China's Financial Policies Harm Domestic Growth
Nicholas R. Lardy | Peterson Institute | October 2008
To date China can, through financial repression - state regulation, which undermines market mechanisms in the financial system - sustain the costs of an undervalued currency. However, by adhering to these financial policies, China's economy may soon endure the resulting backlash: low level interest rates, which drive excessive credit demand, a weak domestic demand and therefore a large dependence on foreign demand, inefficient allocations of capital in the banking system, as well as the creation of parallel, underground financial structures - just to name the most severe repercussions. Furthermore, due to decreasing foreign demand, China's economy faces hard times ahead.
To maintain the falsely undervalued Chinese currency (RMB), China's government, under the guise of the Chinese central bank (People's Bank of China - PBC), undertook massive interventions in the international currency market. Through the accumulation of foreign currency, over USD 1.8 trillion as of June 2008 - whereas at the end of 2002 it was USD 212 billion - the PBC has impeded the appreciation of the RMB (which would have been the consequence of the daunting influx of capital into China during the 1990s). For that reason the Chinese central bank had to absorb money and then sterilize it: a central sterilization measure which consisted of raising the stipulated reserve ratios of commercial banks from 6 to 17.5% from 2002 to 2008 (the other was the sale of central bank bills to commercial banks). The commercial banks, therefore, feel constrained, having to place an additional RMB 5.2 billion on deposit at the central bank.
Both sterilization measures are tantamount to an indirect tax, which will be inflicted on the banks: the interest, which the banks hold on deposited money reserves and central bank bills, lies below the interest that they would receive if they were to lend the money to private clients. In the end, however, it is the private Chinese household who must pay the price for these indirect taxes. The ratio of private household income in China as a share of GDP is constantly declining because the household interest income (interest minus inflation) is exceedingly low or even negative. The result: the ratio of private consumption as a share of the GDP is decreasing and with it consumerism's contribution to Chinese economic growth. The supposed goal of the Chinese government - to supply a wider basis for growth - seems consequently jeopardized by the dependence on foreign investment and export surpluses and the growing domestic credit demand. Moreover, financial repression impedes the development of a commercial banking system and a robust capital market in China. These hidden costs of the Chinese financial policy should therefore be kept in mind during debates on future reforms of China's financial and exchange rate systems.
This summary was prepared by the Atlantic Community editorial team from "Financial Repression in China" published here by the Peterson Institute for International Economics, September 2008.
Related materials from the Atlantic Community:
- Li Yu: A Chinese Student's Wish List For China
- Frank-Walter Steinmeier: Our Wish List for China
- Ethan Christian Arrow: Crouching Tiger, Coward Dragon
