Academic journal article The Cato Journal

Do Financing Biases Matter for the Chinese Economy?

Academic journal article The Cato Journal

Do Financing Biases Matter for the Chinese Economy?

Article excerpt

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

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

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

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

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

The other alternative financing mechanism is foreign direct investment (FDI). In the past few years, this has been my area of research (Huang 2003). …

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