The Role Of Financial Repression In China And The Economic Structural Imbalance

By way of background, China has reached tremendous accomplishments over the last30years, with GDP increasing by sixteen fold and it has displaced Germany and Japan as the second largest economy by GDP size. China’s economic growth has attracted much attention from scholars, entrepreneurs and policymakers and has led to a widely held belief in the "Chinese Miracle" Despite the current financial turmoil initiated in2008with the burst of US Sub-prime crisis, China has coped up with incredible well by posting GDP growth far above any other developed and developing economies. China’s growth is likely to continue in a smooth and slightly slower trajectory upward, carrying the low growth developed world along for the ride. It is absolute fair to say, given the anecdotal evidence; China is far away from a hard landing in terms of economic growth.Nonetheless the world has changed with the economic crisis, so should China’s growth model. As claimed by the Premier Wen Jiabao,"the Chinese economy is unstable, unbalanced, uncoordinated and unsustainable" or the four "uns" as the media addresses. As the world consumption collapsed after the economic crisis, China has struggled to address the need for rebalancing its economy towards more consumption, although recently investment has played a much wider role over Chinese growth than exports through a sort of lending-spurred growth, what indeed may trigger unimpressive future returns on those investments with deleterious effects over the banking system (likely higher level of non-performing loans NPLs).The current thesis aims to shed lights on how China’s growth model could be changed by addressing the existing financial repression in the country. While financial repression translated into lower interest rates (negative real interest rates or nominal interest rates well below GDP growth rate) has played an important role by boosting investment, it is very unlikely a country with a rate of investment of around50%has been allocating capital in an efficient way. If NPLs emerge as a result of the current investment boom, financial repression once again will have to play the role as the government will let the banks to continue enjoying a healthy banking spread in order to clean up their balance sheets. As a result of this financial repression, more income will be transferred from households to corporate and at later stage to banks, dwindling further the household income as percentage of GDP and moving China’s economy further away from its rebalancing.Not only financial repression should be partially blamed by the high share of investment over China’s GDP growth, but also it has become a crucial instrument to maintain the banking system margins healthy enough to offset any future likely banking loss should this investment binge does not materialize into attractive returns.Also given its pegged exchange rate regime and the impossible trillema of open economy macroeconomics, where open or "porous" capital account, fixed exchange rate and independent monetary policy are not altogether feasible, it could be claimed China has not enjoyed a complete independent monetary policy, although it has done quite well sterilizing capital inflows through open market operations (OMOs). Yet, in spite of sterilization of capital inflows Chinese banks are somehow "compelled" to accept central bank bills with yield much lower than lending rates, besides the rising reserve requirement as the main instrument recently adopted by the People’s Bank of China as a way to sterilize capital inflows. The rationale flows to the fact that higher reserve requirements and central bank bills with low yields impair the banking balance sheets. Thus in order to offset this lack of opportunity cost and lower potential banking profitability, financial repression and higher banking spread are used as a crucial instrument to offset these profit eroding effects triggered by the exchange rate regime (pegged). Thus should China pursue a real economic rebalancing, financial repression should be eased along with a higher flexibility of the Yuan. With lower financial repression household income could raise leading to higher levels of consumption as percentage of GDP.The other line of argument that places the role of financial repression as one of the main roots for China’s economic imbalance is the fact that financial repression and the development of the service sector (tertiary). The central proposition of this hypothesis is that financial repression significantly distorts the process of structural change by holding back the development of the service sector. As a labor intensive sector, if the service sector lags behind or it is underdeveloped by government policies, lower level of jobs is created further jeopardizing the rebuild of disposable household income. As such we conducted an econometric analysis with a set of regression in order to offer important insights in terms of negative relationship between service sector development and financial repression by provide revealing statistical significant arguments for the Chinese policy makers to ease financial repression if a consumption oriented economy and more harmonious society is to be achieved.This thesis is sectioned in four parts:The first part China’s growth model is described along with the factor distortions that led the country to pursue this economic growth model that although accomplished to succeed in terms of GDP growth it only exacerbates the inequity as income from household has been transferred to corporate through financial repression to boost investment; the second part aims to address the issue of the current exchange rate regime and how the financial repression has essentially been an important instrument to maintain the current regime, yet by transferring wealth from the household to banks at the end in order to offset the sterilization effects imposed on banks due to capital inflows; the third part of the thesis shed lights on how the banking system and the interference of the state in terms of credit allocation, excessive investments, higher NPLs and further financial repression are all factors that retro-feed themselves and impose self-inflected structural imbalances towards more investments to keep GDP growing in absence of external demand and higher domestic consumption; the fourth part of this study is dedicated to an econometric analysis that purposes to establish some statistically significant negative relationship between financial repression and the development of the service sector. The final part of this thesis we wrap up all previous arguments to claim that the existing financial repression in China as an initial instrument to prevent capital inflows (pegged exchange rate) or stimulate investments are also crucial to protect the financial strength of the banking system. In both aspects:to promote investments and defend the parity and to restore the profitability of the banks, household income has been transferred to corporate and banks what has led China’s growth model further away from its economic rebalancing.