Do financing biases matter for the Chinese economy?

• Author: Huang, Yasheng

It is widely acknowledged that China's financial system is deeply troubled. Its banks have very high nonperforming loan ratios and its stock market has lost 50 percent of its value since 2001 amidst a GDP growth rate averaging some 9 percent a year. Those facts about the accounting aspects of China's financial system are becoming better known in the West. However, what has not been sufficiently highlighted is the precise effect of China's dysfunctional financial system and its broader pattern of allocating resources--in favor of the state sector at the expense of the private sector--on the Chinese economy and society.

Probably the only reason economists and business analysts have found it hard to reconcile the accounting aspects of China's financial system with the performance aspects of the Chinese economy is that China's GDP growth has been so impressive. Some experts (e.g., Rawski 2001,Young 2003) have argued that China's economic performance has not been as impressive as the official statistics indicate. Their work in this area delves into rather specialized and arcane areas of Chinese methods of compiling and reporting data. While this work is analytically important and does resolve some of the puzzles of China's rapid growth, it is very technical and difficult for nonspecialists to understand. Thus, it is unlikely to grab readers' attention away from newspaper headlines touting the rise of China and the huge trade surpluses that country has accumulated.

The more typical approaches of examining China's financial sector range from acknowledging this apparent paradox between a dysfunctional financial system and China's good performance to trying to identify (1) an alternative and positive rationale for having China's system of finance, and (2) alternative sources of capital and finance that seem to have been more supportive of genuine growth engines (such as private firms). Many business journalists have reminded their readers that China's growth has been good but its financial system is bad. Yet there is little analysis of how one can observe both of these phenomena simultaneously.

Some economists deny that such a paradox exists. Their work amounts to backward reasoning--reasoning from outcomes to processes that produced those outcomes. They argue that since we observe good economic performance it must be the case, despite all the accounting manifestations to the contrary, that China in fact has an underlying good financial system. Why is it good? Well, because it supports social stability in a country that needs a lot of it in order to keep growing. The financial system performs a social protection function by providing resources to state-owned enterprises (SOEs) and their workers who would naturally lose from market reforms. The end result is that private firms can grow without hurting the SOE workers. We are told that this arrangement is "Pareto optimal" because it produces all winners and no losers (Lau, Qian, and Roland 2000).

Another line of inquiry acknowledges this paradox and in fact tries to explain the question posed by many business journalists--how a country can grow so fast with so many bad loans. The answer is that China's formal financial system is hugely wasteful but there are alternative financing mechanisms that have sprung up to meet the challenge of financing growth. One mechanism is informal finance. Three finance professors (Allen, Qian, and Qian 2005) have recently put forward the view that informal financial mechanisms have adequately met the financing needs of private entrepreneurs. Going forward, they argue, China should avoid adopting a financial system based on the Western model; it will do better by keeping its informal mechanisms because they have worked so well in supporting the private sector.

The other alternative financing mechanism is foreign direct investment (FDI). In the past few years, this has been my area of research (Huang 2003). The idea here is that private entrepreneurs who are shunned by China's formal financial system have been sourcing capital--in the form of equity capital or FDI from small and medium foreign firms--most of which are based in Hong Kong, Taiwan, and Macau (or what I call ethnically Chinese economies). This is one reason why FDI permeates in China's labor-intensive industries so substantially and in ways we do not observe in other economies, including the most successful labor-intensive exporting economies of South Korea, Taiwan, and Hong Kong in the 1960s and 1970s (where most of the exporting was via inter-firm trade, not intra-firm trade). This is also one reason why we observe labor-intensive FDI in provinces with biased financial policies and lack of labor-intensive FDI in provinces with relatively neutral financial policies. Both types of provinces may be equally successful in exporting but they do it very differently. In this story, the primary function of FDI is a kind of venture capital role in a distorted financial environment, not technology or know-how transfer that FDI specialists are obsessed with.

This article argues that the negative effects of China's poor allocation of financial and other broad economic resources are substantial. The article begins with a demonstration of just how distorted China's financial practices and policies have been. This distortion is defined as a systematic, pervasive, persistent bias in financial policies in favor of the least efficient firms in the Chinese economy--SOEs--at the expense of the most efficient firms in the Chinese economy--China's small, entrepreneurial, and private enterprises. The second section presents evidence of the negative effects of this policy bias. The evidence mainly concerns the micro aspects of the Chinese economy, such as the poor state of China's private-sector development and the poor treatment of the majority of China's population--its rural residents. I will leave aside the question whether these micro issues have affected or will affect China's GDP growth. Suffice it to say that the micro evidence here is consistent with a number of characteristics of Chinese economic growth: its heavy and growing reliance on fixed asset investments, a contraction of rural consumption in the 1990s, low domestic value-added, and so forth. The final section concludes with some broad conjectures.

Financing Biases in the Chinese Economy

China has a huge banking sector, as measured by the ratio of banking assets to GDP. But this huge banking sector has provided very few resources to China's domestic private sector. A number of indicators illustrate this point. One is that cross-country survey evidence suggests that domestic private firms in China are among the most financially constrained in the world. In fact, at least one form of a socialist solidarity seems to be alive and well: The level of financing constraints in China is comparable to the level of financing constraints among transitional European economies (such as Ukraine and Russia) and is far higher than the level of financing constraints existing in the established capitalist economies such as Malaysia, Thailand, and India. Many observers have compared China's growth with that of East Asia. In this particular aspect (and in many other aspects as well), China is not an East Asian economy; it is a socialist economy. A further finding is that India, which is often thought of as a laggard compared with China, appears to have a financial system far more supportive of the entrepreneurial private sector.

The second aspect of our finding is that the level of financing constraints got worse in the 1990s over the level prevailing in the 1980s. Many Western economists believe that the decade of the 1990s represented a golden era of the Chinese economy. They hold such a view only because they know nothing about the Chinese economy other than in the 1990s. The true golden era of the Chinese economy was in the 1980s when the economy grew very fast, the ratio of consumption to GDP was rising, poverty declined sharply, social performance improved along with economic performance, the urban bias inherent in a socialist economy got attenuated, and China made gradual political reforms toward "socialism with a humane face." Most remarkably, all of this happened when some of China's most conservative leaders were alive.

Many of these productive policies were reversed in the 1990s. Urban bias came back with a vengeance; the absolute number of people living under poverty in fact increased since 1999; the ratio of consumption to GDP fell, giving an investment/GDP ratio of 0.50 in 2004 (the highest ever in the history of the People's Republic of China and maybe highest ever in the world during peace time); and, according to the current governor of China's central bank, 90 percent of China's nonperforming loans occurred in the 1990s. I write about these broad topics elsewhere. In this article, I focus on one dimension: financing constraints on domestic private-sector firms increased in the 1990s over the level prevailing in the 1980s.

Cross-Country Survey Evidence: WBES

The World Bank designed and implemented the World Business Environment Survey (WBES) in 1999-2000. The survey was carried out in 81...