A blog on financial markets and their regulation
Financial Repression in China and India
January 16, 2006Posted by on
Raghuram Rajan, Economic Counselor and Director of Research,
International Monetary Fund
“uniquely among fast-growing Asian economies, China
has not raised its share of value added coming from high-skilled industries
significantly, even as its per capita GDP has grown” and that the inadequacies
of the Chinese financial system are to blame for this:
It is unlikely the chairman of a state owned corporation, cash rich because he no
longer has to meet his social obligations to workers, will prefer to return cash to
the state via dividends rather than retaining it in the firm, particularly when banks
are under orders to restrain credit growth. And with financial investments returning
so little, far better to reinvest cashflows in real assets. Indeed, liquidity plays a
greater role than profits in determining real investments.
Similarly, the chairman of a private firm knows that financing from either the stock
market or the state-owned banks is very uncertain. So he too will be unlikely to pay
dividends, preferring instead to retain the capital for investment. Again, instead of
storing this as financial assets and awaiting the right real investment opportunity,
given the poor returns on financial assets, he has an incentive to invest right away.
These tendencies imply a lot of reinvestment in existing industries especially if
cashflow in the industry is high, which inexorably drives down their profitability.
And they imply relatively little investment in new industries. The inadequacies of
the financial system would thus explain both the high correlation between savings
and investment and the oft-heard claim that over 75 percent of China’s industries
are plagued by overcapacity. They also suggest why uniquely among fast-growing
Asian economies, China has not raised its share of value added coming from
high-skilled industries significantly, even as its per capita GDP has grown.
This is an interesting argument against financial repression. It is useful to remind
ourselves once in a while that the occasional stock market scandal that we have seen
in India since the beginning of economic reforms is a small price to pay for
getting rid of financial repression. It is also necessary to recall that as a percentage
of GPD, the annual losses to Indian households from financial repression were
higher than the amount involved in even the biggest of the stock market frauds since
1991. For example, during 1980-81 to 1989-90, time deposits at commercial banks
averaged over 25% of GDP.
I have estimated
that financial repression in the 1980s was about three percentage points. This implies
that holders of time deposits at banks lost 0.75% of GDP annually. If we add the losses
on other repressed financial assets (especially life insurance and provident funds),
the total would certainly exceed 1% of GDP annually. By comparison, the total amount
of fraud in the scam of 1991-92 (involving Harshad Mehta and others) was about
0.75% of GDP. The total amount of fraud in the scam of 2000-01 (involving Ketan Parekh)
was less than 0.2% of GDP.