By Zhuo Xian

Research Report Vol.20 No.1, 2018

Since the Reform and Opening-up policy, established nearly 40 years ago, China has transitioned from “financial repression” to “financial deepening.” In the 1980s and 1990s, in order to achieve the goal of economic catch-up, strict regulations on financial admittance, interest rates, exchange rates, and capital flow, were imposed on China’s financial system. However, China realized rapid economic growth at the cost of financial repression. Marked by a new round of state-owned banks’ reform around 2005, China’s financial development has accelerated at a much faster rate than its economic growth, resulting in a “financial boom,” seen only rarely in the history of major economies.

I. China’s finance: from repression to boom

The value added of China’s financial industry in 2015 was 929.2 billion dollars (current US dollar, the same below), which is 71.9% of the US financial size (1.29 trillion dollars) and ranks China second in the world. China’s financial size is almost 200 billion dollars higher than the total financial value added (hereinafter shortened to FVA) of the countries ranked third to eighth (Figure 1). If China’s financial industry is treated as an economy in the global GDP competition, it will be ranked 16th.

China’s financial share of GDP is highest in the major economies. China’s FVA relative to GDP reached 8.5% in 2015, which was higher than that of the United States (7.2%) and the United Kingdom (7.3%), reaching or approaching twice that of Japan, Germany, France, Italy, and Spain. In the history of major economies, China’s 8.5% in 2015 is second only to the UK’s 9.1% in 2009.

The development of China’s finance reflects not only in the overall scale but also in its structural improvement. According to The Banker magazine’s rankings issued in July of 2017, 12 Chinese banks are among the top 50 banks in the world(measured by assets), accounting for 42.9% of top 50 banks’ profits. The market capitalization of China’s stock market at the end of 2016 was 7.6 trillion dollars, ranking second in the world, more than the sum of Japan and France which ranked third and fourth.

Although the phenomenon of financial boom in China in the last decade is noticeable, it is not unique. Figure 1 shows the changes of the FVA relative to GDP of major economies since 1970. From the post-World War II to the early 1970s, under the Bretton Woods system, the financial systems of advanced economies were also in a state of “financial repression” due to the strict regulation. Their financial share of GDP was mostly around 4% or even lower then. The collapse of the Bretton Woods system in 1973 started a new wave of global financial deepening. However, the progress of financial deepening in major economies is quite different. The share of the US financial industry has risen steadily for nearly 40 years from 4.1% in 1970 to 7.3% in 2007. It was on the rise generally until the subprime mortgage crisis broke out. Compared with the US, the proportion of the UK financial industry has shown much greater fluctuations, reaching 8.7%, 7.8%, and 9.1% in 1984, 1994, and 2009 respectively, but experiencing a sharp decline after each peak. Relatively speaking, the shares of the financial sector in Germany, France, Japan, Italy, and Spain have changed much more steadily. Especially in Germany and France, the financial shares of GDP have been stable at 4%-5%.

Since 1970, nine financial booms have occurred in major economies. A financial boom is a special form of financial deepening that is not a gradual development with economic growth but a rapid expansion far surpassing the foundation of economic growth. We define the phenomenon of financial boom quantitatively as “a financial share increase of 1.5 percentage points within 10 years (or shorter)”. According to this definition, we find that major economies have undergone nine financial booms in the past 45 years . The UK and China have experienced three booms each, and the US, Italy, and Spain have experienced one. A serious decline in the share of the financial sector followed six of the nine booms, with the exception of Spain’s boom of 1970-1980, and China’s booms of 2001-2011 and 2012-2015. It is worth mentioning that after China’s financial industry reached a historical peak in 2015, it dropped slightly by 0.15 percentage points in 2016.

The bigger the financial industry, the better the economy? China’s financial boom is mainly inward-oriented. The financial systems of the US and the UK do not only serve their own real economy but also the global market. Therefore, in some sense, it is reasonable that the proportions of FVA in the US and the UK are higher than other countries. On the contrary, China’s financial system currently serves mainly the domestic economy. Why did China’s financial industry experience a contrarian rise during the period of economic slowdown? What is the impact of financial boom on China’s economic transition? Will financial boom end up with the outbreak of financial crisis? How should the government balance the relationship between financial development and economic growth?

II. The negative externalities make finance overheated

In the classical economics, finance is just the veil of economic growth. As Robinson (1952) argued that “where enterprise leads finance follows”, for a long time, mainstream economists believed that finance which grows in response to increasing demand from the real sector does not affect growth. Many studies have proved theoretically and empirically that finance plays an irreplaceable role in promoting economic growth.Regarding the relationship between financial development and technological innovation, Laeven et al. (2014) built a Schumpeterian model in which financial innovation plays a dominant role in shaping the rate of technological innovation and growth.The empirical results of Aghion et al. (2005) also suggested that financial development is among the most powerful forces for economic growth, especially considering that educational attainment, initial relative output, and a large number of other candidate variables do not have an analogous effect in the same regression.

However, if the role of financial development in economic growth has always been positive, the financial size will develop at the same pace as economic output. Then how would there be a phenomenon of financial boom? Is there a tipping point beyond which the benefits of financial development will begin to decline and even be negative?

While there is no doubt that a developed economy needs a sophisticated financial sector, Zingales (2015) stressed that not all the growth of the financial sector in the last forty years has been beneficial to the society. More and more studies found that the positive effect of finance on economic growth weakens when using recent data. Philippon and Reshef (2013) found that at the very high end of financial development, rapidly diminishing social returns may have set in.The empirical evidence for OECD countries over the past five decades also indicates that the marginal effect of finance on growth becomes negative when FVA is above 5% of GDP (Cournède et al., 2015).

Finance is a special kind of goods whose price largely reflects the risk premium.A large part of financial value added is the reflection of risks. In 2009, the ratio of FVA to GDP reached a historical peak in the UK. The main reason for this is that after the default and liquidity risks rose in 2008, the UK’s banks raised their credit interest rates to make up for the expected loss (Haldane, 2010).The risk of a specific financial activity does not just lie in the two trading parties but would be transmitted to the entire financial system and even the real economy through price fluctuation, credit and debt relation and the guarantee chain.

Given specific technical conditions, real-economy projects that conform to the optimal financial scale are limited, and financial resources in excess of the optimal scale usually go to high-risk speculative areas. The more financial resources that go to those areas, the more obvious financial negative externalitiesare.

The combination of financial liberalization and government guarantee has magnified the negative externalities of the Chinese financial sector and increased financial supply and demand. For a long time before 2006, China’s financial sector had been in a state of “financial repression” wherethe growth of the financial sector lagged behind economic growth. However, the real sector achieved a rapid growth due to “subsidies” from the financial sector (figure 2-left side). Since 2006, this situation has reversed with the financial sector growing much faster than the economy. In the last decade, accompanying China’s shining financial boom,we have seen gloom in the real sector (Figure 2-right side).

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