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.”

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.

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

New theory: Language is your destiny

Lee Kuan Yew (former PM of Singapore) says “Culture is your destiny” , does he say it in English, Chinese, or Malay? Does this really matter?

It does! Amir Licht, Chanan Goldschmidt, and Shalom Schwartz at the Hebrew Univerity of Jerusalem operationalize culture with data on cultural dimensions for over 50 nations adopted from cross-cultural psychology, and find that culture predicts the institutions you adopt.

Most interestingly, they find that whether the language you speak allows you to drop pronouns determines you culture, and in turn the governance structure of your country. For example, if your language allows you to omit ‘I’ , it reduces the conceptual differentiation between person and context, and the culture should emphasize little about uniqueness of an individual, i.e., it is a collectivism society.

Indeed, when Lee Kuan Yew makes his decisions, he rarely thinks it is his decision, but Singapore’s decision. When you are his enemy, you are Singapore’s enemy.

Culture Rules: The Foundations of the Rule of Law and Other Norms of Governance
Abstract:      
This study presents evidence about relations between national culture and social institutions. We operationalize culture with data on cultural dimensions for over 50 nations adopted from cross-cultural psychology and generate testable hypotheses about three basic social norms of governance: the rule of law, corruption, and accountability. These norms correlate systematically and strongly with national scores on cultural dimensions and also differ across cultural regions of the world. Regressions indicate that quantitative measures of national culture are alone remarkably predictive of governance and that economic inequality and British heritage add to predictive power. Instrumenting culture with a linguistic variable on pronoun drop yields consistent results, indicating a significant influence of culture on governance. The results suggest a framework for understanding the relations between fundamental institutions of social order as well as policy implications for reform programs

Pro-business or pro-market: Which works in India?

In the latest issue of IMF Staff Papers, Dani Rodrik and Arvind Subramanian at IMF argues that the pro-business attitudinal change in the 1980s instead of the pro-market reform in the 1990s contributed to India’s growth acceleration .

From "Hindu Growth" to Productivity Surge: The Mystery of the Indian Growth Transition

Abstract: This paper explores the causes of India's productivity surge around 1980, more than a decade before serious economic reforms were initiated. Trade liberalization, expansionary demand, a favorable external environment, and improved agricultural performance did not play a role. We find evidence that the trigger may have been an attitudinal shift by the government in the early 1980s that, unlike the reforms of the 1990s, was probusiness rather than promarket in character, favoring the interests of existing businesses rather than new entrants or consumers. A relatively small shift elicited a large productivity response, because India was far away from its income-possibility frontier. Registered manufacturing, which had been built up in previous decades, played an important role in determining which states took advantage of the changed environment.

T.N. Srinivasan at Yale University is not at all convinced by the argument, and makes some harsh critics.

This is a disappointing paper. It sees a mystery and fails to convince through analysis why it does. Had the authors been familiar with Indian economic literature, they might not have written it! The literature has not only noted the growth acceleration in the 1980s but has also questioned its sustainability on the grounds of its possibly being debt-led and fueled by employment and real wage expansion in the public sector.

Dani Rodrik and Arvind Subramanian strike back and it seems that they do have a point.

How many analysts seriously believe that the Asian financial crisis of 1997–98, arguably much bigger in magnitude than India's in 1991, proves that the rapid growth of Republic of Korea, Thailand, Malaysia, and Indonesia in the decades prior was unsustainable? And we have seen few analysts arguing that the crises in Latin America (Mexico in 1994, Argentina in 2000, or Brazil in 1998–99) call for a change in the market-based reforms preceding the crises on the grounds that they were unsustainable!

Why is India’s financial system less solvent than China’s?

First, I have to make it clear that, I am NOT saying that (1) India’s financial system is insolvent, or (2) China’s financial system is solvent. I am only arguing that India’s financial system is less solvent than China’s, i.e., you should worry about India too if you think China’s financial system is in big trouble.

There is this popular view that India is blessed by a sound and efficient financial system, while China will be troubled by the huge amount of non-performing loans sooner or later.

It is however not clear whether India’s or China’s financial system has greater amount of “non-performing assets”, because financial system is consisted of both the banking sector and the government public finance system.  Chinese banks have to assume some public finance roles and fiscal functions, while India parks all bad assets in the government’s public finance balance sheet. We thus need to take into account India’s bankrupt public finance system when we compare China and India’s financial systems.

In the early stage of China’s economic reform, in order to increase the efficiency of distributing resources, part of the government’s fiscal function was transferred to commerical banks that were spinned out from the planning-era mono-bank. Before the reform, there were no commercial banks, and planning commission of the central government was in charge of disbursing all investment funds.

Certainly state-owned banks are less efficient than private-sector banks, I don’t deny. But this move was an improvement of efficiency for public finance, which is also part of the financial system.  Later empirical studies show that state-owned banks distribute resources more efficiently than government agencies, partly because there are four state-owned bank of equal size operating nationally that are competing with each other.  Most of the non-performing loans were accumulated in this transition period. Argubaly, the other option at that time was to park these liabilities direclty in the government’s public finance balance sheet. This option is choosen by India.

In India, banks are not asked to assume these fiscal functions (burdens) as Chinese banks are, and thus the banks are much healthier. But we have to understand that bad "white elephant" projects are still there. They have to be financed by someone. They are financed by the government, directly. These "non-performing" liabilities don’ disappear, they are simply moved from the balance sheet of the banking sector to the balance sheet of the government’s public finance.  When an Indian PSU wants funding, the government borrows money and the liability is in the government’s balance sheet.  I don’t think PSU sector in any time soon will return large amount of money to the government, and I thus can assume that all the investment in PSUs by Indian government can be defined as “non-performing” if we think of the government as a “bank” that pursues profits

When we evaluate the health of India’s financial system, we have to evaluate the system as a whole, not only the banking system, but also the public finance system.  India’s public debt is more than 80% of its GDP. If Chinese government leverages its public debt to this level, she will have more than sufficient funds to write off all non-performing loans in state-owned banks. And it is legitimate for the government to do for she is the lender of last resort.  This is why depositors are still pouring more money into the system.  For India, the risk is in the balance sheet of the government, and IMF is her lender of last resort.

The reasons why India’s financial system is less solvent than China’s are that (1) when public finance and bank finance is combined, India’s balance sheet is more leveraged; (2) Chinese banks, although much less efficient than Indian banks, allocate resources better than Indian government; (3) India has a bigger public sector, more aggressive and less responsible fiscal policy;  (4) It is not clear whether IMF will bail out Indian government in a prompt fashion when she declares bankruptcy, while Chinese government will certainly bail out her banks as their is concensus that the banks have suffered for the government and it is time for paying back now that the government is flooded with tax revenues that are rising +20% yearly.

Note:   I don’t deny that China’s banking system also is in big trouble. How to improve efficiency of Chinese banks is an extremely difficult task.

The case for having “stupid” banks

Russians bankers are very smart, and thus they will never lend for your business investment (except in resource extraction industry, where it is easier to collateralize you revenues). They know very well that if they do they will end up with a lot of non-performing loans for sure, being aware of the unmatched skill of Russian borrowers in cheating. But is this what we really want? A stable but non-lending banking sector? Why don't you just use your own piggy bank! If they are not performing their roles, why do we care about how stable they are and how low a non-performining loan ratio they've achieved?

Banks not investing enough in economy

Bank credits only account for 7%-8% of total investment in the country and 2%-3% of that are foreign bank credits, he said at a banking conference in Yekaterinburg on Friday. "This is a very small investment in the development of the Russian economy and such a situation needs to changed at the root," he said.

MOSCOW. Jan 27 (Interfax) - Russian banks are not investing enough in the country's economy, Deputy Central Bank Chairman Gennady Melikian said.

China has a huge banking sector, with a lot of non-performing loans. I however argue that, to promote economic growth in a mid-income developing country, it is better to have a Chinese banking sector than to have a Russian one.

Let me explain why non-performing loan is NOT a problem.

When you get bad loans, it doesn’t mean that some wealth is burned away.

Let me give you an example: I have one apple, and I decide to loan it to you and you promise to return two apples to me at the end of the period. You plant the seeds (let’s assume for simplicity that you cannot eat the apple without destroying the seeds), and grow an apple tree with four apples in the tree. Then, either (1) you harvest them and run away from me (i.e. corporate governance problem) (2) Your neighbors come at night and quietly eat them all (business environment problem) . Either way, the result is that I have bad loan, because you don't return apples to me as you promised. But for the society this “project” produces four apples of benefit out of one apple. Remind you that even it the case that you neighbors steal and eat the apples, the society benefit as your neighbors are part of the society too.

However, if I decide not to loan you the apple, but eat it (with the seeds), there will be no bad loans, but no benefit for the society, either. This is what happens in Russia, India,Mexico, etc , where the banking sector doesn’t lend to any risky (but socially productive) investment projects. No one lends, and no bad loans for sure.

In China , however, government-owned banks are “stupid”. They build roads, power plants, steel plants, etc, and somehow borrowers always manage not to pay back the loans, and the banks have a lot of bad loans. But it doesn’t mean that these roads and plants just vanish. The social value of these big projects may be very positive. And as a matter of fact, most of the government-directed investments are put into infrastructure or heavy industries; the tasks are so well-defined that even inefficient SOEs can deliver the projects without wasting too much money (well, they certainly waste a lot of money)

Most private enterprises in China “steal” well-trained engineers and technicians (who bring with them the core techonology too) from SOEs, and some even “loot” the SOEs for machines, but these engineers and machines do not disappear from the economy although they are recorded as loss for the SOEs. So all of these bad loans are just something on the balance sheet, whose share will mechanically shrink as the economy grows bigger.

Finally, I have to remind you that most of China's non-performing loans are the results of policy lending, which means that the state-owned banks are taking away some fiscal burdens from the government. In India, non-performing loan ratio is low, but the government accummulates huge public debts to finance projects that if put into private banks' loan portfoilos will in all cases become "non-performing loans". If you accuse these projects to be unproductive, then they should be unproductive no matter whether they are in banks' portfolios or in government's portfolio. As a matter of fact, Chinese banks allocate resources better than their Ministry of Finance, and thus letting the state-owned banks to perform fiscal role is definitely efficiency-improving.

Smart private sector bankers will shy away once cheated, but stupid state-owned banks will just keep on lending. Sometimes a little bit stupidity accidentally leads to better results. Wright brothers were stupid; Thomas Edison was stupid too.... A smart banker should never listen to Wright brothers, and should never have lent to Delphi, Visteon, Ford, GM.... well, there were no defaults in primitive age when people only bartered...