Our readers should note that throughout our upcoming publications, we’ll be using the term ‘financial repression’ very often. It is crucial that you truly understand how this practice works because the scale of its influence is global.
No doubt that China and Japan are the culprits of Asian financial repression. But their methods of running their respective economies somewhat contradict each other.
Stanford economists Edward S. Shaw and Ronald I. McKinnon coined this term. In short, it means governments essentially use the private sector to service debt.
But in a more detailed explanation: Financial repression are methods for governments to increase tax income and domestically-held debt.
This is done by keeping interest rate levels below that of inflation, effectively taxing the country’s savers. The upside is that cheap loans and credit products become available to borrow, which can lead to economic growth.
Financial repression is also useful for governments to control capital and have its citizens consume the bulk of domestic government debt.
This means a country’s population no longer has many choices when investing their savings. Rather than having money leaving the country to attract foreign assets, it’s funneled towards the government.
Governments can also change prices and push capital to its preferred economic sectors.
But how can a country like China use financial repression to alter several sectors of the economy?
In previous articles, we’ve mentioned the fact that China’s inefficient state-owned enterprises (SOEs) relying heavily on debt is a worrying reality. To know more about this topic, check out our publication on the marginal productivity of debt in Asia.
These entities (often in the field of capital-intensive, heavy industries) are becoming less efficient and productive, while having ballooning debt.
It may seem unwise to provide subsidies and low-cost credit options to prop up these “zombie” enterprises, but this method has its uses.
One Child One Chance
In many developing countries, families can have as many children and grandchildren as they like in hopes of being taken care of when they grow up. That means their saving rates are lower than that of China, which has a longstanding one-child policy.
Chinese households are allowed to have only one child (in 2015, this figure increased to two). This policy means one grandchild may have to look after four grandparents, which is quite unsustainable. With the change of policy, the burden of elderly care can be halved in many cases.
Because China lacks a welfare state for the elderly, the country has some of the highest domestic savings rates (relative to GDP) in Asia. Its savings compared to GDP is much higher than that of India, another huge developing nation, which can be seen with the graph below.
Other than bank deposits, savers do not have many options because of capital controls and restrictions on buying foreign assets. Banks tried using other options, such as life insurance products that have higher yields, to attract savers. Even though this seems to be a more appealing choice, when taking inflation into account, the overall return is negative.
Repercussion of Negative Real Returns
Because the Chinese government has extensive control over its interest rates, the gap between lending and deposit rates has been wide for a long time.
For state-directed banks and credit-hungry SOEs, the abundance of banking deposits that effectively yield negative returns is good news. Banks can effectively offer massive loans to these unprofitable companies, allowing them to continue operating.
Although recently interest rates were reduced, there’s still a 3% gap. Compared to developed markets like the EU and the U.S, this gap is very wide. This improves profitability, which can be seen using a return on equity metric. From the chart below, you can see that Chinese banks have higher profitability margins than their western counterparts on a continual basis.
So long as the negative real returns on loans exist, lending to massive, lethargic state enterprises can continue. This credit abnormality is most effective when there are medium to high levels of inflation.
The Chinese government is still trying to maintain an above 3% interest rate. This helps SOEs service their debt obligations, because high inflation reduces their burden of debt
Here are the three conditions that provide the perfect environment for state-owned enterprises to feed on credit continually: (1) inflation levels remaining high, (2) significant gap between interest rates and (3) negative real returns for savers.
Robin Hood in Reverse
The Chinese government has promised to weed out a lot of these ‘zombie’ state-owned enterprises. However, this is easier said than done, because most of the senior management comes from the ranks of the communist party, and severing old allegiances proves to be difficult.
In fact, the media likes to focus on the subject of habitual and unaccountable lending to SOEs in China. The upper class of these organizations has been heavily scrutinized because of its recently lavish spending behavior.
Look at the scandal of Harbin Pharmaceutical, a Chinese state-owned enterprise and one of the country’s largest drug manufacturers. It was heavily criticized because even though it can afford the lavish spending on its headquarters, it was accused of illegal dumping and water contamination.
State-owned enterprises tend to behave this way. It is the result of companies being supported by the government because they’re considered to be too big to fail. You can clearly see how the elite reap the savings from the masses when there’s unlimited amount of credit.
Governments all over the world use financial repression techniques, but the Japanese government utilizes this the most. Next week, we’ll have a special daily publication on Japan, which discusses how the country has a seemingly unmanageable amount of debt and how it copes with this predicament.