Development Bank Research Bulletin

Raghuram Rajan on Chinese financial sector reform

Related to IMF China mission chief's remarks on Chinese reform priorities, Raghuram Rajan also made similar statements one week earlier (Jan 8, 2006) at the American Economic Association (AEA) meetings.

The title of the speech is "Financial system reform and global current account imbalances". The title is not about China, but the whole speech is centered on China's financial sector reform. As a matter of fact, AEA later invited Dr.Rajan to, based on his speech, co-write a policy article with former IMF China mission chief Eswar Prasad, titled "Modernizing China's growth paradigm", to be published in May issued of American Economic Review. Looking forward to reading it.

Some background reading:
(1) Raghuram Rajan: "China's Financial-Sector Challenge", at Financial Times (May 10, 2005)
(2) Eswar Prasad: "Next Step for China: Why financial sector reform is a crucial element of a long-term growth strategy", Finance & Development (September 2005 issue)

By the way, Dr.Rajan was invited by Chinese National Development and Reform Commission (a government agency in charge of economic reforms) to make the same speech to Chinese officials in July 2005. Chinese are keen in hearing different opinions, however harsh they may be.

I am not that lucky. Since some time ago I have not been able to post any comments on an Indian economy blog. Maybe I shouldn't have criticized India for her mounting government debt. I am still reading their blog though, because I find a lot useful information in it. Why reject information?

IMF mission chief for China: Rebalancing economic growth in China

Found this recent commentary by Steven Dunaway and Eswar Prasad titled “Rebalancing economic growth in China” (Jan 11, 2006). It also appeared as an op-ed on International Herald Tribune.

Nothing unusually new, but it is good to hear them from IMF mission chief for China. I like the article very much because (1) it is a rather comprehensive list of priority items; (2) it is a list of priority items ONLY.

It is too easy and tempting for policy economists to come up with a laundry list. With limited resources and political capital, however, you better focus on priority issues only.

Clearly China has reached a stage when structural reforms have to be carried out.

Several main points they made are summarized as follows:
(1) "Rebalance the economy away from heavy dependence on exports to lead growth towards self-sustaining domestic demand, including a substantial improvement in the efficiency of investment" (READ THIS TWICE, IT IS VERY IMPORTANT)
(2) Develop a broader-based, well functioning financial sector to make best use of the huge amount of savings! It is a key priority!
(3) Increase flexibility of exchange rate regime to provide more scope for monetary policy independence, as well as to bolster household’s real incomes.
(4) Provide better education, health care and pensions, to reduce uncertainty and precautionary savings.

References:
Prasad and Rajan: China's financial-sector challenge
Prasad: Next Steps for China

Raghuram Rajan: India, the past in its future

I have to recommend to you this excellent speech made by Raghuram Rajan (Economic counselor and director of research, IMF) at the Forum for Free Enterprise (Mumbai, India, January 20, 2006). The title of the speech is: “India: The past in its future”

In this speech, he analyzes India’s past experience, current problems, and solutions in a very insightful way.  Dr. Rajan loves India, has the knowledge and intelligence to serve the country, but I wonder how many politicians in India will truly buy his ideas. He says the reason he left engineering and even the country was partly because the economic environment in India at that time simply did not need the creativity and the innovation that he brought to the table.  I am not sure even after so many years have passed whether Indian politicians and bureaucrats will need him in the near future, for his economics expertise.

Some excerpts from the speech are given below. More technical-minded readers also can read this academic paper co-authored by Dr. Rajan, which I believe provides some background analysis behind the speeach. The paper is titled "India’s Pattern of Development: What Happened, What Follows? "

“Because employment was so important for India, encouragement was given to small-scale industries by reserving specific areas of production for them. But because firms could not grow to efficient scale, production was unprofitable, so few jobs were actually created. Government sought to protect unskilled labor in large firms—for example, through laws against firing. But this again meant that large firms stayed away from labor intensive industries, so fewer jobs were created. Moreover, firms resorted to temporary workers or stayed small so that labor laws did not apply. In short, labor laws neither led to the creation of more jobs, nor to the protection of most workers.”

“Similarly, if the goal is to improve primary education, we should avoid the knee jerk reaction of throwing more resources at the problem. We should ask why on any given day in a government school, only 25% of the teachers are playing truant, why at any given time only 45% of the teachers in a classroom are teaching, why the poor are willing to pay hundreds of rupees per month for a private school while avoiding the free government school across the street, and why a private school teacher shows up to teach as often as the government school teacher even though his pay is one fourth to one eight that of the latter's. Government has to understand how to improve incentives better before throwing more resources.”

India to beat China in 10 years? It takes more than belief to get things done!

What a joke! Decades ago Chinese believed that they would overtake UK and USA soon. It takes more than belief to get things done. Chinese learnt a hard lesson on that. Nowadays, very few Chinese are talking about overtaking any countries. You just keep working, and your life will be better off, and talks just won't get you anywhere. Nevertheless, it is always a good thing that people have hope.

India to beat China in 10 years: BBC survey
NEW DELHI, FEB 9:  A BBC World survey in association with AC Nielson on global indians reveals that India will overtake China in terms of economy growth in the next 10 years. While 57% respondents feel India will become the next Asian superpower in the next 10 years, 55% believe India can win a bid to host the Olympics during the same period and 60% believe that the poor in India will benefit from future economic growth. 

Why is Czech doing better? The long-term consequence of previous communist rule

Why did Central European countries such as Czech Republic and Hungary achieve better and faster results in economic and political transitions than other former communist countries such Ukraine and Georgia?

I had always been thinking about it seriously, trying to analyze it based on a wide variety of complicated economic theories, until someone gave me a simple answer that make me suddenly feel that I was a fool:  "they’d been under communist rule for a shorter period time than their eastern neighbors!"

Why didn't I realize it? That makes a lot of sense!

Thorsten Beck and Luc Laeven in the World Bank actually did some formal analysis about it. Their empirical analysis shows that countries that are more reliant on natural resources and spent a longer time under socialist governments are more likely to see former communists remain in power and to start the transition process with less open political systems, with negative repercussions for the development of market-compatible institutions.

Institution Building and Growth in Transition Economies
Drawing on the recent literature on economic institutions and the origins of economic development, the authors offer a political economy explanation of why institution building has varied so much across transition economies. They identify dependence on natural resources and the historical experience of these countries during socialism as major determinants of institution building during transition by influencing the political structure and process during the initial years. Their empirical analysis shows that countries that are more reliant on natural resources and spent a longer time under socialist governments are more likely to see former communists remain in power and to start the transition process with less open political systems, with negative repercussions for the development of market-compatible institutions. Using natural resource reliance and the years under socialism to extract the exogenous component of institution building, the authors also show the importance of institutions in explaining the variation in economic development and growth across transition economies during the first decade of transition.

Well, I actually have a better answer from Samuel P. Huntington's 1993 article in Foreign Affairs magazine titled "The clash of civilizations?" See the map on the right? The line that seperated  Western Christianity  and Orthodox Christianity centuries ago seems to have long-lasting consequence on economic prosperity and political stablity today. And Huntington made that prediction back in 1993!

The fake China threat

In today’s Washington Post,  Sebastian Mallaby  (in “The fake China threat”) explains to us why China is not a threat, but  actually a “generous” contributor to American economy, and why we should stop cold-war way of  thinking. I have to agree with him. The creation of knowledge and advancement of technology has never been a zero-sum game! And America stands to gain more in the pie.

“ Harvard's Richard Freeman, an economist who has studied the market for scientific talent, recounts a conversation with a physicist who'd collaborated with foreigners. "Ah, so you are helping them to catch up with us," Freeman commented. "No, they are helping us keep ahead of them," came back the answer: Because of the superior U.S. business environment, the research was being turned into a company in the United States.

Equally, in the competition to retain the best research scientists, the United States has a lead that tends to reinforce itself. Because nearly all the world's top universities are American, the world's top researchers flock here; provided enough visas are available, it's hard to see why this would change. The story of Gavriel Salvendy, which some might see as an omen of America's declining status, is in fact more subtle. Salvendy has long recruited star Chinese graduate students to Purdue, where he still does most of his research. Of the 18 Chinese who have completed PhDs under his supervision at the Indiana campus, 15 have stayed on in the United States.”

The link between racism and trade protectionism

I love reading Harvard professor Niall Ferguson’s books and articles. He is such a library of history that he can always inform current affairs with similar historical lessons. Many of us rarely realize that history always repeats it self and human beings are very forgetting, and this is why we keep making similar mistakes.

In a recent article “We may have no ghettoes – but Britain must beware the paradox of integration”, he tells us why integration and prosperity of minority groups may not bring peace but disasters to them. 

Through his analysis, I find the true root and reason of  rising trade protectionism and politician hawks’ hysterias in coining “China threat” (note: this is however my own extension of Prof.Ferguson's theory, and he didn't talk about trade protectionism in that article)

“Successful racial integration - whether in the housing or the labour markets - can in fact have precisely the opposite effect, paradoxical though that may seem. Here's how.

A century ago, hundreds of thousands of Jews migrated westwards from Russian-occupied Poland and Ukraine to escape from discrimination and pogroms. Many settled in Western Europe. There they thrived, quickly leaving behind the slums where they had first settled. By the early 20th century the sons and grandsons of immigrants were prosperous businessmen, professionals and academics.

Another indicator of integration: more and more Jews married non-Jews - by the early 1930s, for example, one in every two marriages in Hamburg involving a Jew was to a Gentile. So total was the assimilation of German Jewry that religious leaders feared their community was simply going to dissolve itself.

Yet within a decade, dissolution had given way to the "Final Solution", as first Germany and then all of Continental Europe was gripped by an extraordinary anti-Semitic backlash.

The Holocaust was, of course, a unique historical crime. Yet its underlying cause - a violent reaction against the apparently successful integration of an ethnic minority - was far from unique.

This is not to predict either Nazism or Balkanisation in Britain. But it is to point to the dangers of a comparable kind of backlash against integration. Because for every success story like the academically ambitious Anthony Walker, there are at least two - and probably more - white losers.

Ill-educated, unskilled and probably unemployed, Britain's white losers ought to blame themselves (or possibly their elected leaders and negligent parents) for their plight. But it is much more convenient for them to blame the hard-working offspring of immigrants, whose achievements contrast so starkly with their own. Their resentments are likely to be inflamed by the sight of a non-white man with a white woman, since sexual jealousy nearly always plays a malign role in crises of integration. It certainly did in Nazi Germany.”

Was there a corporate governance failure in Asian financial crisis?

Till these days, I am still not very sure whether the largest problem in Asian financial crisis is corporate governance failure. If the goal of corporate governance is to maximize shareholders' profits, then I think we had very good corporate governance back then.  The losers in Asian financial crisis were creditors, depositors, and taxpayers, none of them are whom corporate governance is supposed to protect. So it was more a government failure, as it is the government's job to protect taxpayers and creditors.

Let’s not confuse between corporate governance and corporate operation. For example, below I cite some statement by ADB.  They seem to be blaming everything on “corporate governance”, but they are actually talking about financing decisions, which is about how a corporation is operated.

“The high level of nonperforming loans among banks and the over-reliance of the corporate sector on them reflect both weak governance and the lack of alternative financing sources to banks.”

Well, how could choice of capital structure be directly related to corporate governance?? We can call it a bad finance decision in hindsight, but  at that point in time, when short-term debt was cheap, it was absolutely in the interest of shareholders to choose such capital structure.  Mismatch of maturity and currency structure in borrowing was key in bringing down Asian corporations. But this is about risk management, not corporate governance.

Cronyism lending is certainly bad. But from the perspective of shareholder in the borrower firm, it is good corporate governance that the firm borrows from connected banks at favorable terms, because it maximizes the profit of shareholders in the borrower firm, although to less extent for minority shareholders.

Even shareholders in the bank benefit, given that depositors, and ultimately taxpayers (when government bails out failed banks)  bear the cost of banking failure, while shareholders may well enjoy higher return had the banks not failed.

If we establish that corporate governance is about the interest of shareholders, then Asian financial crisis is a state failure, not a market failure created by the corporate sector.  The reason why minority shareholders are willing to participate is exactly that they expect they can still extract rents from other parties even after expropriated by the majority shareholders. Thus the greatest problem is transfer of wealth from consumers, potential competitors etc to the listed companies.  And even if the corporate governance is perfect, this benefit transfer will continue, because it is to the interest of shareholders to use political connection to gain benefit for the firm. When corporate governance is weak,  majority shareholders get larger share of the pie, but minority shareholder also benefit, though to lesser extent, otherwise they wouldn’t  have participated in the first place.

If anything about corporate governance has to be done at all, it is about the corporate governance  of banks and financial institutions, not the non-financial corporate sectors. I however won’t call this corporate governance reform, because such reform is about better protection of depositors and taxpayers, who are not shareholders.

For the corporate sector, the problem is  more about the risk management technique. I am sure controlling shareholders have best incentive to adopt good risk management, if they know that corporate failure may trigger nation-wide crisis and no one (including themselves) can escape. I still have strong belief that no incumbent would try to sink their own boats even when they have their own life boats. You still lose a lot, although less than the costs incurred by minority shareholders. It is common knowledge that, when the economy is in turmoil, political powers are more likely to change hands, and no incumbent will like to see it happens, let alone creating it on purpose. The crisis was unexpected for them too.

Who lose when foreign banks enter?

It is not clear whether the entry of foreign banks will benefit local small businesses that are previously underserved by domestic banks. Foreign banks certainly will bring competition to the market which should improve allocation of credits, but as new entrants it is also easier for them to focus on small number of big and very profitable corporations, without stretching too much to reach numerous small businesses. 

But one thing is clear:  connected firms won’t benefit from foreign banks. Foreign banks don’t care whether you are nephew of Suharto!

Mariassunta Giannetti (Stockholm School of Economics) and Steven Ongena (Tilburg University) assess the credit conditions in Eastern Euroopean countries after entry of foreign banks. They find that, one the one hand, small firms benefit less than large firms, but they do benefit; on the other hand, those firms set up in the early stage of economic transitions, presumably by those most connected red barons, are absolute losers facing  the new landscape of banking sector.

Financial Integration and Entrepreneurial Activity: Evidence from Foreign Bank Entry in Emerging Markets    
An extensive empirical literature has documented the positive growth effects of equity market liberalization. However, this line of research ignores the impact of financial integration on a category of firms crucial for economic development, i.e. the small entrepreneurial firms. This paper aims to fill this void. We employ a large panel containing almost 60,000 firm–year observations on listed and unlisted companies in Eastern European economies to assess the differential impact of foreign bank lending on firm growth and financing. Foreign lending stimulates growth in firm sales, assets, and leverage, but the effect is dampened for small firms. The biggest losers from foreign bank entry however appear to be businesses that can be identified as connected to the government or domestic banks. Overall, our findings suggest that foreign banks can help mitigate connected lending problems and improve capital allocation.

South Korea: an economic superpower in the making

The rise of India has long been attracting economists’ attentions, but very few people realize that in one or two years of time South Korean economy will exceed the size of India.

Despite South Korea’s astonishing achievement in raising its per capita income, in the perception of  many people S. Korea is just another  rich but small country like Singapore, and only draw our  attentions because the troubles of her Northern neighbor.

We haven’t’ realize that she is actually a very populated country, and an economic superpower in the making.

If you are Luxemburg, no one care whether you are rich or not. But we are talking about a country of similar population size as France! And with similar income level as Portugal! And unlike Portugal, it is a very innovative country by the way! By the way, Korea still invests 30% of its GDP, a ratio that is close to China's (40%); and all countries with higher investment ratio than Korea's are poor countries.

Unlike Taiwan that make profit by exploiting cheap labor in China  , South Korea has been manufacturing products under their own global brand names such as Samsung.

Professor Hasung Jang , Dean of Korea University's Business School, who was named Star of Asia by BusinessWeek for his contributions in reforming Korean corporate sector, is very proud of his country’s great industrial competiveness and potential:

“Korea is the only country that boasts of competitiveness in many manufacturing sectors, including automobiles, electronics, steel, shipbuilding, petrochemicals, and IT. It is hard to find a country that has competitiveness comparable to Korea’s. Therefore, we have to make good use of these excellent advantages and draw up growth strategy in this knowledge-based economic era.”

Please imagine a France rising up in East Asia, it is difficult, but try.

Japan has less than three times that of South Korea’s population, and every international  investment bank has a region called Asia (excl. Japan),  I wonder whether in 20 years time we will have a region called Asia (excl. Japan and South Korea)

I would like to refresh you with some basic facts that many of us usually haven’t realized:

(1) South Korea’s population is nearly 50 million. To put this number into perspective, France has a little more than 60 million, and Japan has less than 130 million.
(2) South Korea is the 12th largest economy in the world. By the end of 2005,  at market exchange rate, Korea’s GDP is 726 billion USD, while India’s is 735 billion, and Russia 740 billion. I would say the gap can well be due to estimation errors.
(3) They’ve been through economic crisis and political transitions. Unlike India and China that are still addressing easy problems, Koreans have gone through the tough times, endured the short-term pains, became a democratic country, and further increase of income is just a matter of time.

To Professor Hasung Jang, the big problem is whether the political leadership of the country can make best use of his country’s advantage:

“It seems that the confrontation between conservatives and liberals is getting worse. But what’s more worrisome is that rightists, who are accustomed to the government-led economy and chaebol dominance, and leftists, who are insensitive to global trends, are managing the economy in a manner that runs counter to the global trend,” he said.

Well, at least in Korea political parties try to differentiate themselves in economic policy, whereas in Taiwan no one can win on the platform of better economic policy. Taiwan has one advantage though: they don’t have militant leftists.

For more information on Korea, check CIA factbook