«Loren Brandt and Xiaodong Zhu May, 2001 Department of Economics University of Toronto 150 St. George Street Toronto ON M5S 3G7 Canada Telephone: ...»
From Intermediation by Diversion to Disintermediation: A
Long-Run Perspective on Growth and Inflation (or Deflation)
Loren Brandt and Xiaodong Zhu
Department of Economics
University of Toronto
150 St. George Street
Toronto ON M5S 3G7
Email: email@example.com and firstname.lastname@example.org
We argue in this paper that the key to the recent sluggish growth in China is
financial disintermediation. This has adversely affected investment in the non-state sector, which has been the source of much of the dynamism in the Chinese economy since reform. Our analysis suggests that the current reform strategy for China’s financial sector, while important, will not solve this fundamental problem. Rather, the solution lies in the introduction of new, privately owned, locally based financial intermediaries that can provide efficient financial intermediation for the small and medium sized enterprises in the non-state sector.
Key Words: Financial Disintermediation, Inflation, Deflation, Growth, China
1. Introduction Since 1994, China has experienced a prolonged period of declining inflation during which growth has also fallen sharply. Over much of the last three years prices have actually declined. The simultaneous reduction in growth and inflation has led many to attribute the macroeconomic problems China is now facing to the condition of weak aggregate demand. Not unexpectedly, the Chinese government has cut interest rates several times and has vigorously pursued an expansionary Keynesian spending policy in hopes of stimulating aggregate demand. However, these measures have had only limited effects. Prices in most sectors continue to fall1, and output growth remains sluggish.2 The persistent decline in economic activity the last several years is in stark contrast to a highly cyclical pattern of growth between 1978-1994, during which high inflation rather than deflation was the main concern of the government.
In this paper, we provide an explanation for the behavior of output growth and price level changes in China that can account for both the cyclical pattern between 1980and the secular decline in recent years. Central to our explanation are the government’s commitment to the state sector and the behavior in the financial system.
Our analysis suggests that the reason for the declining growth is not weak aggregate demand. Thus, traditional aggregate demand policies have not and will not be very helpful. Rather, we contend that the lackluster growth is a result of financial disintermediation, which has caused slower growth of investment in the non-state sector.
The financial disintermediation, on the other hand, is a result of the government’s financial repression policy over the last two decades and its recent effort in centralizing the financial system. For the economy to grow more rapidly, the Chinese government needs to eliminate financial repression and allow the entry of new, privately owned, locally based financial institutions.
Prior to 1994, the central government maintained a strong commitment to employment growth in the state sector. Severe fiscal constraints forced the central While the consumer price index showed a modest 1.5 percent increase last year, the retail price index, which had been the official price index until this year, continued to move downward and decreased by 0.4 percent last year.
There appears to have been a slight pick-up in economic activity this year, but this is largely a product of external factors, namely, an increase in export demand.
government to look to the financial sector as a source of revenue for supporting the state sector. While there was some financial decentralization, the central government continued to impose control on the financial system’s credit allocation. During this period, more than 80 percent of the banking system’s credits were directed to the state sector, and lending to the non-state sector can best be described as a process of intermediation by diversion. Because of higher average returns in the more productive non-state sector, whenever possible, state-owned banks (SOBs) diverted credits intended for the state sector to the non-state sector. While this increased output growth, it also forced the government to rely more heavily on money creation to finance the transfers to the state sector, which led to high inflation. The cyclical pattern of growth and inflation up through 1994 was the result of the government’s inability to control the state banks’ credit diversion in the face of financial decentralization and the periodic need to resort to recentralization and administrative control of credit allocation to reduce inflation.
The cyclical growth process, however, was inefficient and unsustainable. The government’s use of the financial system to support the state sector resulted in soft budget constraints for both the SOBs and the state-owned enterprises (SOEs) and was the main reason for their deteriorating financial performance. As the productivity gap between the state and the non-state sector widened, there was a steady increase in the size of the transfers required to support SOEs. Mounting losses of the SOEs led to a rapid increase in non-performing loans in the SOBs, putting the whole financial system at risk.
There is also a limit to how much revenue can be raised through money creation, and the rapidly rising inflation in 1993-94 indicated that the required transfers were pushing this limit.
It was largely because of these difficulties that beginning in 1994 we see an overall tightening in policy towards the SOBs and SOEs. The People’s Bank of China (PBOC), China’s central bank, centralized and significantly reduced its lending to the SOBs, and the government began an effort to commercialize the SOBs by putting them in position of assuming increasing responsibility for their losses and bad loans. The government was able to do so by reducing its long running commitment to the state sector. It privatized some small SOEs, allowed large SOEs to lay off workers, and shifted much of the costs of these layoffs to local governments. As an integral part of the overall tightening policy, the government also lowered money supply growth rate significantly, leading to the prolonged decline in inflation.
While these measures have had a desired consequence of hardening the budget constraints of the SOBs and the SOEs, they have also had an important unintended consequence: Disintermediation in the financial system and a decline in lending to the non-state sector. This has occurred for several reasons. First, The SOBs have become highly risk averse because of their bad debt problem and their increased responsibility for their losses. Second, banks are handicapped in identifying good projects due to a lack of information and human capital. Both of these factors have contributed to a voluntary tightening of credit by the SOBs. Third, the financial system has become more centralized in recent years, making the financial institutions more biased against lending to small and medium enterprises (SMEs) in the non-state sector. Fourth, as part of its financial repression policy, the central government has clamped down on and closed many informal financial institutions such as rural credit cooperative foundations (RCFs) that were not directly under its control. This has denied the non-state sector a valuable source of financial intermediation. Since 1994, the growth of credit to the non-state sector has declined sharply. It is this decline in credit growth to the non-state sector that is largely responsible for the economy’s continued decline in output growth the last several years.
There are several policy implications regarding China’s financial system that we can draw from our analysis. First, relaxing constraints on the financial institutions through new infusions of funds from the PBOC, as was often done in the past, is not the solution. Second, major policy initiatives, including the re-capitalization and commercialization of the SOBs, the much-discussed entry of foreign banks with WTO, and opening the capital markets to non-state firms, while very important for large firms, will only have limited effects on overall growth prospects. Third, it will not be efficient simply to target SMEs for increased lending by existing financial institutions or by any newly established centralized financial institutions.3 To solve China’s economic woes in both the short and long term the government should adopt a more radical strategy of The monetary commission of the PBOC has recently recommended the government to establish a new state-owned bank specializing in making loans to SMEs.
reform for the financial system: allowing the entry of new, privately owned, locally based financial institutions that can provide efficient financial intermediations for the SMEs.
The rest of the paper is organized as follows. In section 2, we examine the main determinants of price level changes and output growth in China. The analysis in this section highlights the stable relationships between the money supply and inflation, and between credit allocation, non-state sector investment, and output growth. It also shows that the declining inflation and output growth is a direct result of a tightening of monetary policy and a decline in credit expansion. The impact of the Asian financial crisis on deflation is also discussed in this section. Since the behavior in the financial system is central to our analysis, we provide a brief overview of China’s financial system in section
3. In section 4, we analyze the monetary and credit policy employed by the government up through 1994, paying particular attention to the role of credit diversion by the banks in the growth and inflation cycles. In section 5, we examine the major policy regime shift that dates from 1994, and its implication for money supply, financial intermediation, and growth. In section 6 we analyze the fundamental reason for the declining growth in China, financial disintermediation. Based on our analysis, we explain in section 7 why fiscal and monetary policy have been ineffective in recent years and why they are not going to be effective in the near future. Finally, in section 8 we examine the policy implications for China’s financial reforms and the design of China’s financial system.
2. What Determines Price Level Changes and Output Growth?
2.1 Money Supply and Inflation China’s current deflation follows in the wake of a steady decline in the rate of inflation. After peaking late in 1994, inflation fell for three years until deflation set-in beginning in 1998. Inflation is usually a monetary phenomenon, and in China this is also the case.
Over the last twenty years, there is a very strong relationship between the behavior of M0, the narrowest measure of the money supply, and the changes in the retail price index in China.4 In Brandt and Zhu (2000), we show that the increase in M0 as a percentage of GDP predicts inflation exceedingly well for the period up through 1994.
This close relationship between the inflation rate and the increase in M0 continues to hold for the period after 1994. (See Figure 1.) The declining inflation rate is a direct result of the sharp reductions in the increase in money supply since 1994.
2.2 The Asian Financial Crisis and Deflation While tight monetary policy can account for the generally low inflation rate experienced the last several years, it cannot fully account for the deflation that started in
1998. Some have suggested that the deflation is a result of excess capacity. Lardy (1999), for example, argues that excess capacity has created a tendency for manufacturers to cut prices in an effort to sell their products. There is a problem, however, with this argument.5 Excess capacity is not a new phenomenon in China. For the last twenty years or so, inventory investment as a percentage of GDP has averaged 6.3 percent. During the period 1995-1998, inventory investment actually declined monotonically from 6.7 percent to 4.6 percent of GDP.6 So, if anything, the pressure to cut prices as a result of excess capacity should be greater in the years before 1995. Yet, the average inflation rate was very high in those years.
A more plausible explanation for the deflation is that it is a response to the competitive pressure created by the devaluation of several other Asian currencies. Since China effectively maintains a fixed exchange rate with the US dollar, the devaluation of the Asian currencies put downward pressure on the prices of tradable goods.7 Table 1 lists price indices of several major goods and services, as well as imports and exports.
The price of exports fell most, averaging slightly more than 8 percent in 1998 and 1999, followed by prices of imports. It is clear that domestic goods that are most subject to international competition, such as food and household appliances, experienced the next Because banks’ decisions on reserves and loans are heavily influenced by the government’s credit policy, which varies significantly over time, more broadly defined money such as M1 and M2 are not good measures of monetary policy.
For a criticism of the excess capacity argument in the context of Japan’s deflation, see Krugman (1999).
Unless stated otherwise, all the numbers cited in this paper are from various issues of China Statistical Yearbook.
The continuing deflation in Hong Kong appears to be the result of similar forces related to the peg of the HK dollar to the US dollar.
strongest decline in prices. On the other hand, services and housing, which are internationally non-tradable, have experienced inflation, rather than deflation.
Thus, deflation may simply be a result of market adjustment of the real exchange rate in response to external shocks under a fixed exchange rate regime, which may have actually helped to dampen the impact of the Asian financial crisis on China’s exports and overall growth. What, then, caused the growth slowdown? We attempt to answer this question in the next section.