declines, then there is no reason to criticize the system – and in fact until recently nearly all China-focused analysts characterized China’s banking system as well organized and a critical source of China’s economic success.

But there was nonetheless a serious flaw in the banking system and this flaw, I would argue, has been at the heart of the imbalances that will ultimately force China into a difficult rebalancing. To see why, it makes sense, I think, first to understand under what conditions the system adds value. To do so it is useful to go back to the work of the Ukrainian-born American economist, Alexander Gershenkron (1904-78).

Gershenkron posited in the 1950s and 1960s the concept of “backwardness”, and argued that the more backward an economy was at any point in time – with relatively low manufacturing capacity and infrastructure, and perhaps higher levels of social capital – the more growth could be generated under conditions in which consumption would be constrained in favor of investment and the savings rate forced up (see, for example, Economic Backwardness in Historical Perspective, Cambridge, 1962, Belknap Press). He argued that because of failures in the private financial sector to identify investments with positive externalities, there was likely to be, and ought to be, a greater reliance on state-directed banks to allocate capital.

In a 2003 book review Columbia University economist Albert Fishlow very usefully elucidated Gershenkron’s position (“Review of Economic Backwardness in Historical Perspective”, February 13, 2003, EH.net):

1. Relative backwardness creates a tension between the promise of economic development, as achieved elsewhere, and the continuity of stagnation. Such a tension takes political form and motivates institutional innovation, whose product becomes appropriate substitution for the absent preconditions for growth.
2. The greater the degree of backwardness, the more intervention is required in the market economy to channel capital and entrepreneurial leadership to nascent industries. Also, the more coercive and comprehensive were the measures required to reduce domestic consumption and allow national saving.
3. The more backward the economy, the more likely were a series of additional characteristics: an emphasis upon domestic production of producers’ goods rather than consumers’ goods; the use of capital intensive rather than labor intensive methods of production; emergence of larger scale production units at the level both of the firm as well as the individual plant; and dependence upon borrowed, advanced technology rather than use of indigenous techniques.
4. The more backward the country, the less likely was the agricultural sector to provide a growing market to industry, and the more dependent was industry upon growing productivity and inter-industrial sales, for its expansion. Such unbalanced growth was frequently made feasible through state participation.

This of course sounds a lot like the Chinese growth model, and that of a number of other countries that experienced growth “miracles” in the 20th Century. In fact countries undergoing the process described by Gershenkron were able to generate fairly substantial increases in wealth for long periods of time – as clearly happened in China, at least during the first fifteen or twenty years since the reforms of 1978.

But the case of China, and every other case of an investment-driven growth miracle, suggests that the model cannot be sustained indefinitely because there are at least two constraints. The first has to do with the constraint on debt-financed investment and the second with the constraint on the external account, and one or both constraints have always eventually derailed the growth model.