Debt and Distortion: Risks and Reforms in the Chinese Financial System


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Risks and Reforms in the Chinese Financial System

The financial system has continued to lend freely and cheaply as the economy has slowed, and the risk of crisis has mounted.


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In response, the government has initiated the most ambitious financial reforms in twenty years. Financial markets, businesses and governments are concerned about these risks and are struggling to understand what the reforms will mean for China and the rest of the world.

By analyzing the topic in terms of a few fundamental distortions, this book makes an otherwise complex topic accessible while simultaneously providing new insights. These distortions provide a simple framework for understanding the nature of the Chinese financial system and its future prospects.

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Debt and Distortion: Risks and Reforms in the Chinese Financial System - Hardcover

Springer Professional. Back to the search result list. Growth Model Abstract. It has created more wealth and lifted more people out of poverty in a shorter time than any other country in history. In this chapter, we explore the economic system that made this possible. This is a necessary prerequisite for analyzing the financial system for three reasons. First, the financial system evolved to support the economic system that brought this growth, and it is impossible to understand the financial system without understanding the system it was designed to support. Second, we need to understand why such a successful system needs to be reformed and, by extension, why the financial system needs to change to accommodate that reform.

Finally, financial reforms will undermine the existing drivers of economic growth and replace them with new drivers. This transformation will be difficult and risky, and the challenges and dangers will need to be understood in advance and incorporated into the reform plans. Almost all financial crises stem from excessive accumulation of debt.

Although the specifics of crises may differ, they share common features that make it possible to describe the common underlying dynamics. Perhaps the central thinker on such dynamics was Hyman Minsky. His work, relatively unknown during his lifetime, has received a great deal of attention since the subprime crisis. The basic idea is that debt tends to amplify both booms and busts.


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During a boom, borrowing increases profits, encouraging the buildup of debt; during the bust, it exacerbates losses, leading to a rapid reversal in economic performance. The next section provides a more detailed explanation of how this happens and why it can be hard to manage. Between and , Chinese interest rates were very low. Figure 3. This graph uses the consumer price index CPI to adjust for inflation. Michael Pettis has argued that rather than CPI, we should deflate interest rates using the GDP deflator a broader measure of inflation that considers all sectors of the economy rather than just consumers.

Using this measure, the real lending interest rate between and was just 0. All investment involves risk since cash must be given up for uncertain future returns. The more uncertain these returns are, the greater the risk. Historically, debt defaults were not isolated events. The most direct index to measure total debt is its ratio to GDP, namely debt leverage or debt ratio.

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And the leverage is broken down into four parts from the government sector, the non-financial sector, the financial sector and the resident sector. But saw a downward trend for three consecutive quarters. Local governments accumulated higher debts through soft control of budgets and financing. From the debt side, the sustainability of debt growth should be considered. Because the investment and consumption based on debts can promote GDP, the nominal GDP per capita can still maintain positive growth if the debt growth per capita is faster than the leverage growth.

Debt and Distortion: Risks and Reforms in the Chinese Financial System by Armstrong-Taylor, Paul

Thus, a country with a different level of sustainability can show a different level of economic performance at the same leverage level. Instead, China turns the debts into fixed asset investments, forming infrastructure and large scale state-owned assets. Take the non-financial sector for example. Because redirecting the flow of resources necessarily undermines institutions that have long controlled access to these resources, in China as elsewhere, these institutions prevent reforms from being implemented quickly enough to avoid either much slower growth or a risky increase in the debt burden.

There is a second set of constraints, however, that limit the positive impact of reform in ways I believe Lardy, and most economists, tend systematically to underestimate.


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This point is often contested, mainly because it is so poorly understood. Ask how much debt is too much, and these economists usually respond with debt ratios.

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But debt matters enormously in two important ways that are largely missing in the debate about China. First, the structure of the balance sheet can exacerbate volatility.

Dinny McMahon: Local Governments in China Fueled China's Great Wall of Debt?

Second, it can create financial distress costs. Distortions in the credit market, and especially in interest rates, usually create imbalances in the way growth is distributed, and the more growth depends on pro-cyclical credit expansion, the more it is unbalanced. Albert Hirschman often reminded us that all growth is unbalanced, and that these imbalances eventually reverse.

But as the optimism of the s and s among development economists was eroded by events, so too was his casual attitude toward rebalancing. By the s Hirschman began to worry that a successful rebalancing was the most difficult constraint to long-term growth.

Debt and Distortion: Risks and Reforms in the Chinese Financial System Debt and Distortion: Risks and Reforms in the Chinese Financial System
Debt and Distortion: Risks and Reforms in the Chinese Financial System Debt and Distortion: Risks and Reforms in the Chinese Financial System
Debt and Distortion: Risks and Reforms in the Chinese Financial System Debt and Distortion: Risks and Reforms in the Chinese Financial System
Debt and Distortion: Risks and Reforms in the Chinese Financial System Debt and Distortion: Risks and Reforms in the Chinese Financial System
Debt and Distortion: Risks and Reforms in the Chinese Financial System Debt and Distortion: Risks and Reforms in the Chinese Financial System

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