Debt and Distortion

China’s unprecedented growth has transformed the lives of its people and impacted economies across the globe. The financial system supported this growth by providing cheap loans to boost investment and, in a virtuous cycle, rapid growth insured that these loans could be repaid. However, in recent years, this virtuous cycle has turned vicious. The financial system has continued ...

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China’s unprecedented growth has transformed the lives of its people and impacted economies across the globe. The financial system supported this growth by providing cheap loans to boost investment and, in a virtuous cycle, rapid growth insured that these loans could be repaid. However, in recent years, this virtuous cycle has turned vicious. The financial system has continued to lend freely and cheaply as the economy has slowed, and the risk of crisis has mounted. In response, the government has initiated the most ambitious financial reforms in twenty years. Financial markets, businesses and governments are concerned about these risks and are struggling to understand what the reforms will mean for China and the rest of the world.

Debt and Distortion: Risks and Reforms in the Chinese Financial System addresses the need for an up-to-date and accessible, yet comprehensive analysis of China’s financial system and related reforms. It will take a systematic look at China’s financial system: how it worked in the past and how it will work in the future; why reforms are needed; what risks they bring; and their impact on China and the rest of the world. By analyzing the topic in terms of a few fundamental distortions, this book makes an otherwise complex topic accessible while simultaneously providing new insights. These distortions provide a simple framework for understanding the nature of the Chinese financial system and its future prospects.

Reform in China will transform the world’s second largest economy and impact everything from Peruvian copper mines to the London housing market. Business people, government officials, financiers and informed citizens would all benefit from understanding how changes in China’s financial system will shape the global economy in the coming decades.

Paul Armstrong-Taylor is Resident Professor of International Economics at John Hopkins School of Advanced International Studies, Nanjing University, China, where he teaches classes on finance, strategy and the Chinese economy. Previously, he was Visiting Professor of Economics and Finance at the Antai School of Economics and Management, Shanghai Jiaotong University. His profess...

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Paul Armstrong-Taylor is Resident Professor of International Economics at John Hopkins School of Advanced International Studies, Nanjing University, China, where he teaches classes on finance, strategy and the Chinese economy. Previously, he was Visiting Professor of Economics and Finance at the Antai School of Economics and Management, Shanghai Jiaotong University. His professional experience includes positions as a consultant at Monitor Group and London Economics, and as an investment banker at Morgan Stanley.

Paul received his BA and MPhil in Economics from Cambridge University, and his PhD in Economics from Harvard University. His research interests include the Chinese economy, game theory, business strategy and finance. He has published numerous articles on China and the economy for academic and non-academic media, and has spoken at a number of events, including The China Economics Forum and the Annual US-China Business Council Conference in Shanghai.

Part I Current Economic Model 1
1 Growth Model 3
How Did China Grow So Fast? 3
Why Can h is Growth Not BeSustained? 6
2 Financial Risks 11
Minsky’s h eory ofFinancial Crises 12
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Part I Current Economic Model 1
1 Growth Model 3
How Did China Grow So Fast? 3
Why Can h is Growth Not BeSustained? 6
2 Financial Risks 11
Minsky’s h eory ofFinancial Crises 12
Japan 13
USA 16
China 19
3 Financial Repression 25
What Were theEf ects ofFinancial Repression? 27
Transfers Wealth fromHouseholds toFirms andGovernment 27
Excessive Investment 28
Depressed Consumption 29
Ineiciency 30
High Asset Prices 31
Why Did Investors Not Move Money fromDeposits toOther
Investments? 32
Shadow Bank Products 32
Stocks 33
Bonds 34
Real Estate 34
International Investment 35
What Would BetheEf ects andRisks ofLiberalizing
Interest Rates? 35
Deposits 36
Loans 37
Asset Prices 39
4 Government Guarantees 41
Role ofFinancial System inManaging Risk 42
Government Guarantees andMoral Hazard 45
Effect ofGovernment Guarantees onFinancialRisk 47
Solvency Risk 47
Liquidity Risk 49
Systematic Risk 51
5 International Distortions 55
Undervalued Currency 55
Problems 55
Restrictions onInternational Capital Flows 58
Advantages ofClosed Capital Accounts 59
Disadvantages ofClosed Capital Accounts 60
6 Overview 63
Part II Domestic Reforms 65
7 Banking 67
Liberalizing Interest Rates 67
Competition forState-Owned Banks 70
Better Incentives forBank Oicials 73
Improved Risk Management 75
8 Shadow Banking 81
Trust Companies andWealth Management Products 84
Purpose 84
Risks 85
Benei ts 86
Reforms 87
Informal Lending andtheWenzhou Crisis 88
Wenzhou Model 89
Wenzhou’s Financial Crisis 89
Lessons fromWenzhou 91
Wenzhou Reforms 92
Loan Guarantee Firms 94
Purpose 94
Risks 95
Reforms 97
9 Stock Markets 99
Advantages ofEquity over Debt 99
Immaturity ofChina’s Stock Markets 101
Volatility 101
Corporate Governance 104
Capital Controls 107
Government Intervention 108
Unlocking thePotential oftheStock Market 110
Reduced Government Involvement 110
Corporate Governance 112
Capital Controls 114
10 Bond Markets 117
Bonds over Banks: Market Forces andLiquidity 117
Characteristics: Large but Illiquid 118
Risks: Challenges toBanks andGovernment Control 121
Reforms: Finding theMiddle Path 122
11 Local Government Debt 125
Causes, Scale, andCharacteristics 125
Conl ict Between Central andLocal Governments 125
Centralization ofTax Revenue 126
Distorted Incentives 127
Scale andCharacteristics ofDebt 129
Local Government Debt: ANexus ofFinancial Risk 131
Solvency andLiquidity Risk 131
Links totheFinancial System 133
Links totheReal Estate Market 133
Risks totheBroader Economy 135
Balancing Local Government Debt Reform
withEconomic Growth 135
Stock andFlow Problems 135
Development ofLocal Government Bond Market 138
Funding Gap 140
Implications ofReform 141
12 Real Estate Market 145
Does China Have aReal Estate Bubble? 145
How Would aReal Estate Crash Af ect China’s Economy? 148
Households 148
Local Government andCorporate Risk 150
Reducing Risks fromtheReal Estate Sector 153
Reduce Real Estate Risk 153
Insulating theFinancial System fromReal Estate Risk 155
Part III International Reforms 159
13 Exchange Rate Liberalization 161
Renminbi: FromUndervalued toOvervalued? 162
Pre-2008 162
2009 Onwards 164
Letting Go: Moving toaFloating Exchange Rate 166
Loosening Control over theExchange Rate 166
Relationship Between Exchange Rate Liberalization
andOther Reforms 167
14 Renminbi Internationalization 169
Benefits andBarriers toInternationalization 170
Trade Settlement 170
Investment andReserves 172
Short History ofInternationalization 174
Challenges ofManaging Risk withInternational Currency 176
Impact ofInternationalization onChina andtheWorld 179
Domestic 179
Politics 182
International 183
15 Capital Account Liberalization 185
Treacherous Tides: Risks ofInternational CapitalFlows 186
Financial Freedom andPolitical Commitment:
Benei ts ofanOpen Capital Account 188
Tentative Steps: Progress toCapital Account Liberalization 189
Portfolio Flows 189
Direct Investment 190
Unoicial Capital Flows 193
Policy Laboratories: Free Trade Zones 195
16 Asian Infrastructure Investment Bank
andtheNew Silk Road 199
Infrastructure Investment 200
Global Financial Power 202
Domestic Rebalancing 203
Conclusion 204
Part IV Politics 207
17 Political Conl icts over Reforms 209
Conlficts Within the Chinese Communist Party 209
Reform andtheParty’s Power 209
Reform andthePersonal Finances ofOicials 210
Broader Conl icts over Reforms 211
Losers fromReform 211
Winners fromReform 212
Greater Inl uence ofLosers 213
18 Strategies toOvercome Opposition toReform 215
Anticorruption Drive 216
Anticorruption Drive andFinancial Reforms 216
Anticorruption Drive andLegitimacy ofCCP 216
Effectiveness ofAnticorruption Campaign 217
Effect ofReduced Corruption onEconomic Growth 218
Centralization ofPower 219
Process andBenei ts ofCentralizing Power 219
Costs ofCentralization ofPower 220
Part V Risks and Consequences 225
19 Domestic Risks 227
Level andDistribution ofDebt 229
Foreign Debt 229
Domestic Debt 232
Quality ofInvestment 235
Asset–Liability Mismatches 238
Liquidity Risk 239
Currency Risk 240
Corporate Governance andtheRegulatory Environment 241
Corporate Governance 241
Regulation 242
Ability ofGovernment toManage Financial Risk 245
Preventing aCrisis 245
Containing theEf ects ofaCrisis 247
20 International Consequences ofReform 249
Consequences ofEconomic Transition 250
International Impact ofFinancial Crisis 252
Trade Links 252
Financial Ties 253
21 the Future 255
Exaggerated Pessimism 255
Short-Term Risks, Long-Term Benefits 258
Appendix: Financial Decision Making
in the Chinese Government 261
Major Central Government Institutions 261
Chinese Communist Party 261
State Council 262
Central Leading Groups 262
Central Discipline Inspection Committee 263
Ministry of Finance 263
People’s Bank of China 264
Financial Regulatory Commissions 264
National Development and Reform Council 265
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