Linda Yueh on the China Institutions Story the Media Is Missing, Malinvestment Dangers to the Chinese Banking System
Where do you begin to start in writing a book about the Chinese economy? What are the core takeaways for readers?
Linda Yueh: The most important theme that I've highlighted is the importance of institutional change and institutions in trying to understand the Chinese growth experience.
The way the book is organized is that each chapter is very clearly delineated. One chapter will be focused on how the labor market has changed, how state-owned enterprises has changed, how the growth model has changed. Weaving it all together is the theme of institutions.
This has really been the big lesson in economic development and growth for the past few decades. No country can successfully grow just by adopting incentives and principles without paying attention to how institutions work, how institutions underpin a well functioning market and economy.
The way [China] has managed to use institutions to first inject incentives for farmers -- a really big reason why China grew well initially, when it started to reform in 1979, is that farmers had the incentive to produce output, and then their savings went into creating rural industry.
All that was done by subtly weaving in market supporting institutions, giving them just a little bit more incentive to preserve the stability of the system. That has been key.
So, that is the theme of the book. To try and look at China through a prism of understanding the vast changes -- through looking closely at how its institutions have actually changed and putting that at the forefront -- is worthwhile.
You advised the Chinese government on their latest five-year plan back in 2010. What are the insights you gained from communicating directly with the economic planning apparatus of China?
Linda Yueh: China is well aware of the extraordinary feat of growing very well for 30 years -- it's almost unprecedented for a major economy to be able to do that. The challenge is: How do you replicate it for the next 30 years?
[Chinese leadership] knows that growth will slow, but obviously they want to have a plan in place to try and make sure that China, whose average incomes by the way right now are only $4000 USD, can achieve upper-middle country status in the coming decades.
Our job was to try and point out the ways in which growth has been successfully driven, but also where there is still a need. Continuing on the theme of institutions, it's been extraordinary how well they have managed -- sometimes with very informal institutions -- to incentivize output, to reform the centrally planned economy and make it more like a market.
Going forward, legal reforms will be much more important. One, because the market is more mature; second, because China is globally integrated. That means if you look at all of the laws passed in the 2000s, they are very good starting points for the kind of market-supporting institutions that China needs to preserve its strong growth potential.
In other words, if you don't have good protection of intellectual property, it's hard to stimulate innovation. If you don't protect property rights, it's hard to incentivize not just domestic enterprises, but keep foreign firms investing and trading with China.
As a financial news personality who has also written a textbook on the Chinese economy, what are biggest misconceptions you see in the media about the Chinese economy today?
Linda Yueh: I think there is an under-appreciation of how unusual the Chinese context is. In other words, if you took a standard output model and you said, "This is the output gap -- this is the difference between what an economy can grow at and what it grows at," and you take your model and you stick it on China, not surprisingly, it doesn't seem to work that well.
That is an example of trying to apply -- rightly so -- rigorous analysis, but to a country where sometimes the data, sometimes the information, and sometimes the entire economy just isn't yet a Western, market economy.
For instance, you can't run an output gap analysis on China because there is no accurate unemployment figure. Unemployment is only measured for the urban population. That is only half of the population.
I think that is one of the big challenges. When you look at the economy of China -- the second biggest economy in the world -- you want to apply a lot of (rightly so) very technical or analytical ways of looking at its market, it's economy.
I think you have to step back and say, "This is still a developing country. This is the technical analysis, but what is the context? How can I interpret this outcome knowing the flaws in the data, in the way that the economy is constituted?"
I think it is that additional level of qualitative analysis that is needed to really get a grasp on this economy.
How great are the risks to China's economy and banking system posed by non-performing loans and malinvestment?
Linda Yueh: That is the kind of thing that is still very much in need of reform in China. We do know some statistics about the banking system. For instance, the Chinese National Audit Office thinks that the amount of local government borrowing from the banking system is 17 percent of Chinese GDP.
Now, if some of those loans go bad, then clearly that is going to be a huge burden on the banking system. Then, you have to reconcile that with the official statistics, which tell you that non-performing loans in 2010 were only 1.1 percent of the banking system.
Those two numbers may not necessarily go together. I think it is very difficult for economists and analysts to get a hold of exactly how stressed the Chinese banking system is, and those are some of the reasons why.
I think the way that economists think about banking systems is if there are enough resources at the governmental level to recapitalize the banks, then even if the banking system is under stress, it would be manageable.
That's not to diminish the impact of a banking crisis. That would be very disruptive, especially in terms of people's deposits and borrowing and feelings of wealth. So obviously there is a huge impact, but in terms of a systemic crisis, it wouldn't be as likely if the government has enough funds to recapitalize Chinese banks.
That is really the gauge we should look at. The Chinese banking system has improved over the past 15 years, but in the last few years, it has begun to go back to perhaps some of the old habits of using the banking system to finance stimulus.
If you think about the existing state-owned enterprises -- this legacy of potentially non-performing loans -- that is the worry. I have been worried for some time that China could have a banking crisis. I know that the Chinese leadership are constantly worried about it as well.
This is actually one of the reasons why reforms of opening China's capital account or financial sector have been so slow. They are very much worried about trying to reform the state-dominated banking sector first.
For me, that is one of the biggest risks for China, but I have been saying that for quite some time.
What are the most important metrics for people to watch if they are concerned about these risks?
Linda Yueh: Certainly how the banking system is faring -- whatever data can be gleaned on non-performing loans. In particular in recent years, two sources of stress: one is local government borrowing. That should be coming off a little bit because they are allowing more municipal bonds to be offered.
Second: state-owned enterprises. At the central level, there are only about 150 state-owned enterprises left, surprisingly, but there are still actually quite a few dotted around the country. They are borrowing from the banking system. That is one key area to continually watch for.
China is going to have a very rough year this year because clearly, its biggest trading partner -- its biggest export destination -- is the European Union. The major region in the world heading for recession this year -- according to the IMF and the World Bank -- is the euro region.
Looking at how China is able to rebalance its economy over the medium term toward domestic consumption -- that's got to be a key trend to watch. In the immediate term, it's the ability of the government to use stimulus or government spending offset what is almost certain to be a decline in exports.
That will determine Chinese fortunes this year. The IMF's latest outlook for China says they think that Chinese growth could be halved by a European recession -- down to about 4.2 percent growth, worse than 2009 -- but they think the government can stimulate the equivalent of 3 percentage points of GDP, bringing the growth rate to about 8 percent.
So, in the immediate term, I would say stimulus and whether that is being held back by inflation and excess liquidity -- too much money flowing around because of the undervalued renminbi -- those are the short-term risks.
Will China have a dramatically increased role in the international monetary system?
Linda Yueh: I think China will. In fact, one of the biggest signs to look for is the internationalization of the renminbi. The Chinese are pushing for it to be used. London is in the running to become an international renminbi center in the same way that Hong Kong has been established as one as of July 2010.
This means that China is keen to -- for its currency, and therefore, its own central bank -- play a much bigger role in the international monetary system. One of the trends and issues that is often talked about is moving the renminbi toward becoming a reserve currency, so that would be the next step for the internationalization of the renminbi.
I think this is all very promising, but I think the challenge for China is that to do this, they would have to take on first a bigger role in the international monetary system. That is having to contend much more closely with the issue of global imbalances and some of the responsibilities that would come that.
Second, for its own development: whether it opens its capital account. It would have to speed up its financial reform. Right now, it's pretty close because they are slowly reforming their banking system.
I think in the international system as a whole, there is a much greater push to have some degree of not quite Bretton Woods II, but some type of international system that at least monitors global liquidity.
We have seen in this global crisis a much greater coordination of central banks. That kind of action in a globally integrated world points to a different way of thinking about monetary policy -- thinking about the global consequences of when you intervene in your currency or when you set interest rates in your country, what you do in a crisis.
That kind of coordination and intervention -- that kind of action -- is probably going to be a hallmark of the future. It's a positive thing, I think, because if you have a globally integrated financial system, you need to have global institutions to be able to stabilize markets across national borders.
That is a trend for the future. The only part I'm not sure about is how ready the Chinese are to play a big role in that, but I think they eventually will have to if they want the renminbi to become internationalized.
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