Financial Repression in China: Kleptocracy in Action
A fair warning to our readers: The term ‘financial repression' is going to be mentioned a lot throughout our upcoming publications. It is essential that you have a solid understanding of this practice, as its influences have global implications The biggest offenders of financial repression in Asia are undoubtedly Japan and China. But the way in which they run their economies is at opposite sides of the spectrum.
The term was first coined by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Simply put, it means that governments effectively rob the private sector to pay for debt.
To explain the concept further: Financial repression is a series of measures that governments use to increase tax revenue and domestically-held debt.
This is done by deliberately keeping interest rates below the level of inflation, which effectively acts as a tax on the nation’s savers. The benefit of this is that borrowers can access cheap loans and credit products, which in turn can generate economic growth.
Financial repression can also be used by governments to force citizens to consume large amounts of domestic government debt, via the use of capital controls.
This means that the population of a nation has fewer choices as to where they can invest their savings. So more funds are funneled towards the government, rather than leaving the country for more attractive foreign assets.
So, how does someone (like China) use financial repression techniques to manipulate a number of economic elements?
As we have mentioned in previous articles, China’s concerns over inefficient and debt-dependant state-owned enterprises (SOEs) is becoming a worrying reality. For more information on this topic, see our publication on the marginal productivity of debt in Asia.
Productivity and efficiency are diminishing, whilst debt levels via loans to these entities (often involved in capital-intensive, heavy industry activities) are ballooning.
It would seem like genuine insanity to continue to prop up these “zombie” enterprises with subsidies and low-cost credit options. But there is a method to the madness.
One Child One Chance
Saving rates in China are much higher than other nations. That's primarily due to its longstanding one-child policy. In many other developing countries, families have the option to produce as many children and grandchildren as they see fit, to hopefully support them in old age.
However, until 2015 Chinese families were restricted to one child per household (it has now been increased to two). The policy of one grandchild to look after potentially four grandparents was never going to be sustainable, so the elderly care burden since the change in policy can be halved in many cases.
The absence of a welfare state for the elderly prompted some of the highest domestic savings rates in Asia when compared to GDP. As you can see from the graph below, savings as a percentage of GDP is much higher than India, another large developing nation.
Due to capital controls and restrictions on purchasing foreign assets, savers are left with very few options, aside from bank deposits. Banks have also explored other options to tempt savers, such as life insurance products that have higher yields. This marginally more appealing choice still produces an overall negative return when offset against inflation.
Some individuals are looking to the property market as a savings mechanism, but bank deposits still are the preferred choice for the majority of Chinese depositors.
The Consequence of Negative Real Returns?
As the government exerts significant amounts of control over interest rates in China, the disparity between the deposit and lending rates has remained wide for prolonged periods of time.
The abundance of banking deposits that effectively yield negative returns is good news for state-directed banks and credit-hungry SOEs. Banks can effectively make copious amounts of loans to otherwise unprofitable whales, helping maintain their operations.
Although interest rates were recently compressed, they still maintain a 3% spread. That's much wider than in developed markets like the EU and the U.S. This enhances profitability as observed when using a return on equity metric. You can see in the chart below that Chinese banks continually achieve higher profitability margins than their western counterparts.
Lending to mega-sized, lumbering state enterprises can continue, as long as the negative real returns on loans exist. This credit phenomenon works best when there are levels of medium to high inflation.
The Chinese government is pushing to keep inflation levels at above 3%. This assists SOEs in maintaining their credit obligations, as high inflation diminishes the impact of their debt burden.
The perfect environment for state-owned enterprises to continue to binge on credit is: (1) negative real returns for savers, (2) significant interest rate spread disparity and (3) inflation levels remaining high.
Rise of the Kleptocrats
The Chinese government has vowed to cull many of these ‘zombie’ state-owned enterprises. But when the majority of senior management comes from the ranks of the communist party, severing old allegiances has proven to be easier said than done.
In fact, the habitual and unaccountable lending to SOEs in China has been the subject of much media attention. Recently the levels of opulent spending from the higher echelons of these organizations has come under intense scrutiny.
Take for example the Harbin Pharmaceutical scandal, a Chinese state-owned enterprise and one of the country’s largest drug manufacturers. The company was heavily criticized for the extravagant spending on its headquarters, whilst it was entrenched in allegations of water contamination and illegal dumping.
This level of excess isn’t uncommon in state-owned enterprises. It is symptomatic of what happens when a company is propped up by the government and deemed too big to fail. This behavior demonstrates how the savings of the masses are effectively looted by the elite when an endless credit line is available.
Financial repression techniques are being used by many governments across the world, but none more so than the government of Japan. Join us next week for our series of special daily publications on Japan and how the most heavily indebted nation on the globe is coping with a seemingly unmanageable amount of debt.