Author:Huang, Yiping

When China began economic reform in 1978, it had only one financial institution, the People's Bank of China (PBOC), which, at that time, served as both the central bank and a commercial bank and accounted for 93 percent of the country's total financial assets. This was primarily because, in a centrally planned economy, transfer of funds was arranged by the state and there was little demand for financial intermediation. Once economic reform started, the authorities moved very quickly to establish a very large number of financial institutions and to create various financial markets. Forty years later, China is already an important player in the global financial system, including in the banking sector, direct investment, and bond and equity markets.

However, government intervention in the financial system remains widespread and serious. The PBOC still guides commercial banks' setting of deposit and lending rates through "window guidance," although the final restriction on deposit rates was removed in 2015. Industry and other policies still play important roles influencing allocation of financial resources by banks and capital markets.

The PBOC intervenes in the foreign exchange markets from time to time, through directly buying or selling foreign exchanges, setting the central parity, and determining the daily trading band. The regulators tightly manage cross-border capital flows, and the state still controls majority shares of most large financial institutions.

Often such repressive financial policies are subject to criticisms in both academic and policy discussions. Academics believe that state interventions reduce financial efficiency and inhibit financial development (Lardy 1998; McKinnon 1973). Private businesses complain about policy discrimination, which made it very difficult for them to obtain external funding. Sometimes, China's repressive financial policies are also a source of controversy in discussion of its outward direct investment (ODI). Some foreign experts argue that the Chinese state-owned enterprises (SOEs) compete unfairly with foreign companies, since they receive subsidized funding in China. This issue is also at the center of die current trade dispute between China and the United States (USTR 2018).

Despite all these potential problems, for quite a while, the repressive financial policies did not stop China from achieving rapid economic growth and maintaining financial stability. During the first three decades of economic reform, China's GDP growth averaged 9.8 percent per annum and its financial system did not experience any systemic financial crisis, although the volume of nonperforming bank loans was quite large in the late 1990s. Unfortunately, during the past decade, the above rosy picture faded away quickly as economic growth decelerated and systemic financial risks escalated sharply. It appears that what worked before could no longer continue.

China's unique experience of financial reform raises some important intellectual and policy questions. Why did die Chinese government maintain extensive interventions in the financial sector during the reform period? Is financial repression as bad as what is commonly believed? Do costs and benefits of repressive financial policies vary under different circumstances? How should the government respond to changing impacts of financial repression on economic growth and financial stability? At the background of these discussions, there is also a more fundamental but somewhat hypothetical question: Were China to adopt the "shock-therapy" approach in its financial reform at die beginning, would the Chinese economy have performed better?

This article addresses those questions and offers recommendations for future financial reform policies. It also draws some general lessons from the Chinese experiences that are relevant for financial liberalization in other developing countries.

Key findings of this article can be summarized as follows. First, China's financial reform and development during the past four decades could be characterized as strong in establishing financial institutions and growing financial assets, but weak in liberalizing financial markets and improving corporate governance (see Huang et al. 2013). On the one hand, starting with one financial institution in 1978, China has built a very large financial sector, including large numbers of various financial institutions and gigantic sizes of financial assets. On the other hand, free-market mechanisms remain seriously constrained in the financial system, including in pricing and allocation of financial resources. This unique pattern of financial liberalization is closely linked with China's gradual dual-track reform approach--maintaining SOEs while creating favorable conditions for the private sector to grow rapidly (Fan 1994; Naughton 1995). In retrospect, this gradual dual-track reform approach worked better than the "shock-therapy" approach as it helped maintain economic stability in the transition toward the market system. Repressive financial policies, through depressed cost of capital and discriminatory allocation of financing, provide de facto "subsidies" to the SOEs. In other words, financial repression is a necessary condition for the dual-track reform approach.

Second, several empirical analyses, using either Chinese data (Huang and Wang 2011) or cross-country data (Huang, Gou, and Wang 2014), confirm that repressive financial policies could have positive effects on economic growth and financial stability during early stages of development. But over time, such positive effects could turn to negative impacts. Possibly, there are two types of effects of financial repression: one is the McKinnon effect and the other is the Stiglitz effect (Huang and Wang 2017; McKinnon 1973; Stiglitz 1994). The McKinnon effect is generally negative, as financial repression hinders both financial efficiency and financial development, while the Stiglitz effect is mainly positive as repressive financial policies could help effectively convert saving into investment and support financial stability. Both effects exist in all economies, but their relative importance varies. The Stiglitz effect is more important when both the financial market and the regulatory system are underdeveloped. This, again, validates the observation that financial repression did not disrupt rapid economic growth and financial stability during Chinas' early stage of reform.

And, finally, repressive financial policies began to hurt China's economic and financial performance recently. Economic growth decelerated persistently after 2010. One of the important reasons is that, as China reached the high mid-income level, its economic growth has to rely more on innovation and industrial upgrading, instead of mobilization of more inputs. But repressive financial policies are not best positioned to support corporate innovation. They are also not well suited to provide asset-based income for Chinese households. In the meantime, systemic financial risks also rose markedly, as the two most important pillars supporting financial stability, sustained rapid economic growth and government implicit guarantee, weakened visibly. These suggest that the policy regime that worked quite effectively during the first several decades could no longer deliver the same results. Further reforms are urgently needed to support growth and stability in the future. These should probably focus on developing multilayer capital markets, letting market mechanisms play decisive roles in allocating financial resources, and improving financial regulation.

These findings offer important implications for the general thinking about economic reform and for the current trade disputes between China and the United States. In economies where financial markets and regulatory systems are underdeveloped, a certain degree of financial repression could actually be helpful. If China gave up all government interventions at the start of die reform, it would have experienced several rounds of financial crises. In this sense, repressive financial policies in China are transitory measures. They are an integral part of the gradualist approach and effective ways of supporting economic growth and financial stability. Today, however, the Chinese government needs to push ahead with further financial reforms, especially increasing the role of the market and opening the financial sector to the outside world.

The remainder of this article is organized as follows. In the next section, we briefly explain China's process of financial reform and development, summarize its distinctive features, and rationalize the logic behind it. We then assess the reform policies and distinguish the McKinnon effect and Stiglitz effect of financial repression on economic growth and financial stability. Next, we discuss the recent deterioration of economic and financial performance in China and suggest some future directions of financial reform. Finally, we conclude by drawing some general implications for China and other...

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