Finance & Development, September 2005

Prasad The exchange rate regime is just one piece of the broader reform agenda in China. The author assesses what China needs to do to ensure the durability of its economic expansion by addressing the looming issues of financial sector reform and the need to bolster balanced domestic-led growth. Research shows that countries benefit relatively more if their trading partners grow faster than they themselves do and are richer.

People in Economics The Globalization Guru Arvind Subramanian interviews Jagdish Bhagwati, a leading economist in the area of trade and development and a tireless opponent of protectionism and advocate of free trade. Back to Basics 10 Myths About Governance and Corruption Daniel Kaufmann A bolder approach is needed to improve governance and curb corruption around the world. The World Bank Institute is designing a transparency reform scorecard and constructing a transparency index to complement its well-known governance indicators.

While the techniques and instruments to absorb fluctuations have improved, there is a great deal of uncertainty about how they will perform in a serious downturn. Country Focus China Economic growth has remained strong and inflation low.

A large trade surplus, together with strong capital inflows, has kept accumulation of official reserves high. In July, China abandoned the de facto peg of its currency to the U. Free Email Notification Receive emails when we post new items of interest to you. We welcome your Feedback on articles. Please fill in this pdf survey.

A quarterly magazine of the IMF. September Volume 42, Number 3. The explicit costs of such sterilization have been held down simply by requiring the state banks to purchase government or central bank bonds at low interest rates that are close to, or below, the rate of return earned on reserve holdings. This approach has been facilitated by the relatively closed capital account and the fact that the banking system is state owned. Of course, even China cannot escape the basic laws of economics.

Account Options

In truth, the broader costs of sterilization may just not be obvious. For instance, a major part of the costs has been implicitly borne by Chinese households who, for want of other investment opportunities, have left their deposits in the state-owned banking system and earned very low real returns on their savings. A greater concern engendered by the fixed exchange rate regime had been that, over time, the capital controls would prove increasingly ineffectual as the incentives to evade them became stronger.

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Maintaining a fixed exchange rate system in the face of the inevitable erosion of capital controls could have posed risks to the financial system, which remains weak in many respects. Thus, in many ways, moving toward greater exchange rate flexibility will mitigate some of these costs and help foster economic stability in China.

Account Options

But that is hardly the end of the story. A different perspective on the balance of payments is that the current account, in effect, represents the balance between domestic saving and domestic investment. Chinese saving rates are very high, with gross national saving amounting to almost half of GDP—this includes saving by households, the corporate sector, and the government.

Perhaps the real question is why the current account surplus is only 5 percent of GDP since even this implies a ratio of investment to GDP that is an astonishing 40—45 percent of GDP, with a substantial fraction of this investment being undertaken by enterprises. Cheap bank credit has played an important role in financing the recent investment boom. Such high investment rates are, in principle, a boon for a developing economy, since most such economies tend to be labor-rich but capital-poor.

But the disturbing fact is that, in recent years, investment growth has been mostly concentrated in a few sectors such as aluminum, autos, cement, real estate, and steel. While demand growth has been strong, there is a fear that annual rates of investment growth exceeding 50 percent in some of these sectors—fueled by cheap credit and overoptimistic expectations about future growth in demand—are likely to result in a buildup of excess capacity. Indeed, in some sectors such as autos and steel, there is already some evidence that rising competition and excess capacity are beginning to drive down prices.

This could result in an accumulation of new nonperforming loans in the banking system, setting back a good deal of the progress that has been achieved in recent years. In short, one basic problem in China is that the high degree of thrift that fuels such rapid investment growth has a low payoff because of the fragile threads holding the economic picture together. Providing cheap capital to enterprises, especially state-owned firms, requires low interest rates.

Sustaining bank profits then requires correspondingly lower rates of return on deposits. Thus, maintaining economically unviable state enterprises and supporting them through the banking system results in large implicit costs. But why does all of this matter if growth remains as robust as it has in recent years? Could not China simply grow out of a lot of its problems? Growth is undoubtedly a wonderful tonic. But there is a potential dark side associated with the fact that a significant portion of this growth in recent years has come from investment, with rising fixed investment becoming the main driver of output growth since see Chart 3.

A good chunk of this investment is likely to prove unproductive from a long-term perspective. Even building bridges to nowhere can raise output in the short term but is hardly a good use of resources.

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For it is ultimately consumption rather than investment or even output that is a true measure of economic welfare. So how does one square the circle? Reform of the state-owned banking sector is an essential component of this agenda since banks continue to dominate the financial landscape, with the stock and bond markets still relatively underdeveloped.

But development of the broader financial sector cannot be ignored, because this will be essential to provide alternative vehicles for saving and alternative sources of financing for firms and households. This would have the added benefit of promoting banking reforms by exposing state banks to domestic competition.

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Progress has already been made in improving the oversight of the banking system. The formation of the China Banking Regulatory Commission in early and its mandate to improve the supervision and regulation of the banking system have provided a kick-start to banking reforms.

Capital injections into three of the major banks have improved their balance sheets and are bringing their capital adequacy ratios in line with international norms.

And foreign strategic investors, who are being invited in and have begun taking stakes in the large banks, are expected to bring in technical expertise and inculcate improved corporate governance practices. But it is difficult to turn around behemoths on a dime. And notwithstanding measures taken to streamline their operations, the large Chinese banks are still massive by any standards—with hundreds of thousands of employees and tens of thousands of branches in far-flung areas. This makes the reform process a logistical challenge. Furthermore, rooting out the legacy of government-directed lending, and training banks to make lending decisions based purely on commercial considerations, with adequate regard to viability and riskiness of projects, remains a major reform challenge.

This is far from obvious.

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Providing households with opportunities to use financial markets to smooth consumption could in fact reduce the level of saving for precautionary purposes. It would also allow individuals to borrow against their future income and could thereby spur consumption growth. Saving by enterprises could also decline if they had better access to financing for commercially viable projects and did not have to rely as much on retained earnings.