Wednesday, December 29, 2004
Saw an interesting op-ed in the FT about foreign exchange reserve and SOEs, but SOE pension obligation is such a passe issue. Much of the problem has disappeared, and the remaining problem is really managable. The problem is continuing soft-budget to SOEs. Below are my responses to the op-ed.
The Chinese government has used the foreign exchange reserve to recapitalize the big state banks, which have poured trillions into SOEs. They are likely to use another 40 to 50 billion USD to recapitalize ICBC and ABC in the future. They might use some of the money to finance the social security fund, but I haven't heard anything about it. Regardless, it is a bad idea to use the money specifically to cover SOE social pension. The SOEs have used social obligation as an excuse to get more subsidies in the past decade. In fact, a modest investment in the early 90s could have saved the Chinese government trillions of yuan in money poured into the SOEs. Zhu Rongji was in fact quite successful in reducing SOE staff as a share of urban employees. The main task now is to establish a national social security system that benefits all workers regardless of where they work.
The problem is that soft budget going to SOEs continues regardless of social obligation. Much of the money going into SOEs is used to finance investment and expansion. Some of the money seemed justifiable, given recent supply shortage. However, there is bound to be enormous distortion in the flow of money to SOEs since banks are still encouraged to lend to SOEs and the SPC still approves major investment of SOEs. As Professor Lal points out, there is still capital control and a repressed financial system. The SASAC is now taking tentative steps toward the final stage of SOE reform, privatization, but ideological, institutional, and legal barriers make this a slow process. Granted, financial liberalization and privatization need to take place gradually, but in the meantime, distortion is the price that one has to pay. So, using the foreign exchange reserve just for SOEs is not a good idea, since they receive plenty of soft-budget already and banks are still not operating independently. The Chinese government needs to diversify, and they are doing so already by reducing purchasing of US treasuries.
Financial Times
How foreign reserves could make China yet strongerBy Deepak LalPublished: December 28 2004 19:36Last updated: December 28 2004 19:36
Foreign exchange in ChinaChina's economic performance in recent years has been extraordinary. This year, growth in gross domestic product is forecast to exceed 9 per cent, with industrial production up a remarkable 16 per cent. Many fear that the country's financial system may be too fragile to sustain such growth in the long term. Fortunately, the country's burgeoning foreign exchange reserves could provide an ideal remedy.At the root of the problems in China's financial sector are the continuing subsidies directed to state-owned enterprises via the banking system. The purpose of these is to prevent unemployment and the loss of welfare benefits to former and current employees. Although the government has closed the worst loss-makers, the remainder continue to be subsidised.In the long term this is likely to damage China's currently high savings rate, the foundation of its economic miracle. At present, nearly 90 per cent of household savings are held in deposits with state-owned banks, partly because of the lack of alternatives. Most of these deposits are lent to SOEs. By contrast, most of the investment in the dynamic, private non-SOE sector that is propelling China's industrial growth is self-financed, or dependent on foreign capital. With few of these non-state growth enterprises being willing - or allowed - to issue shares, trade on domestic stock exchanges is mainly in SOEs, whose non-transparent accounting practices and perceived lack of viability deter households from holding much of their savings in them directly. Hence the thinness and volatility of the domestic stock markets, as even a little news from the opaque SOEs can trigger big price movements.This lack of adequate savings vehicles and the low return on deposits in state-owned banks pose a threat to China's high rate of savings. This is likely to be compounded by the depressing effect on savings of an increasingly elderly population. But the state-owned banks cannot promote higher savings by raising their deposit rates without a rise in their lending rates to the unviable SOEs. These SOEs' losses would then grow, leading the banks to advance more loans to cover them, with the result that the banking system would be burdened with yet more non-performing loans.These microeconomic difficulties in using interest rates to stimulate savings that can then be fed into a well-functioning stock market have macroeconomic consequences. As the central bank is in effect prevented from using the interest rate to manage aggregate demand, heavy-handed (and, given the self-financed nature of most non-SOE investment, inefficient) administrative measures are needed to cool the economy.Furthermore, given the fragility of the banking system, fully opening up the capital account of the balance of payments and moving to a completely flexible exchange rate system is ruled out. I do not think China's export-led growth has depended on maintaining an undervalued exchange rate. As most of China's manufactured exports are processed goods with little domestic value added, changes in the exchange rate would have little effect on companies' profitability. The move to a flexible exchange rate is not only needed for a more efficient use of China's national savings, but also to fend off the growing pressures for a revaluation of the renminbi from private speculators and China's main trading partners.Behind all these dangers to China's economy lie the social burdens carried by the SOEs. These must be removed so the viable SOEs can prosper and the rest can be taken over or closed down.Fortunately, China's large build-up of foreign exchange reserves provides the answer. In October, these stood at more than $600bn, in a roughly $1,000bn economy. They are about 60 per cent of gross domestic product and are largely held in US Treasuries. Apart from the absurdity of a relatively capital-poor developing country making these large, unrequited transfers to a rich country, China must have seen a loss in the real value of these assets. Since its peak in 2002, the US dollar has depreciated by nearly 30 per cent in trade-weighted terms against big currencies.There is a better way for China to use its reserves. At most, only a small proportion - say $100bn - is needed to fend off any speculative attack in order to maintain the dollar peg. The rest - some $500bn, as well as any future accruals - could be put into a social reconstruction fund under the central bank. This would function like any other big pension fund, such as that for the World Bank, whose annual return, averaged over 10 years, has been about 8 per cent. If the proposed fund for China could match this, it would yield an annual income of $40bn, or 4 per cent of GDP, which could be used gradually to cover the SOE's social burdens. The SOEs could then be treated as normal enterprises, to be privatised if viable and closed down if not.This would bring many benefits. It would end the need for the subsidies that are sapping the banking system's vitality. Banks could instead concentrate on mobilising domestic savings and transferring them to high-yielding investment projects. SOEs with market-traded stocks would have more incentive to adopt transparent accounting. The authorities would be able to use interest rates as the primary means of managing demand. With a more robust financial system, the renminbi could even be allowed to float. In time, as the SOE problem receded, the income from the fund could become the basis for a fully funded pensions system for China's ageing population.There are good reasons to worry about the robustness of China's financial system, it is true. But a country with $600bn in reserves is not exactly devoid of options.
The writer is the professor of international development studies at the University of California, Los Angeles
The Chinese government has used the foreign exchange reserve to recapitalize the big state banks, which have poured trillions into SOEs. They are likely to use another 40 to 50 billion USD to recapitalize ICBC and ABC in the future. They might use some of the money to finance the social security fund, but I haven't heard anything about it. Regardless, it is a bad idea to use the money specifically to cover SOE social pension. The SOEs have used social obligation as an excuse to get more subsidies in the past decade. In fact, a modest investment in the early 90s could have saved the Chinese government trillions of yuan in money poured into the SOEs. Zhu Rongji was in fact quite successful in reducing SOE staff as a share of urban employees. The main task now is to establish a national social security system that benefits all workers regardless of where they work.
The problem is that soft budget going to SOEs continues regardless of social obligation. Much of the money going into SOEs is used to finance investment and expansion. Some of the money seemed justifiable, given recent supply shortage. However, there is bound to be enormous distortion in the flow of money to SOEs since banks are still encouraged to lend to SOEs and the SPC still approves major investment of SOEs. As Professor Lal points out, there is still capital control and a repressed financial system. The SASAC is now taking tentative steps toward the final stage of SOE reform, privatization, but ideological, institutional, and legal barriers make this a slow process. Granted, financial liberalization and privatization need to take place gradually, but in the meantime, distortion is the price that one has to pay. So, using the foreign exchange reserve just for SOEs is not a good idea, since they receive plenty of soft-budget already and banks are still not operating independently. The Chinese government needs to diversify, and they are doing so already by reducing purchasing of US treasuries.
Financial Times
How foreign reserves could make China yet strongerBy Deepak LalPublished: December 28 2004 19:36Last updated: December 28 2004 19:36
Foreign exchange in ChinaChina's economic performance in recent years has been extraordinary. This year, growth in gross domestic product is forecast to exceed 9 per cent, with industrial production up a remarkable 16 per cent. Many fear that the country's financial system may be too fragile to sustain such growth in the long term. Fortunately, the country's burgeoning foreign exchange reserves could provide an ideal remedy.At the root of the problems in China's financial sector are the continuing subsidies directed to state-owned enterprises via the banking system. The purpose of these is to prevent unemployment and the loss of welfare benefits to former and current employees. Although the government has closed the worst loss-makers, the remainder continue to be subsidised.In the long term this is likely to damage China's currently high savings rate, the foundation of its economic miracle. At present, nearly 90 per cent of household savings are held in deposits with state-owned banks, partly because of the lack of alternatives. Most of these deposits are lent to SOEs. By contrast, most of the investment in the dynamic, private non-SOE sector that is propelling China's industrial growth is self-financed, or dependent on foreign capital. With few of these non-state growth enterprises being willing - or allowed - to issue shares, trade on domestic stock exchanges is mainly in SOEs, whose non-transparent accounting practices and perceived lack of viability deter households from holding much of their savings in them directly. Hence the thinness and volatility of the domestic stock markets, as even a little news from the opaque SOEs can trigger big price movements.This lack of adequate savings vehicles and the low return on deposits in state-owned banks pose a threat to China's high rate of savings. This is likely to be compounded by the depressing effect on savings of an increasingly elderly population. But the state-owned banks cannot promote higher savings by raising their deposit rates without a rise in their lending rates to the unviable SOEs. These SOEs' losses would then grow, leading the banks to advance more loans to cover them, with the result that the banking system would be burdened with yet more non-performing loans.These microeconomic difficulties in using interest rates to stimulate savings that can then be fed into a well-functioning stock market have macroeconomic consequences. As the central bank is in effect prevented from using the interest rate to manage aggregate demand, heavy-handed (and, given the self-financed nature of most non-SOE investment, inefficient) administrative measures are needed to cool the economy.Furthermore, given the fragility of the banking system, fully opening up the capital account of the balance of payments and moving to a completely flexible exchange rate system is ruled out. I do not think China's export-led growth has depended on maintaining an undervalued exchange rate. As most of China's manufactured exports are processed goods with little domestic value added, changes in the exchange rate would have little effect on companies' profitability. The move to a flexible exchange rate is not only needed for a more efficient use of China's national savings, but also to fend off the growing pressures for a revaluation of the renminbi from private speculators and China's main trading partners.Behind all these dangers to China's economy lie the social burdens carried by the SOEs. These must be removed so the viable SOEs can prosper and the rest can be taken over or closed down.Fortunately, China's large build-up of foreign exchange reserves provides the answer. In October, these stood at more than $600bn, in a roughly $1,000bn economy. They are about 60 per cent of gross domestic product and are largely held in US Treasuries. Apart from the absurdity of a relatively capital-poor developing country making these large, unrequited transfers to a rich country, China must have seen a loss in the real value of these assets. Since its peak in 2002, the US dollar has depreciated by nearly 30 per cent in trade-weighted terms against big currencies.There is a better way for China to use its reserves. At most, only a small proportion - say $100bn - is needed to fend off any speculative attack in order to maintain the dollar peg. The rest - some $500bn, as well as any future accruals - could be put into a social reconstruction fund under the central bank. This would function like any other big pension fund, such as that for the World Bank, whose annual return, averaged over 10 years, has been about 8 per cent. If the proposed fund for China could match this, it would yield an annual income of $40bn, or 4 per cent of GDP, which could be used gradually to cover the SOE's social burdens. The SOEs could then be treated as normal enterprises, to be privatised if viable and closed down if not.This would bring many benefits. It would end the need for the subsidies that are sapping the banking system's vitality. Banks could instead concentrate on mobilising domestic savings and transferring them to high-yielding investment projects. SOEs with market-traded stocks would have more incentive to adopt transparent accounting. The authorities would be able to use interest rates as the primary means of managing demand. With a more robust financial system, the renminbi could even be allowed to float. In time, as the SOE problem receded, the income from the fund could become the basis for a fully funded pensions system for China's ageing population.There are good reasons to worry about the robustness of China's financial system, it is true. But a country with $600bn in reserves is not exactly devoid of options.
The writer is the professor of international development studies at the University of California, Los Angeles
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