Time to replace financial repression with liberalization

With entrenched vested interests and past history, government's effort to discard the old financial method will not be a smooth ride.

The phrase "new normal" reflects dramatic changes in China. However, it also implies that there is an "old normal".

The hope of change lies in that the present conditions of China's old model in economic growth no longer exist. There will be no choice but to move to a new model. Since finance is the core of modern economy, there is also a version of old normal and a new one.

As the old model of economy mainly depends on government investment, the government needs to mobilize enough funds. In such a case, for developing countries, the general financial policy is financial repression, which is exactly the core of China's old financial model.

The term financial repression was introduced in 1973 by Stanford economists Edward S Shaw and Ronald I McKinnon. It refers to "policies that result in savers earning returns below the rate of inflation" in order to allow banks to "provide cheap loans to State-owned companies and governments, reducing the burden of repayments".

China's financial repression consists of the following:

1 Government controls almost all banks and financial institutions.

2 Direct or indirect capping of interest rates, such as on government debt and deposit rates.

3 Creation or maintenance of a captive domestic market for government debt, achieved by requiring banks to hold government debt via capital requirements.

4 Most free social money is guided to follow into banks by restricting development of capital market products.

5 Government restrictions on the transfer of assets abroad by capital controls.

These measures allow governments to not only issue debt at lower interest rates but also acquire cheap and a lot of deposit to provide funds for government investment projects. A low nominal interest rate can reduce debt costs, while the negative real interest rates caused by inflation erode the real value of government debt. Thus, financial repression is most successful in mobilizing social money in government investments.

Government investment can help rapid expansion of State-owned enterprises to provide infrastructure and livelihood that people urgently need. But the model, if applied for a long time, can cause several severe problems:

1 The interest rates, as the most important prices for guiding money into profitable projects, are mispriced, which split the financial market into expensive private market and cheap State-owned market. The State-owned banking system, lacking competition, can hardly efficiently provide loans and services for profitable projects. This makes the society's most innovative SMEs difficult to acquire loans that are much needed.

2 Private banks' development, which is essential for SMEs, is seriously hindered.

3 The capital market, which is very important for modern economy, is seriously hindered.

4 The negative real interest rate has hurt the ordinary people's consuming power. These people's consumption elasticity is the highest and their consumption is important for the transition of economic growth model.

5 Excessive capital controls are harmful to efficiency of fund allocation and internalization of renminbi.

6 Government investments become the main rent-seeking fields.

7 Government-oriented rigid payment has distorted the expectation of capital return and further distorted the capital market.