Pain and prosperity

AT THE TIME, the “Five-Year Plan for a New Economy” seemed a courageous fresh start. The government vowed to wind down controls on interest rates, allow companies to borrow abroad, open domestic markets to foreign investors and sell its holdings in dozens of state-owned enterprises. Officials had promised at last to end “delay and vacillation”, remarked a leading reformist. Five years later the currency was plunging and banks’ bad loans were surging. It took a bail-out from the International Monetary Fund to douse the fire.

An imagined scenario of what lies ahead for China? No; this is a potted account of South Korea’s economic history in 1993-97, a period of bold deregulation that culminated in financial turmoil. Parallels with China are imperfect. For a start, South Korea’s vulnerability stemmed from the fatal combination of a whopping current-account deficit and a reliance on short-term foreign funding; China has neither to worry about. Yet two lessons are relevant to it. First, moving from a state-directed financial system to a market-based one is almost bound to cause serious turbulence. China is following a successful Asian development model pioneered by Japan and replicated by both Taiwan and South Korea. Their governments were unabashed in protecting infant industries and promoting exports and used banks to mobilise domestic savings for capital-heavy investment. In all three countries the benefits of such controls eventually faded away, but undoing them caused trouble, in the form of property and stockmarket bubbles in Japan in the 1980s; similar, if slightly smaller, bubbles in Taiwan by 1990; and South Korea’s financial crisis in 1997-98.

Such problems are not confined to Asia. Carlos Díaz-Alejandro, an economist, arrived at the same diagnosis in Latin America decades ago. The title of his classic 1985 paper went to the nub of it: “Goodbye Financial Repression, Hello Financial Crash”. Details vary from place to place, but there are common features. The most significant is the moral hazard that builds up in managed financial systems over time. Because the state wields so much control, lenders and investors alike come to count on it as a backstop when trouble arises. As Mr Díaz-Alejandro wrote, “warnings that intervention will not be forthcoming appear to be simply not believable.”

Deregulatory risk

Belief in the government’s role as guarantor is particularly dangerous when deregulation begins. Suddenly, opportunities arise for higher profits because returns are no longer capped, but financial institutions do not yet have proper risk safeguards in place. Some might even calculate that it is in their interest to expand as quickly as possible, gambling that by the time the government pulls the plug on guarantees they will have become “too big to fail”.

These dynamics are already at play in China. Over the past few years its banks have been piling on risk through their shadow operations. To attract funding, they have offered higher rates to depositors through wealth-management products. They have put more of their cash into higher-return assets, often dodging regulatory limits to do so. Mid-sized banks, those on the cusp of too-big-to-fail status, have been the wildest. Insurers, peer-to-peer lenders and asset managers, among others, have all been drawn into the race to offer higher yields, at the very moment when growth is slowing and returns are declining. And whereas the official preference is to move slowly, money is not waiting around. If need be, it will move abroad.

If deregulation involves such dangers, why would anyone want to risk it? The reason is that repressed financial systems eventually outlive their usefulness. Dysfunctions begin to corrode previously potent growth models. Returns on capital decline as banks roll over loans to struggling companies. Shadow banks flourish as companies and investors work around rules. Controlled capital accounts come apart at the seams. These ills are already far advanced in China. Just look at the growing amount of debt it employs to fuel short-term growth.

The second, more hopeful, lesson from the experiences of other Asian dynamos is that financial tumult need not spell the end of development. In recent years it has become fashionable to present crises as opportunities, but that is far too glib; the effects of a crisis are unpredictable and the damage to people’s lives all too real. Yet it is also clear that mistakes did not stop South Korea or Taiwan from subsequently doing well. Precautions are needed to limit the turmoil, but putting off change indefinitely will spell steady decline.

China’s financial reforms have been edging in the right direction, but not fast enough

China’s financial reforms have been edging in the right direction, but not fast enough. Many observers expect it to follow Japan towards chronic malaise. For China, that would be even worse. When Japan stumbled, its people’s incomes were close to American levels, but average Chinese incomes today are just a quarter of those in America.

China, however, is different from Japan in a number of ways. Some are helpful: it is less developed than Japan was in the 1980s, giving it more scope for catch-up growth—and for recovery from financial missteps; its exchange rate is under pressure to depreciate, not appreciate; its property bubble is less gigantic; and its stockmarket has already crashed.

Ideological differences are more worrying. The Communist Party is, almost by definition, wary of the market and suspicious of the West. In Japan, South Korea and Taiwan, economists who trained abroad eventually returned home and pushed for reform. China has an embarrassment of talented citizens with global experience, but many of those who have returned have grown frustrated with the party’s grip and left government. Without more political openness, the road to financial reform will be fraught.

There is another big difference to consider. China’s weight in the global economy is far larger than that of any other country whose banks have gone through a similar transition. The case for change is plain: the government needs to cede more control to the market to make the financial system work and to unleash the economy’s potential. Even if it gets it right, the process will be rough for China and bumpy for the world. The alternative—that it fiddles while its banks falter—is too awful to contemplate.