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 Finance: Bending not breaking

The Economist

May 26, 2012

Dongwook LEE

Development economics, Fall 2012


Although the earthquake in Sichuan province did great damage to the region’s property and infrastructure in China, the pace of economic activity picked up in the wake of disaster. Along with economic rehabilitation, Chinese government tries to activate savings in the formal banking accounts by citizens and investing companies. Analyzing The Economist article “Finance: Bending not breaking” allows us firstly to look at the impact of lifting the interest rate ceiling, then to explore the paths of development in the country along with government financial institutions.

Since China went out of poverty and currently started speculative actions in the financial sector while meeting basic needs, Chinese problem should be tackled in a different perspective from other developing countries struggling for economic independence of an individual or a household. In short, China’s recent investment spree was driven by a “credit frenzy” which will turn into a painful “credit bust”.[1] The article is worrying about future economic crisis in China in the same pattern as United States in 2008, South Korea in 1997, and Japan in 1991 showing highly soaring credit as percentage of GDP.

At the early stage of Chinese economic development, government-owned national banks provided the very low interest rate, so that uninteresting sectors were nationalized. This policy of financial repression maintained a low interest rate in national banks, to provide money to entrepreneurs who are wiling to invest in China. From a typical dual monetary system with an organized money market and an unorganized money market, China made a step toward the elimination of this major factor price distortion with the removal of artificially low nominal interest-rate ceilings in the organized market as well as other related steps toward financial liberalization.[2] If there are three categories of credit such as big banks, small banks, and informal lending, households would be better rewarded for their saving if the deposit ceiling is lifted so that interest rate for saving increases.

Lending also jumped from 122% of GDP in 2008 to 171% just two years later.[3] However, banks rest stable thanks to a captive source of cheap deposits that leaves Chinese banks largely shock-proof and let them have a big margin for error. Using the traditional Harrod-Domar model, increase in savings rate also increases the growth rate according to incremental capital-output ratio (ICOR). However, a big pool of savings in China does not seem clear to lead to high quality productivity for growth, and this argument can be supported by Easterly’s explanation.

Moreover, a basic presumption for Chinese households is that they set a goal while saving in a bank. If the goal, such as saving money in case of potential medical emergency, university tuition or marriage supports for children, can be achieved without continuous strenuous saving, they turn to riskier funds. Higher incomes caused by increased interest rate to saving that matches a market interest rate will make them spend more and save less, leading to a decreased savings rate. Thus, the effect of increasing growth rate is limited to the point that additional income finishes its contribution to growth in consumption.

In 2011 new deposits amounted to 9.3 trillion yuan, according to official figures, more than enough to cover fresh loans of 7.3 trillion yuan.[4] High degree of governmental control to keep the interest rate had its tradition beginning in 1979, which Gorbachev during the perestroika era had been strongly influenced by the earlier agricultural successes in China when giant rural communes were broken up in favor of largely market-based small-farmer leaseholds – the so-called household responsibility system.[5]

This can be a bad news for China, but economic crisis comes after the rate liberalization as banks start to offer high returns to depositors even though their assets are producing low fixed returns. In a 2009 paper, Tarhan Feyzioglu of the IMF and his colleagues strongly endorsed Chinese rate liberalization.[6] But they also acknowledged that it can be mishandled, citing America’s S&L crisis as well as even worse debacles in South Korea, Turkey, Finland, Norway and Sweden.[7] In places like Wenzhou, a city in Zhejiang province, rate ceilings have encouraged firms and rich individuals to make informal loans to each other, bypassing the regulated banking system in favour of unsafe, unprotected intermediation in the shadows.[8] With a graph explaining credit rationing, or shortage of formal lending, this is coherent with a general thought of higher interest rate in an informal credit market.

According to the article, rural infrastructure projects are often “unbankable”, failing to generate enough income from fees, charges and tolls to service their financial obligations.[9] But the infrastructure may still contribute more to the wider economy.[10] That is especially likely for stimulus projects, which employed labor and materials that would otherwise have gone to waste.[11] Starting from 1979, Chinese government provided subsidies for formal lending for peasants and rural poor. As the 1977 case of India shows, reduced incentive for good management from both borrowers and lenders led to the program’s failure. The article from 2012 seems to show the more advanced development program to help the poor.

Yingxiu in Sichuan province suffered a calamitous loss of people and property, but this was followed by a conspicuous upswing in output (especially construction) and employment.[12] If this output is deemed as a modern sector in the mainly agrarian area of Sichuan, capital stock increases lead to a massive hiring without increasing wages. This can be interpreted as structural transformation of Lewis model in dualism. As high productivity and marginal product of capital come from building factories, and as machines have higher output than labor, inland Chinese economy started to move towards modern growth.

A growing number of short-term savings instruments with maturities of less than a month show the preference of both banks and customers. However, as net corporate deposits did not grow at all in 2011, the Chinese government is also trying to increase the interest rate in large long-term deposits as well. As The Economist explains, studies from the IMF worry about exclusion to financial markets of small private firms, and overestimation of the interest rate causing the share of Chinese investment of GDP more than optimal.

Chinese economic development has the similar trajectory as other countries that had repressive financial policies by the government in the past, before having a financial crisis. The Economist article made a hopeful remark of after-the-crisis development in western China, but at the same time warning about the upcoming predicted financial crisis concerning current freely market behavior for formal loans and short-term maturity financial products believing in bank accounts of normal citizens.



[1] “Finance: Bending not breaking” (The Economist, May 26, 2012), http://www.economist.com/node/21555766

[2] Michael P. Todaro, Stephen C. Smith, Economic Development (11th Edition), Prentice Hall, 2011, p. 733.

[3] “Finance: Bending not breaking” (The Economist, May 26, 2012), http://www.economist.com/node/21555766

[4] Ibid.

[5] McKinnon, Ronald I., The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy, The Johns Hopkins University Press, 1993, p. xii.

[6] “Finance: Bending not breaking” (The Economist, May 26, 2012), http://www.economist.com/node/21555766

[7] Ibid.

[8] Ibid.

[9] Ibid.

[10] Ibid.

[11] Ibid.

[12] Ibid.

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