does china’s financial sector jeopardize economic growth? · 2009-04-17 · does that inhibit...

CARNEGIE ENDOWMENT FOR INTERNATIONAL PEACE

DOES CHINA’S FINANCIAL SECTOR JEOPARDIZE ECONOMIC GROWTH?

WELCOME: URI DADUSH,

DIRECTOR, INTERNATIONAL ECONOMICS PROGRAM, CARNEGIE ENDOWMENT

MODERATOR:

JAMES A. LEACH, JOHN L. WEINBERG VISITING PROFESSOR,

WOODROW WILSON SCHOOL, PRINCETON UNIVERSITY

SPEAKERS: ALBERT KEIDEL,

SENIOR ASSOCIATE, CHINA PROGRAM, CARNEGIE ENDOWMENT

NICHOLAS LARDY, SENIOR FELLOW,

PETERSON INSTITUTE

PAUL SAULSKI, SENIOR COUNSEL, OFFICE OF INTERNATIONAL AFFAIRS,

U.S. SECURITIES AND EXCHANGE COMMISSION

WEDNESDAY, APRIL 15, 2009

Transcript by

Federal News Service Washington, D.C.

Transcript Not Checked Against Delivery

URI DADUSH: Good afternoon, ladies and gentlemen. I’m Uri Dadush, director of Carnegie’s new International Economics Program, standing in for Jessica Mathews today, who is traveling in the Middle East. I would first of all like to welcome all of you and say it’s a great pleasure to have you with us. Thank you for coming. It would be nice to ask you to turn off your cell phones, if you possibly could, so that we can have an uninterrupted session today.

First I would like to say thank you to our corporate sponsor, the GE Foundation, for its very

generous financial support for the debate series that we’re part of today. And I would also like to thank Senator Casey for making this space available to us.

This is actually the ninth debate in the Carnegie series, “Reforming China Policy.” The

purpose of the series is to propose fresh thinking on the most critical and controversial issues involving China’s economic, political, social, military evolution and the policy implications thereof. And so our aim today is to have a debate, a spirited and open and well-informed debate, we hope. Previous topics in the series have been the future of Communist Party rule, China’s rapid economic growth, its military modernization, human rights, and the U.S. policy towards Japan. All of this – towards Taiwan. All of this can be seen on the Carnegie Endowment Web page where you have the transcripts or you can listen to the debates.

The theme of our debate today is economic, and we will be discussing specifically whether

China’s financial sector can in fact support long-term growth – continue to support long-term growth without substantial and accelerated reforms. And our panel has been asked to address four questions: on the repressed nature of China’s financial system, on the reform progress China’s securities market, on the high retained earnings in China’s corporations, and on capital accountability and exchange rate reforms. And on all of these issues the question is whether in fact the current structure supports long-term development.

So, to help navigate this important subject we have three experts that are presenting

contrasting views, and very credible views nevertheless. You have their bios. I’ll just mention their names: Albert Keidel, who is with the Carnegie Endowment; Nick Lardy, who is with the Peterson Institute; and Paul Saulski, who is senior counsel in the Office of International Affairs at the U.S. Securities and Exchange Commission.

And so, without further ado, I’m going to turn this session over to our moderator, the

Honorable James Leach, who of course is a 30-year congressional veteran, now a visiting professor of public and international affairs at the Woodrow Wilson School, Princeton University. And let me just say that you will find all of the detailed bios for our four speakers in the program. Again, thank you for coming. Mr. Leach?

JAMES LEACH: Thank you very much, Uri. And I’ll be very brief. As an economic

subject, we’re going to be talking about the efficiency or inefficiency of the system, the prudential or imprudential nature of the system in China, and in so doing I want to make it very clear that as someone from a Capitol Hill perspective that has been in many discussions of this nature and other natures with regard to China, this is not a period in which the United States of America is in a very good position to be preaching anything to anybody, and so we’re a panel that is designed to be making comments and hoping as well that any other country in the world, as well as our own citizens, can look at events here and make some conclusions in what we can do better and what they might be able to do better.


Our three panelists are extraordinarily distinguished. This is called a debate series. It isn’t

quite that. It is mainly a series in which extremely thoughtful people with somewhat differing perspectives will present these differing perspectives. I’m going to suggest that we – I want the panelists to know, if they ever want to abbreviate what they’re saying, because we’re going to do the equivalent of a minutes of this to be potentially published, that we can accept a little bit of a congressional privilege of revising and extending to modest degrees, and that that will be possible at the end of this set of hearings.

The format is that we’re going to have opening remarks of five to 10 minutes, and then

we’re going to have audience queries, and then we’ll have closing remarks of maybe three to five minutes. And with that as the framework and format, let me begin with our first speaker and we’re going to go left to right of the podium, conclude right to left. And so we will begin with Bert Keidel. Bert, please.

ALBERT KEIDEL: Thank you very much, Professor Leach, and it’s a privilege to be here.

I also want to thank Senator Casey of Pennsylvania for making this room available and for supporting us so much in getting ready for this debate, and also to the GE Foundation.

What are the U.S. policy issues here? Just let me state quickly they seem to be how much

pressure should the United States put on China to accelerate reform and liberalization of its financial sector? Is China’s failure to fully open up to foreign ownership in its domestic financial sector part of a subtle protectionist system requiring U.S. countervailing legal actions and other steps? Or is the pace of China’s reforms, as it has been going forward, necessary and prudent and in the best interests of the United States in that we also would like to see a strong and growing China to help share with us responsibilities in this increasingly complex world.

I will argue today that the pace of China’s financial sector reforms and the liberalizing steps

it has been taking and plans to take have been appropriate and prudent for a country at China’s relatively low per-capita GDP level of economic development. What is the desirable pace of financial development for a poor country anyway? The international advice on this is in a way contradictory. It will say you can’t build a financial sector on a bed of sand. You need good accounting, good regulatory systems, good court systems, trained professionals, but then they go right ahead and recommend a first-class financial system, and that it be built on a bed of sand. Financial sophistication is deep in a country where it works. You need corporate internal checks, bank oversight, client business, bank internal checks. Other financial institutions need their own internal checks for prudence. You need government regulatory sophistication and independent capacity, especially in developing and emerging economies where powerful vested interests would seek to weaken such oversight.

Acquiring these capabilities requires time and overall economic sophistication, and without

them you have a bed of sand. So the United States should not be pushing China to imprudently rapidly expand poorly supported practices built on such beds of sand. This conclusion is based on some fundamental principles of economics. There is the theorem of the second best from the 1950s that says, if you don’t have perfect market conditions, just following market rules can send you completely in the wrong direction. And we have Friedrich List, a German-American economist of the early 19th century, who was a hero of Japanese economists in an earlier era and now of Chinese


economists, for emphasizing the important role of the state in managing economic development, especially rapid economic development.

Let’s review the dimensions quickly of this debate. Is China’s financial sector repressed and

does that inhibit growth? My answer is that China’s financial sector is partially repressed and partially repressed in a usefully designed way. Many institutions and their practices have powerful, competitive, profit-oriented goals in the midst of significant competition. At the same time, government’s role in China is powerful for ensuring that sufficient funds for essential large-scale public investments – investments private firms won’t make – those funds are the main reason that China – the need for those funds is the main reason that China has this partial repression of its financial system.

The repressed dimensions of its banking sector involve interest rates set by administrative

methods, targeted loans, commercial banks either directly lending for infrastructure or other key public programs, or lending the money through purchases of bonds to the state development bank or other agencies who then on-lend and monitor the use in public investments, so that competition doesn’t determine the interest rate and pure search for profit and rate of return doesn’t determine the distribution or the structure of investment in public services. So financial repression keeps interest rates low in two of China’s three economic dimensions.

China has a system of directing credit from deposit institutions to key projects. That’s the

repressed dimension. It has a competitive financial system that is immature but rapidly developing and is building the supporting institutions to make it increasingly effective in a market-based sense. And it also has by far the most important dimension of its financial sector in terms of volume: a system for reinvesting retained earnings that is highly competitive, in which firms find the most appropriate ways to use their money with an eye to making a profit. So even though the repressed interest rate is low, actual interest rates are very high. China doesn’t have too many people, it has too little capital, and that capital is very productive and profitable.

These public investments are financed through this repressed system; if well-designed, help

fulfill Adam Smith’s requirement for an efficient economy of expanding the scale of the market as a way to provide opportunities and alternatives for the private sector. And, yes, it’s a tax system, but governments tax their people. In the discipline of public finance the question is, how do you design that taxation? And the answer is, in ways that don’t disrupt incentives for productivity gain and, if they can, accentuate incentives for private gain. Well, those Chinese that just want to park their money passively in a bank, according to China’s tax system through this repressed financial system, they don’t deserve much. They are not taking any risks. They are not expending the effort to see whether their investment is in fact productive or not, and therefore China is taxing them by not paying them a very high rate of return, if any at all, and channeling that money where the public authorities think it can most contribute to growth.

So my conclusion is that China’s degree of financial repression and the skillful channeling of

lower-cost financing to critical public investments is probably the single most important reason for China’s sustained economic growth success in the past 30 years and will remain very important for a decade or more going into the future.

What about China’s restrictions on stock and bond markets? Here China has had a mixed

and troubled history in securities markets. They have blown up in their face. At the local level


they’ve required the central government to come in and make them good. The transparency of firms, whether they’re private firms or state-controlled firms, is poor. The accounting systems have serious irregularities. And, in my view, China will continue to fluctuate its implementation of bond and stock market expansion in ways that it has in the past: try it, expand it like it is now, find out where it’s blowing up, pull back, fix the charters, fix the regulations, and then go again. That will be the pattern we’ll see and I think it’s appropriate and prudent and they would be making a mistake to accelerate that liberalization in a dramatic way.

What about the use of their retained earnings? Here I argue quite strongly that the retained

earnings and their allocation within the Chinese economy is probably the most efficient from a market-based perspective that they can achieve. The interest rate may be low at the banks, but for firms looking where to invest their money, the cost of capital is where else they might invest it. The opportunity cost of that money is what determines where they allocate their retained earnings, and that includes depreciation funds because this is gross domestic product – not just profits but profits plus depreciation, which is a large sum. The real test is whether that extra investment adds to extra GDP, and in China’s case, that extra output for extra GDP called the incremental capital output ratio is as good as India’s and sometimes better, looking at five-year, 10-year and 15-year periods.

So then you might say, but China has too high an investment rate; they ought to distribute

these funds. There is no economic law that says a country should keep its investment share of GDP below 40 percent. The real question is, can they raise it above 40 percent and still keep it productive? And if you can, that’s the fastest way to increase consumption as well, because consumption share in GDP will remain fairly constant if you have a constant share of investment, even at a very high level, and it will expand very rapidly.

Should China move to open its capital account? This is our fourth topic. And should it

allow its exchange rate to be determined on a market basis? These are two separate but interrelated questions. Does it really make sense to determine your exchange rate through the markets if you don’t have an open capital account? It’s an imperfect market. Supply and demand are incomplete. Uncertainties also can inhibit trade. China hasn’t yet developed the advantages of hedge funds and other ways of making sure that your exchange transactions are coming in at the price that you need down the line.

What has turned into a discussion about the efficiency of China’s exchange rate is, is the

currency undervalued? And here economists don’t like to talk about that, but many point to China’s current account surplus and say that’s proof that China’s currency is undervalued and therefore markets should force it up. But I would point to the enormous increase in liquidity in the United States that’s the result of liberalization of our financial systems since the early 1990s that has resulted in expansion of purchasing power far and above what it would be without those new financial instruments.

My concluding remark is, therefore, that China should not open its capital account any faster

than it already is. It’s doing it in a stepwise basis. And its exchange rate is not responsible for the large current account imbalances. Other huge forces that are swinging back and forth are, and China’s financial sector pace of reforms is appropriate, and especially for such a low per-capita GDP country, and it would be a mistake for China to try to accelerate that already impressive pace of financial sector reform and liberalization. Thank you.


MR. LEACH: Thank you, Bert. Nick Lardy. NICHOLAS LARDY: Well, I would like to thank Carnegie for inviting me to participate in

this debate and I look forward to the give and take among ourselves and then later with the audience as well.

I do have a different point of view. I am of the view that financial repression in China, it

may not jeopardize China’s rapid economic growth, but I do think it distorts the character of the growth, and the consequences of this are quite adverse, both for China and for the rest of the world. And let me just lay out why I say that. As Bert has already acknowledged, the real interest rate that firms pay to borrow is relatively low. Indeed, in most of last year it was highly negative. That is, the real rate of inflation for manufactured goods was higher than the interest rate that borrowers were paying from the banking system, and that has generally been true. The real interest rate has been declining over most of this decade, and that means that the borrowing costs for firms have gone down. It has led to a massive increase in the share of output going to profits in China over that period, and a concomitant reduction, obviously, in the share of output that’s going to wages.

So owners of capital are doing extremely well in this distorted interest rate environment and

wage earners are not doing so well. Wage earners are not only losing because of the share of output going to capital is going up, they’re also losing because the interest that they receive on their deposits is, as Bert has already again acknowledged, is extremely low, and indeed, in most of last year, for example, it was actually negative.

So the result is that the growth of household income is below the path that would be

achieved in a less-repressed financial environment. Interest income, part of what the Chinese refer to as property income in their accounting of this, is much less than it would be in a more liberalized financial environment. Indeed, although household savings as a share of GDP have roughly doubled over this decade, or since roughly 2002, the interest income that households receive from these savings has actually declined by about 60 percent because the real interest rate has been going down.

So household income is much less than it would be as a result of financial repression, and

since the motivation for household savings is primarily precautionary, that decline in the real interest earnings leads to a further increase in the household savings rate, and thus China has the lowest share of consumption of GDP of any country ever in the world in peacetime. The household share of consumption is about 38 percent – or, no, about 35 percent now – 35-point-something percent of GDP.

Then – again going back to the borrowing side – the very low cost of capital has tilted

investment in China overall into the manufacturing sector. Over the last five to six years, the share of investment going to manufacturing has roughly doubled, and the share of investment going into the services sector has declined significantly. And the reason is very straightforward: The manufacturing sector is much more capital intensive, so a subsidy is much more beneficial. An interest-rate subsidy, in effect, is much more beneficial for the manufacturing sector than it is for the services sector.

Now, these manufacturing industries are also the most energy-intensive, and thus they have

pushed China to become the largest emitter of greenhouse gas, sulfur dioxide, and all the other


contaminants that we’re worried about, obviously with very dramatic adverse results for the world. And domestically – and this is one of the reasons I said this pattern is not so desirable from the point of view of China – domestically this has slowed the pace of job creation in China over the last decade, compared to the earlier period since reform began in 1978. China’s services sector has stagnated as a share of GDP in the last decade as compared to the 1980s and 1990s when the service share of GDP doubled and job growth was much more rapid.

So, in short, I would say China’s growth has been very rapid, but the distortion of interest

rates, which is caused by central bank controls, on the interest rate structure, this kind of financial repression has meant that the growth that China has achieved has been relatively costly, as measured by depressing wages in order to boost the return to capital, depressing consumption in order to boost the share of output going to investment, diminishing the pace of job creation, and heightening China’s contribution to global emissions and global warming. So this pattern I don’t think is in China’s long-term interest and it’s certainly not in the long-term interests of the world.

China – yes, China is a low-income country, but I believe it would be possible to finance the

public sector investments – which I admit are very important – with alternative mechanisms that would be much less distorting. Only about one-fifth of all of the lending from China’s banking system, for example, in recent years has gone to infrastructure investment. So there could be mechanisms where you provide some kind of reduced interest rate for lending for that purpose rather than having a distortion of the entire interest rate structure, which encourages over-investment, increase in the return to capital, and depresses personal income and consumption.

I do believe China made a big mistake. It quit liberalizing its interest rate. They were on a

very orderly path of interest rate liberalization and then in the fall of 2004 they stopped. I do take some encouragement from the fact that Wen Jiabao, in his report to the National People’s Congress last month, said that we need to return – or to resume market-based reform of interest rates. So it’s coming back on to the agenda and I very much hope that China will move to reduce the – or eventually eliminate distortion in the financial sector. I think it will be good for maintaining more balanced growth in China and I think it will be good for the global economy as well.

MR. LEACH: Thank you very much. Now Paul Saulski. PAUL SAULSKI: Thank you. Well, first let me express what an honor it is to be invited by

the Carnegie Endowment to participate in this very important debate series, and also what a pleasure it is to have the opportunity to share the podium with Bert and Nick, two men whom I’ve greatly admired and whose research and scholarship has influenced my own work tremendously.

And, finally, before I begin my remarks, or my portion of the discussion, I have to give the

standard disclaimer that my views, or the views that I express here today are my own and not those of the Securities and Exchange Commission, any individual commissioner, or any of my fellow SEC staff members.

Well, the question that is presented today is, does China’s financial sector jeopardize

economic growth? Well, where do I come down on this? Professor Leach mentioned that we all come from different perspectives and we’ll have different kind of points of view on this, and you’ll probably see that in my kind of opinion because I’m focused – I’m coming at it from the point of


view of a regulator, someone who has spent a lot of time in China working with the regulators there in helping to develop the institutions for the efficient capital markets.

So, with that, where do I come down on this question? And after spending considerable

time, I think I have the authoritative view to state a definite maybe. (Laughter.) Well, I realize that you probably were looking for something a little bit more definitive but, you know, my equivocation is I think not due to a lack of knowledge or some lack of courage to take a definitive stance, but instead my prevarication is because I think the final answer will be determined by the future actions of the Chinese government, which of course I cannot predict. Specifically, I think the answer will depend on whether the Chinese government will continue and accelerate the pace of reform in the financial system that we have witnessed over the past couple of years, and in particular the development of the institutions that are going to be needed for a truly efficient capital market.

As I see it, the current state of the Chinese financial system – and that is one that is

characterized by financial repression and is overwhelmingly dominated by the banking sector – although it is capable of supporting continued growth over the short term and most likely into the mid term, is not sufficient to sustain the needed growth into the long term. If China is to continue to grow in the long term, it will inevitably need to shift from the growth-focused, state-led industrial policy model to an economic system that increasingly relies on market forces to determine allocation of capital to worthy investment projects, for it is only through efficient allocation of China’s scarce capital resources that it will hope to sustain the growth that it needs in the foreseeable future and in the long term.

I mean, I think we can discuss this in the question and answer period, on where I come down on this with Bert’s idea of the second-best model and the need to have more government intervention. And basically I’m coming down on the view that that is probably true to a point but there is a time period when all of these economies that use this development model are going to have to make that transition to the market economy or more market-based economy, and China needs to develop those institutions now and needs to start focusing on developing institutions so that transition will be smooth and seamless and not be – I mean, we won’t see some sort of wrenching change as seems to be the case in most rapidly developing economies.

Now, I believe the Chinese government has acknowledged as such, and since 2003 have

made several public announcements signifying their need to broaden the financial sector, and over the past few years China has been very successful at implementing some essential reforms to the financial markets and strengthening those institutions that underlie an efficient capital market. Now, I won’t go into detail on these reforms. Hopefully some of you have read some literature on this, particularly Bert’s and Nick’s, but there’s obviously been significant improvement in the banking sector and improvement, what I think is most significant, related to the safety and soundness of prudential regulation of the banking sector, improved capital adequacy requirements that are risk-weighted and that are closer to the international standards.

In the securities sector, in 2007 the Chinese government passed a new securities law which

basically overcame many of the problems and failings of the earlier version, most particularly in providing the Chinese Securities Regulatory Commission the authority and powers to crack down on the pervasive problems of insider trading, market manipulation, and abuse of customers that we see in the securities markets in China.


As for the bond markets, this has been a persistent complaint that the bond – the corporate bond markets have not – have been anemic and have not been able to develop into a secondary source for raising capital, but over the last couple of years we’ve seen some important improvements there, particularly the shifting of the approval process for medium- and long-term corporate bonds from the National Development and Reform Commission to the China Securities Regulatory Commission. Now, they of course have much more experience in reviewing and judging the quality of financial reports and issuance of securities by corporations, and I expect this will have an important impact on deepening and expanding the corporate debt market in China.

So these are all just a couple of – these are just examples of the increasing development and

implementation in China of what I call the institutional infrastructure that’s necessary for truly efficient and competitive financial markets, but of course despite these, China is faced by a number of – the Chinese financial system is faced by a number of obstacles and inefficiencies. We’ve already talked about the predominance of the banking sector and the fact that the vast majority of the loans coming out of those banks go to state-owned enterprises, or at best the most well-connected and largest private firms. The bond market still is anemic despite the improvements that I mentioned.

The securities market, the stock market, is policy driven. What do I mean by that? The

Chinese securities – well, Chinese investors focus on what the government is going to do, what interventions they may have, and not the quality of the stocks or the securities and their future prospects, and so those are all problems. And so for this reason it’s still very difficult for small and medium-sized firms, entrepreneurs, to raise capital in China, and this is unfortunate because, in my view, when that transition from the state-led growth model is going to happen, what China needs to do to continue its long-term growth is to focus more on that entrepreneurial sector, the private industries, for its continued growth in developing new industries, innovation, et cetera.

So, to sum up, in my view China, like – well, it’s no doubt that the current state of China’s

financial system is capable of supporting continued growth over the short term and likely into the mid-term. However, to ensure that its financial system does not jeopardize the long-term prospects for growth, China must build the legal, regulatory and institutional infrastructure that is necessary to support the efficient financial system in a multi-tiered, competitive capital market. The question is whether the Chinese government will continue and accelerate these reforms. Thank you.

MR. LEACH: Well, thank you very much. What we are going to do now is Michael Swaine

is going to circulate – and this is Michael. Would you raise your hand? Turn around? MICHAEL SWAINE: Oh, they have cards already. MR. LEACH: And we’ll collect cards for any questions. While that is occurring I will begin

with the first and then turn it over to all of yours. And, listening to all three people at this panel, I’m struck – if someone is sitting and looking at China and the United States this last year, they might be asking who should be lecturing whom. (Laughter.) And the Chinese – it strikes me there’s some differences in our societies, and let me just go down real quickly.

The Chinese have too much savings and too little benefit going to workers. The United

States has too little savings and too much benefit going to higher income. The commonality is it looks like the worker is not doing as well as they should be in either society. The non-commonality is that we have a savings versus non-saving culture. From a regulatory perspective it’s my very


strong view that the United States has the most sophisticated financial institution regulatory system ever devised, and in the last year we’ve exercised as poor judgment as could conceivably be engendered. China has had a very unsophisticated system that is getting more sophisticated, but arguably not as bad judgment. And it is definitively improving while the United States has somewhat failed.

Here in our country, very smart people have been buying credit default swaps. In China

they’ve been buying United States government bonds. The Chinese worry about this, but if you look at all instruments in the world, it’s United States government bonds that have, relatively speaking, done the best. And so I return and asked this panel, who should be lecturing whom?

(Laughter.) MR. SAULSKI: I’m a bit remiss to really get into this. I’ve already put out the disclaimer

that of course these are my own views. And then obviously there is plenty of room for finger-pointing or at least inward-looking here in the U.S. at the failings of our own system, particularly over the last few years. Though when I am in China, as well as other emerging markets, providing technical assistance, which is training to emerging market regulators, we try to go there as humbly as we can and we generally start off our discussions by stating that we are not perfect and we don’t have all the answers. However, generally we have made the mistakes already and we are able to then tell you what mistakes we’ve made and how to avoid them as you try to reach our level of prosperity.

And so I think, in a sense, the current situation that we’re experiencing might actually help

us to better understand the role of markets, the role of sound regulation to be able to, again – because we’ve been there already – to, in if not lecturing, to advise or to have, I think, informative discussions with the Chinese.

MR. LEACH: Yes, go ahead, Nick. MR. LARDY: Well, at meetings in the Treasury, on quite a number of occasions over the

last three to four years, I have advised very strongly against going to China and arguing that they should open up their financial market, allow more foreign financial institutions to play a larger role so they can introduce, quote, unquote, “more sophisticated” financial products that would help China do everything even better.

So I think maybe Bert and I have the same view on this. I don’t – that’s not the kind of

financial liberalization I think China needs at this point. And one of my arguments has been, and my belief continues to be, that China has been very well served by not having securitized products, not allowing derivative products, and so forth. And, furthermore, you can’t even think of introducing all those products in a basic environment where basic interest rates are not set by supply and demand, where you don’t have a market-determined interest rate structure. And so I have argued strongly that the most important thing China needs to do is resume the interest rate liberalization that they began almost 10 years ago and then stopped after October, 2004.

And so I would not lecture them, and advise against lecturing them, about allowing United

States investment banks and other financial institutions to play a bigger role, but I wouldn’t mind offering the advice that I think it’s a big mistake to have a completely government-determined interest rate structure for the entire financial system.


MR. KEIDEL: Well, Nick and I have backed each other up in those meetings at Treasury in

not going to Beijing and lecturing them on liberalization and opening up. That’s true. I think, in answer to your question, the Chinese decisions are the right decisions for China

and have been in facing this – they’re not the right decisions for the United States. We’re so much more sophisticated and so much more advanced that we, as Nick says and Paul has said, the lessons we’re learning now they’re going to look back 10 or 15 or 20 years from now and say, well, how did they solve those problems? What did they need – what did they put in place not to meet – run into the same problems that we are now looking at or worried about?

So I think that interest rate liberalization is the kind of thing that if it’s done quickly

completely undermines this other channel of finance, and infrastructure, in a formal sense, transport and ports and telecommunications, water, urban infrastructure, those are a significant share of Chinese investment but not as large as you might think. But the Chinese, and also Friedrich List and others, would say that public investments for a rapidly growing economy go beyond just those.

You need strategic investments because the market is myopic. The market only sees a

certain distance down the road, and if you’re a catch-up economy with a 3 (thousand dollar) or 2 (thousand dollar) or 4 (thousand dollar) or $5,000 per capita GDP in a country where the United States and Japan has $40,000 per capita – South Korea, the province of Taiwan and others are at high teens, approaching 20,000, there’s a lot you can learn and implement in a big hurry just by doing it, sort of an Army Corps of Engineer approach to rapid growth. And there, the myopia of the market and the potential for good leadership – and this is where a lot of developing countries fail – the potential for good leadership, to use these funds well, overrules the need for liberalization of the financial sector and the interest rate.

MR. LEACH: Good. I’m going to turn to the questions, but first I have to very briefly

answer the question I gave. I think the Chinese would be extremely wise to look at the model of America’s community banks, regulated by state regulators, and look at the sophistication of the SEC and learn from its disastrous mistakes of the last several years, as well as that of the Fed and the Treasury. But the community banking model, where very few banks bought derivatives products because they, A, didn’t understand their relevance, and, B, didn’t understand them themselves, has served China rather well.

Anyway, the next question comes from the audience: How will the current crisis affect PRC

financial liberalization? MR. SAULSKI: Starting with me? Well, first, actually, if you don’t mind, I would like to

give kind of a follow-up to my response from the last one because I just – I would hate for there to be a misconception about the SEC’s role in our technical assistance program overseas, as well as it would possibly, you know, misconstrue my basic point that I’m trying to make, is that the – it’s true, the Treasury has a very aggressive kind of stance when they go to China, trying to basically get access for the U.S. industry players, the large banks, investment advisors, et cetera. That is not what the SEC does when it goes there. In fact, we do everything we can to have the appearance that we are somehow promoting the industry here. We are the regulators and we have no – we don’t want any skin in that game.


My personal opinion is basically the same as Nick’s and Bert’s, that they are not sophisticated at – you know, the markets are not developed enough for these foreign players to come in, and that is why we are there, basically trying to develop that basic infrastructure, basic supervision abilities, basic enforcement investigations, safety and soundness regulations.

So what does the current crisis teach? I think it pretty much follows up on what we’ve been

already discussing. It’s the importance of sound, good regulation. There is this kind of misunderstanding between this idea of regulation and deregulation that has been bandied about a lot. But it’s not a question of no regulation or deregulation but proper and sound regulation. I think our current crisis will be very informative in helping both the U.S. to understand and come to grips on what is the needed regulation for an advanced, complex global financial system, or for firms dealing in that system, as well as for China as it increasingly moves along that path.

MR. LARDY: Well, I think the current crisis reinforces China’s view, which we’ve seen over

recent years, of not wanting to go in the direction of much, much more sophisticated financial products. I think they feel that what is sometimes called the utility model of banking, which I think is very similar to the kind of community based banking, can serve them fairly well. That means you have banks that operate with capital – you know, a balance sheet that is maybe 10 or 12 times their capital, not 25, 30, 35 or 40 times their capital, as was very widespread in the U.S. all the way through 2007. So I don’t – I think they want to stay with fairly deleveraged institutions.

So I think the lesson they’re drawing from the crisis is to reinforce their prior belief that they

would not be well served by introducing a range of products that has led to the problems that we have in the United States.

MR. KEIDEL: I think it’s interesting that in China’s stimulus program for overcoming the

current crisis, they are throwing a lot of money in a lot of directions, and I think we’re in the midst of probably one of the greatest experimentation periods in terms of expanding the freedom with which various institutions can use that money, so that they will end up finding out where it goes bad and pull back again from those lessons and improve the regulatory system, improve the charters of the institutions that they’re overseeing. The money is going to local governments in a big way. Local governments are being allowed to sell bonds, which has just always been so problematic in the past because they end up not honoring them. There is a lot more going into SMEs – small and medium-sized enterprises – and the banks are being encouraged to lend in this direction. Whether that turns out well or not we’ll see.

So I think this crisis and the need to push so much money into the Chinese economy – and

if my calculations are correct, the new lending in the first three quarters of this year over and above new lending last year. The increase in new lending over the same variable last year approaches 8 percent of GDP. I mean, it’s just a huge amount of money. And if that then gets leveraged and spread around and starts to grow, we’ll quickly see which institutions used it badly and which used it well.

So, on the point of also in the longer term and the medium term, they will look back and see,

but I think it’s an open question about when we say they will transition to a modern financial system, what that modern financial system should ideally look like, because we’re learning now that our modern financial system has a lot of flaws and what is the appropriate role of state in influencing where the money goes, how it gets distributed, including for public purposes, because


one of the complaints has been that our own program for supporting infrastructure and so forth has been inadequate. So I think this crisis will inform that future target for China as well as for us.

MR. LEACH: Thank you. The next question is: This week, possibly today, the Treasury

Department will release their currency report, which may label China as having misaligned and manipulated its currency. Does the panel believe such a statement from the administration will effect changes in the financial sector policy of China, and if so, how?

MR. SAULSKI: I’m almost going to pass on that – (laughter) – but I think that would be

counterproductive to label China as the manipulator, so I’ll just leave it at that. MR. KEIDEL: I think the easy answer is it won’t influence the Chinese, no. The issue is

how do you satisfy perceptions in the United States that China is a cheater in its trade with foreign countries through its exchange rate mechanism? And so I would look – and I was on the Web site at about 1:00, just before I stepped in a cab to come here, to see whether that report had come out yet or not. And, you know, it’s been late so many years – so many times in the last couple of years so as not to jinx upcoming strategic economic dialogue meetings that this one could easily be delayed, and that might be a smart thing to do. A young administration here, let it get its feet under it.

But I think the idea that China’s exchange rate is the cause of the global problems we’re

facing now, which is the long chain of causality that has appeared in a number of op-ed page pieces, that China has manipulated the exchange rate and therefore there has been an imbalance there, and therefore they’ve got all this money and then they put it back in the world economy and it has sloshed around and caused interest rates to be low, which caused people to buy mortgages that they didn’t need, which caused the crisis, that – I think we need to back away from that whole emphasis on the Chinese exchange rate.

MR. LARDY: Well, I’d be astounded if China is named a manipulator this time around, and

I say that obviously because we’re in the midst of a financial crisis. China has an expansionary fiscal stimulus program that, among emerging markets, is what I have been saying for some months, is the gold standard. No one – at least according to the way the IMF measures it, no other emerging market economy comes close to having a stimulus program the size that China does relative to the size of its economy, and since a major goal of the United States has been to encourage kind of coordinated stimulus, it would probably not serve us very well to go after them on the currency issue at this point.

Secondly, I think it is worth noting, on the exchange rate itself, if you look cumulatively at

what China has done since July 21st, 2005 when they moved to a somewhat different exchange rate system, depending on which index you use, the cumulative appreciation of the currency is somewhere between about 20 and 24 percent, which is now getting into the significant range. But the most important thing is that about half this appreciation has occurred in the last year. In other words, the pace of appreciation has accelerated dramatically over the last year to 15 months compared to what it was in the first two-and-a-half years of their so-called new system.

So I am firmly of the believe that they currency remains undervalued. I think on any

commonsense definition they are manipulating their currency. No other country in the world has ever bought up $1.9 trillion worth of reserves. No other country in the world of any significant size


has ever run a current account surplus greater than 10 percent two years in a row. So, on any commonsense definition they’re a manipulator, but I would not charge them with that at this point in time.

MR. KEIDEL: I would just like to ask you, Nick, what effect on Chinese balance of

payments do you think the extraordinary leveraging of American purchasing power has had on their balance of payments and on the export of, in some ways of thinking, American potential inflation to China, requiring them to try to slow down their economy in 2004 from the overheating that it was experiencing at that time? So that this isn’t just sort of a normal game in which someone has sort of gouged somebody, but the enormous purchasing pressures from the United States that show up also around the world make it less likely in my mind – I don’t know what you think – that this is a supply-driven issue where China has really produced too much and under-priced it. The other phenomena in the world economy makes me wonder about that.

MR. LARDY: Well, I mean, obviously if some country has a gigantic surplus, someone has

got to have a deficit, and we’ve had the deficit but I think there’s plenty of blame to go around. I think China’s currency has been undervalued. I think our financial sector has been misregulated in a way that allowed people to spend more than their incomes year after year after year, and I don’t – you know, it may have been good while it lasted. Lots of people had fancy cars and went on nice vacations and so forth and so on, but whether or not that improved our welfare in the long run now that we’ve wiped out 20 percent of the wealth of the household sector in the last 18 months I think is not a proposition I would care to defend.

MR. LEACH: Let me go to another question here. I’ll read it precisely. “The heretofore

conventional wisdom, namely that China exerts more economic leverage over the U.S. than the other way around, appears to be shifting. What is your assessment? Do current macroeconomic and financial trends suggest that the Sino-American economic relationship will more or less stay as is, or that it will change appreciably in years to come?”

MR. LARDY: Well, I think it will change. I think it is already changing, and it’s changing

because the household savings rate in the United States is going up, either because of households that have decided that since their net wealth has declined they need to save more, or people who haven’t come to that conclusion but have found out their bankers won’t lend them anymore money. So the savings rate has gone from, you know, slightly negative to up to in the neighborhood of 4 or 5 percent, and we are going to have a much smaller current account deficit this year than we did last year. Indeed our current account deficit peaked in 2006 and has been coming down.

So we’re not going to be in the – I don’t think we’re going to resume the pattern of earlier

periods, and I think, similarly, China’s own current account surplus certainly is going to plateau this year and perhaps even shrink, given the decline global growth, and I think China will remain relatively strong in its growth, certainly will remain far and away the most rapidly growing economy. So I think they will begin to pull in more imports relative to their export growth as we move through the year, and I think their external surplus will ameliorate or diminish this year as compared to last year, particularly the year before.

So it won’t – the degree of imbalance, the global imbalance is, I think, in a period of

reduction, so we’re heading in a different – toward a different pattern than we have been in over the last five years.


MR. KEIDEL: I would supplement those remarks by saying that China’s economy is still

four-something-trillion dollars and the American economy is still 14 trillion (dollars), and the OECD is 30-some-trillion dollars, so that China can’t really have a great deal of leverage over the U.S. economy or the world economy with that small an economy.

I think also that the idea that the savings mismatch is what’s responsible for the current

account imbalance – the savings linked to current account imbalances is an identity – it’s an accounting identity, which, the way the causality flows, takes a much deeper kind of analysis, and it – if the Chinese savings appears to be introducing a lot of money into the world economy as savings and investment, you could make it for two reasons. One is that their savings is very large, or that their investment suddenly wasn’t as big as their savings pool. And what did happen in 2004 or ‘5 when their current account surplus began to increase – in other words, their savings going to the rest of the world, it was not that their exports began to accelerate their growth bur rather imports slowed down and capital investment slowed dramatically because they were fighting inflation in 2004, 2005.

So the causal reasons behind what is an accounting identity, a current account balance and

external savings, that accounting identity says nothing about causality but it’s quite popular these days to assume that the savings is what’s driving it all. And I would caution us to take a close look at the enormous spending that is demand driven, coming out of the United States, that is overheating economies like China who, when they try to cool it off, it also affects their balance of payments.

MR. SAULSKI: I would only add that, you know, it’s obvious that over the past number of

years China has really emerged as an economic world power and will continue to, and so the U.S. will have to take into account China’s new position in the world when we make our decisions related to economics and world affairs. But as Bert says, the U.S. is still vastly larger by GDP scale than China, and I don’t believe we’re going to be kind of manipulated or our policy will be driven by China.

MR. LEACH: Next question: The Chinese seem to be concerned about the stability of the

United States dollar. Could you please discuss China’s rationale for a universal currency? Is this political or is this an economically realistic prospect?

MR. KEIDEL: All right. I think they’re making the appearance of being concerned about

the stability of the U.S. dollar, largely for domestic political reasons. There are criticisms in China that their foreign exchange reserves have been handled badly. The evidence for that on the credible side is that they did take a good chunk of their reserves and buy into hedge funds and other questionable, very risky ventures that then completely collapsed. But what you do or how successful you are in your experiments in investing in a risky world are very different from whether you’re wisely putting the bulk of your reserves in a certain currency as a reserve currency. And there the Chinese are very clear, and for very good reason, that there is no alternative to the U.S. dollar in this world or in the world we’re going to see for the next decade or two anyway.

So the idea that came out of the bank – the central bank and its governor that we need to

move to a universal reserve currency based on the IMF’s Special Drawing Rights. The SDR, I think even in his document was something to consider as possible for the very distant future, and nobody is considering it now. It did help boost the credibility of the SDR and the IMF at a time when the


G-20 were moving into what must have been something of a debate about how much money to give to the IMF.

So, from that regard it had an effect and it ended up giving the IMF more reserves to help

poor and emerging economies now. But the whole idea that there could be a universal currency gets very complicated if there are several equal major world currencies that are contributing to it, because that SDR then would have to, itself, become market based, in my opinion, and if that becomes market-based, then it could also move, depending on the fiscal policies and inflation in the various major powers whose currencies make it up.

So it’s a conundrum of a problem. How do you have a global currency as a reserve and

avoid the contradiction that the country that has that currency both has to serve its own domestic purposes and be responsible to the world, a responsibility the U.S. sort of abandoned in the last decade?

MR. LEACH: And could Jefferson or Confucius or Machiavelli be on the currency?

(Laughter.) Does anyone else want to answer the basic question? MR. LARDY: I can give it a go. MR. LEACH: Here is a very precise question, somewhat interesting: Can you explain the differences between Chinese A-shares that Chinese companies trade in Hong Kong and Chinese ADRs traded in the United States? Are the ADRs considered higher quality?

MR. SAULSKI: I guess I’ll take that one, since I do have a class at Georgetown that tends to focus on these kinds of questions. Well, so, the Chinese stock market is divided, and this is the domestic shares traded in Shanghai and Shenzhen are divided between A-shares and B-shares; A-shares traditionally were denominated in renminbi, the Chinese currency, and only available for Chinese citizens. The B-shares were set up as a separate shares in the same companies that are listed on those exchanges for foreign investors denominated in foreign currency. This is to keep that wall of separation between the renminbi and foreign exchange markets. Shenzhen I believe is Hong Kong dollars and in Shanghai the B-shares were denominated in U.S. dollars. There’s been a little bit of opening up on the A-share market so that now qualified foreign institutional investors can also invest in that market. However, foreign individuals cannot partake in the A-share market in Shanghai or Shenzhen. Now, the idea of ADRs – there’s another type of share that you normally hear when you read about the Chinese stock market and those are H-shares and sometimes you hear N’s and S’s et cetera and L’s. Basically these are just shares that are of Chinese companies that are also dually listed on foreign exchanges, and those are those shares traded on foreign exchanges; they were called H because most of them are in Hong Kong of course, though there are shares traded through USADR facilities in New York and then also in London, et cetera. So an ADR is when a foreign company – doesn’t matter where it is, it could be a European company, et cetera Latin American company – basically wants to list in New York and they – it’s a complicated structure – but they create this facility and they put their shares in New York so those


are the ADRs and you might also hear them as H-shares or N-shares. So the question is, what is the difference between these if you’re going to invest? If the markets were efficient, there should be no difference, right? You’re investing in the same companies; it’s just where you are investing. So but as we’ve already discussed or as I’ve mentioned and broken down a little bit, the domestic Chinese market has basically seen a lot of volatility and I believe that that’s not – it’s not because of the actual fundamental quality of the companies traded there, but because of a lot of outside pressures and boom and bust cycles basically created by government policy et cetera And so often you will see a disparity in the prices between the shares traded in New York and the shares traded in Shanghai or Shenzhen. But one last thing, if I may, is that those Chinese companies that have listed in New York, particularly New York and you see a little bit of those who list in Hong Kong and London, but particularly that list in New York have had a definite increase of value. That is a decreased cost of capital, both on the Chinese market as well in New York and that is surely because they were bonding themselves to a kind of, a very stringent and tough regulatory regime basically overseen by the SEC and the other U.S. regulators. And basically they’re getting a kind of gold seal and so that’s why it is kind of a prestigious thing for Chinese companies to be able to list their ADRs in New York, and basically claim that they’re regulated by the Cadillac model of regulation, et cetera. So that has been a traditional story but we can talk a long time about that. (Chuckles.) MR. LEACH: Thank you, appreciate it. This question comes from possibly someone in New York: “Chinese firms have unfettered access to United States consumers. Isn’t it only fair for United States banks to be allowed to compete in China’s rapidly growing banking sector” –and I might add insurance to that, an insurance sector? MR. SAULSKI: I think there’s less disparity than one might expect just from looking at the number. There are a couple of hundred foreign banks operating in China under the liberalization that took place after China’s entering into the WTO. There are very, very few restrictions now on the kinds of services that foreign banks can offer, the kind of clients they can serve and so forth. So I think there’s been quite a liberalization in terms of – access particularly to the retail market. So Chinese people can open up a bank account at HSBC or Citi bank or wherever they want and there’s beginning to be some competition, but again, not enough competition because there’s no competition on interest rates. You’re not going to get any better interest rate on your deposit by going to HSBC than you get at Chinese state-owned banks. So the ability of foreign banks to compete in this market is very, very severely handicapped. I mean, in a normal banking environment, the foreign banks, hopefully, maybe we wouldn’t believe it anymore, but hopefully have a better ability to determine the credit quality of potential borrowers. They would pick, on average, better borrowers. They would earn more money and they could attract more deposits by offering slightly higher returns to depositors. But that whole process is truncated in China because the deposit rates have a ceiling and the lending rates have a floor. So they can’t compete to get better borrowers and they can’t compete to get more deposits, so the net result is the foreign share of banking assets in China is stuck between two and 3 percent. But I think it’s largely a function of the controls on interest rates rather than any other kinds of restrictions. And the Chinese will say, this is national treatment, every financial


institution in China is subject to the same restriction so this is not inconsistent with our WTO obligations. MR. KEIDEL: Is the question – could you repeat the question – is the Chinese have – who has unfettered access and who is blocked? MR. LEACH: The question is: “Chinese firms have unfettered access to United States consumers. Isn’t it only fair for United States banks to be allowed to compete in China’s rapidly growing banking sector?” MR. KEIDEL: Okay, that sounds like Chinese firms, meaning that by most-favored nation status, they could sell product, goods and services. And then in the question is sort of equating that privilege with financial sector opening, which is quite a different kettle of fish and in the WTO to boot. So I’m not sure that we would be making the comparison between access for commodity trade in one direction versus financial sector access in another; it’s just very different spheres of comparison. MR. SAULSKI: No, I think both comments are exactly correct. I know that one area where the foreign banks think that they’re going to have a step up over their Chinese competitors is in credit cards. As well as other sophisticated products which we’ve already discussed, we’re not sure if this is really the, Chinese has the regulatory environment to start introducing overly sophisticated products. And I think it’s time for the foreign firms maybe to ratchet back the idea of penetrating the Chinese market and focus on their own houses right now. MR. LEACH: Well, I’m going to end with one last question and then we’ll turn to closing statements. And this question is based on your varying experiences and perspectives, if you could recommend one or two specific suggestions to PRC financial regulators or first steps in the next wave of reform, what would they be? MR. LARDY: Well, I have a list: Interest rate liberalization is number one; secondly is capital market liberalization and by that I mean a much more transparent market-driven listing process for firms and they want to get listed on the equity market, and for firms that want to be able to access the bond market as well. I have always believed that one of the reasons that we have not seen faster progress in reform of the banking system is they don’t face any competition. Firms don’t raise much money through equity market, and they don’t raise much money through the capital market, and they can’t compete with each other on interest rates; so it’s a very monopolized, uncompetitive world. So the combination of having interest rate liberalization phased in as they started to do in the earliest part of this decade and allowing firms’ greater access to the bond market and to the equity market is a way of introducing a lot more competition and improving the allocation of resources. I don’t think they need CDOs and securitized instruments and derivatives and all this other stuff that has led us to the mess we’re in. But I do think they need those fundamental reforms. MR. KEIDEL: Yes, I would say three things in terms of recommendations. The first is that they spend a lot more time with people like Paul and expand those programs. And my understanding from my days at Treasury is, there is indeed an insatiable appetite in China for that


kind of contact and training. The problem is the world doesn’t have the available experts at that level to provide to them so they need to continue doing that. Second would be to use expansionary periods like this one to continue to figure out and make experiments in where you can liberalize and try it out, but be ready to pull back again. And the third would be to work hard with other international financial intellectuals about what kind of financial system is really suitable for a middle-income country and for a more developed country, given what we’ve learned about some of the weaknesses in the current world’s most advanced financial systems. And figure out how to design a path to get to what is in fact a more optimal, a mature country’s financial system, and that’s something we need to do together as a global financial community. MR. SAULSKI: I think if I would have been asked this question two, three years ago, my list would’ve been to strengthen the securities law, to enhance disclosure of firms that are both distributing stock or equity securities as well as bonds and to strengthen the oversight ability of the regulators, both the banking and the securities regulators as well as to adapt a more international standard for accounting. Actually, that has all occurred in the last couple of years, I’m very happy with the progress and that’s what I was trying to express in my opening statement. The Chinese have basically really strengthened the powers of the securities regulator, they have heightened the power, they’ve actually created a new banking regulator and imbued them with significant power to oversee the safety and soundness of the financial institutions, et cetera. So I think they made some important steps and so staying away from the issues of interest rates, I probably mirror Nick closely, though I do appreciate the plug, Bert – (chuckles) – in that now it’s about liberalizing the process to which firms can access those capital markets; particularly the equity and the bond markets. Unfortunately still the CSRSC is the gate-keeper for IPOs and issuing of securities on the stock markets and there’s a long queue and inevitably that queue of firms that are being considered for IPOs are all the same state-owned enterprises that have access to the bank loans, et cetera. And those private firms, those kinds of venture firms that have innovative ideas that can create new industries are not able to capture that market. And so my dream is for China to move towards opening up the capital markets away from state-owned enterprises exclusively, maybe create a secondary market for venture firms as well as to move away from the strict kind of merit-based decisions on who should raise capital to a more open disclosure-based system. MR. LEACH: Well, thank you very much; we’ll now move to concluding statements and some of the differences aren’t as vibrant as we might have expected in certain debate settings, but I’m going to suggest that each of you may, if you wish, address the most important regulatory question of the year. And that is, in the spirit of the Olympic Games and the President’s call for NCAA football play-offs, should our most important regulator, the NBA, authorize a franchise in China? (Laughter.) But, with that, you may or may not address but we’ll begin with concluding comments with Paul. MR. SAULSKI: I think I’ll pass on the NBA question and so I guess just to conclude, I think what we need to focus on, or at least what I consider to be the most important issue for China in ensuring that its’ financial markets do not become a hindrance to its continued economic growth


is to make sure that they continue to develop the institutional infrastructure for transparent, well-regulated capital markets in a financial system. I understand Bert’s point of view that from an early development stage you need to perhaps repress the financial system so that the state can be involved in directing capital to the most worthy, what they see as the most worthy projects, because perhaps the market is not sophisticated enough at that time to make those decisions. However, there will be a point where that transition has to be made. Historically, rapidly developing countries have been very bad at making that transition and they have had very significant economic distress related to their inability to make that transition. I think China needs to start preparing for that transition soother rather than later and by preparing I mean developing a very sophisticated – all the institutions with sophisticated capital market structure that can help them make that transition and, if possible, we won’t even see that transition happen. We’ll just one day realize that it is no longer a state-driven economic system, but one that is more geared to capital markets that determine capital should be allocated. MR. LARDY: I certainly acknowledge that there are some benefits in terms of financing public sector investments through the kind of financial distortions that China still has, but I think while we recognize those, we should also look and see what the costs are. As I indicated in my opening statement, I think they’re quite substantial from the point of view of distorting investment choices, not more broadly over the entire economy in order to benefit important but small, a relatively small sector of the economy that inhibits job creation, that depresses wages, that it depresses consumption, that it minimizes the gains from China’s rapid economic growth, and it has been very costly in terms of it its environmental consequences. So the conclusion I come to is that we really should look much more closely at alternative means of financing needed public sector investments. They could come through the kind of policy banks that China thought it was creating 10 years ago, but it never really succeeded in doing. It could come from interest rates subsidies provided through the budget, which would be perfectly feasible in China and a number of other alternatives. So I am not persuaded that the benefits from having a cheap source of finance for needed public sector investments outweigh these costs when you take them in the aggregate and I think China should move towards much more rapid reform along the lines that I’ve been discussing. But as I said before, I don’t think this means they should be trying to emulate the path that we’ve been on for the past decade. I think they should stick to a plain vanilla financial system, the banking system in particular should be something of a utility model but have much more competition from a more robust capital markets and, in particular, as I mentioned before, a market-driven entry process to listing on the stock exchange or to raise capital through the bond market rather than the politically controlled that seems to prevail today. MR. KEIDEL: Well, thank you again, Professor Leach, for a wonderful job moderating and to my colleagues, it’s been a very useful and educational time for me. I want to first address the idea that the National Basketball Association might issue a franchise to China. I think this introduces a very important lesson for the United States in integrating with China – that it’s not enough just to export a model of our own, but we need to change ourselves internally as well.


The National Basketball Association couldn’t be the National Basketball Association if it had a Chinese franchise. It would have to reform itself to become the World’s Basketball Association, and that kind of wrenching change in light of a new emerging power in the world, domestically, is something that I think we might learn from an NBA process of going through that exercise. (Laughter.) In terms of the financial sector, I would, as you would guess, say that China should continue to repress its financial sector for the intermediate future and I think I agree with Paul that it eventually in the long term needs to unwind it. One of the problems I was talking about short term, medium term, long term, is you don’t put any dates on it. But in another 20 years China’s economy – will it be as big as America’s will be then? It won’t be nearly as rich in per capita terms, so there’s some question about whether it will be able then to support the kind of sophisticated system. It won’t even have the per capita GDP that the United States enjoys now. That doesn’t happen ideally until about 2050 on its current growth trajectory. But the whole principle, while the older system continues to function in its necessary and advantageous ways to sustain growth that it needs to fill the shell that increasingly has substance for what is a modern financial system – to create the institutions as they did in the 1980s and the 1990s, give them their names, give them heads, start funding them and then start turning them into what they must become.

That’s a long process and it’s the right way to go about it; the idea that you should wipe away one old system and then try to build the other is clearly wrong. But the old system needs to be kept in place while it is increasingly qualified by the new functionality of what was at first a shell. In bond markets, I will just say that this has a lot of threats for instability if the bonds aren’t honored. There are a lot challenges in terms of the transparency of the issuers. And so China will learn how to improve its regulatory and its market savvy in a Chinese environment by expanding those rights quickly and looking to pull them back again. And that’s been the pattern sine the very first finance companies were introduced in 1986 and immediately blew up in term of liquidity provision that was irresponsible. So that is, again, this idea of experimenting, moving ahead prudently but not erasing all restrictions that you do have on bond markets. On the scale of development I think Nick and I probably need to have another lunch about the detrimental impact of the low interest rates and the large scale of investment compared to consumption. I noticed that Nick, you said that the share of consumption in GDP had stagnated for a long time; well, that sounds terrible that it would stagnate for that long. MR. LARDY: It’s actually going down. (Laughter.) MR. KEIDEL: I’m just quoting you because – MR. LARDY: It’s the service sector that has stagnated.


MR. KEIDEL: Well, the service sector is stagnated but it’s still growing at the rate of growth of GDP which has been extremely fast. And there are arguments for certain emphases in the evolution of an economy going through a manufacturing phase that’s quite strong particularly when the world’s demand for those products shifts to you because of the capability of your labor force.

So I would say that the best way to promote growth of Chinese consumption, rapid growth of Chinese consumption is to continue to promote rapid growth of the economy and keep consumption share in that, not necessarily if you raise it to a higher level then you’ve reduced the amount of investment goods that you have to help it grow faster and growth slows an consumption goes slow too. So as long as you can use your investment efficiently, I would encourage them to maintain a high rate of investment. And I think we’ve not really talked a great deal about opening the capital account. I don’t think any major financial, international institution or the U.S Treasury, unless it shifted recently is encouraging China to open its capital accounts and adopt capital account transparency or liberalization or convertibility along IMF models anytime soon. That’s the case of Korea recently, has again shown that that’s a risky issue and on exchange rate, I think our views will probably continue to converge over the long term. Thank you very much. MR. LEACH: Well, thank you, each of you. Let me just end by noting several things. This is one of the large number of “debates” in quotation marks that the Carnegie Endowment has conducted. Each of these debates can be looked at by going to carnegieendowment.org/chinadebates in a week or 10 days. This one will also be available for anyone view. Again, we want to thank Senator Casey and his staff for arranging this room. We also want to thank the GE Foundation for their assistance and at this point I would conclude the meeting and ask that each of you give an expression of applause to our three panelists. Thank you very much.

(Applause.)

(END)

does china’s financial sector jeopardize economic growth? · 2009-04-17 · does that inhibit...

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