The Asian Experience

Perception that the state in late late-industrializing countries uses the financial sector as an instrument in a process of regulated development. On the other hand, liberalization is seen as ‘freeing’ the financial sector as part of a strategy of market-led development.
Ignores the possibility that growth in market-mediated economies requires financial intermediation, irrespective of the nature of the policy regime.
The financial sector ‘matters’ and the state continues to play a role.
The role the financial sector plays and the effects that macroeconomic policies have varies with the nature of financial intermediation.

As widely recognized, in interventionist regimes the emphasis is on a fiscally proactive state. State expenditure not only enhances domestic demand and income with attendant multiplier effects, but also relaxes supply constraints and closes imfrastructural gaps.
Issue is how expenditure is financed. Must finally be based on progressive taxation and appropriation of a part of private surpluses. But while the tax-to-GDP ratio is being raised, a proactive fiscal stance must exercise the ability of the state to borrow to raise government expenditures. The result is fiscal dominance.

Fiscal dominance implies that monetary expansion is driven by the fiscal stance and the degree to which fiscal expenditures are funded with borrowing, especially, but not solely, from the central bank.
Dominance often ensured through preemption of bank lending (the SLR in India).
Also ensured through state control over the financial sector, which provides the basis for allocation of savings.

Regulation needed to realize an a priori plan that defines how high the investment rate should be, how that investment must be allocated and how much should the state itself spend and invest. This is true in both domestic market- and export-oriented economies.
Mechanisms to ensure that credit provision to the private sector also privileges the investment allocation that the state favours.
Also mechanisms like development banking that involve establishing state-directed institutions that can through direct transfers from the budget or central banks access low cost resources that are directed to priority projects.

In many countries the transition warranted in the first instance by the the inability to mobilize resources through taxation, making the state’s role dependent on the ability to continuously raise borrowing.
Borrowing limited because it is predicated on the ability to tax in future, but more importantly because debt-financed expenditure runs up against supply constraints, leading to inflation or balance of payments problems.
Transition partly an attempt to use the post-1970s surge in liquidity in the international financial system, to obtain a temporary reprieve. Translates into a shift in strategy.

In growth strategies with a strong role for exports (such as Korea and China) export success (realized through rather different trajectories) raises costs, strengthens exchange rates and undermines competitiveness.
Financial liberalization here driven by demands from countries that are important external markets and the need for an already influential financial sector to move into alternative sectors to compensate for business lost and losses incurred in traditional areas of lending and investment.

Problem remains of finding an inducement to investment and stimulus to growth in the new period.
Government is even more reticent to raise tax revenues and liberalized regimes emphasis “fiscal consolidation”.
If exports do not provide that stimulus and fiscal space is limited, there is need to generate it from within the private sector.
Only way policy can attempt to spur consumption and investment is through the provision of large volumes of cheap liquidity.

An ostensibly ‘independent’ central bank pursuing inflation targets deregulates the capital account and sees reason in trying to manipulate interest rates downwards while allowing liquidity expansion a free reign. Liquidity expansion also driven by capital inflows.
Banks awash with liquidity now need to lend more at a time when government borrowing is under control.
The result is a change in financial sector behaviour and bank lending practices.

In countries not damaged by the 1997 crisis there is a sharp increase in credit to GDP ratio. Levels vary, but direction and speed of movement more or less the same.
In countries that were hit badly the credit to GDP ratio declines and is yet to regain pre-crisis levels in some countries.
So increased lending to the private sector a common characteristics, but sustainability depends on state of the financial sector.

Within the private sector the segments that accessed the debt that excess liquidity provided varied across countries and over time in individual countries.
Broadly, the shift can be analyzed in terms of three alternative sets: households vs corporate entities; investment vs consumption; and old sectors vs new sectors.
An important result of the transition is the rise in share of lending to households in many contexts. This did imply that rather than facilitating investment induced by other stimuli
(like government spending), the financial system was serving as source of stimulus by driving debt financed private spending.

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The shift from investment to consumption and corporates to households was most marked in Korea after the 1997 crisis.
Starting at around Korean Won (KRW) 210 trillion in 1997, the debt of households in Korea rose to more than KRW 450 trillion in 2002 and stood at KRW 922 trillion at the end of June in 2012.
Household debt to net household disposable income from less than 100 per cent before the turn of the century, to the 3-digit mark in 2001, more than 140 per cent in 2006 and 160 per cent in
2011.
Collapse of the household savings rate from more than 15 per cent before the 1997 crisis to around 10 per cent in 2000 and a low of 2-3 per cent recently.

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According to a 2011 survey conducted by Statistics
Korea and analysed by the Korea Development
Institute, six out of ten households in Korea were in debt, and more than a third of them were unable to meet their annual expenses with their incomes.
Debt also weighed heavy on current incomes. One in every 10 households spent more than 40 per cent of annual income on servicing that debt.

Ever since the early 1960s bank lending to the private corporate sector in Korea was much higher than in many countries with extremely high debt to equity ratios.
As South Korean industry lost competitiveness and many of its chaebols moved abroad, banks that were primed to lend shifted in favour of real estate and stock markets with the hope of sustaining their profitability. But that made the financial system vulnerable to the crisis in 1997.
And when that crisis occurred both the debt-burdened private corporate sector and the banks over-exposed to them took a hit. But “recapitalized” by the government.

But this did not end the lending boom. Increased lending to the household sector resulted in an increase in the ratio of household debt to GDP.
South Korea’s halting recovery from the crisis was driven by debt to the household sector, which touched 150 per cent of household disposable income by 2013. The danger of massive default on such debt which could have precipitated another major crisis forced the government to step in and set up an 800 billion won fund to buy distressed household debt from the banking sector at a discount and restructure or write off a significant part of that debt.

Financial reform in China is instructive because it involves the transition from a completely state run and controlled financial structure, in which taxation and terms of trade adjustments were the principal “financial techniques” used to channel surplus incomes (over expenditures) to investment, to an increasingly market-mediated system with a structurally more diverse financial sector.
However, the legacy of central planning has meant that the domestic banking system is still dominantly public. This experience facilitates an assessment of what the consequences of a growing reliance on market mediation are, in a context where initial conditions were substantially different.

The so-called “mono-bank” system created after the
Revolution, in which the PBC was the sole commercial bank and was characterized by a limited degree of institutional diversification and barely any decentralization of decisionmaking, was in existence till 1984.
In 1984 the PBC was formally designated as China’s central bank, and its urban commercial banking functions were transferred to the Industrial and Commercial Bank of
China (ICBC), making it the largest state-owned commercial bank. Significantly, commercial banks were handed the responsibility of financing the state owned enterprises.

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Since the post-crisis stimulus of 2008, total public and private debt in China has risen to more than 200 per cent of
GDP. Credit to the private sector rose from 104 per cent of
GDP in 2008 to 130 per cent in 2010, before declining marginally in 2011.
Rapid growth of lending by the ‘shadow banking’ system, at the forefront of which are wealth management products
(WMPs) offering high interest rates. Loans are then provided to borrowers such as real estate developers to whom lending by the banks is being restricted. WMPs are placed at around 10 per cent of total deposits in Chinese banks, but the rate of growth is high.

Outstanding debt of the private non-financial sector rose from 70 per cent of GDP at the end of 1985 to a little more than 115 per cent by 2008.
Then over the next seven years to 2015, when financial liberalization was intensified, it shot up to more than 200 per cent.
In this period household debt rose from 19 to 38 per cent of GDP.
Debt to the private non-financial sector other than households too obviously rose sharply. What were more or less sequential developments in India, occurred simultaneously in China. But there too the overall rise in private debt has resulted in increased default and rising financial fragility.

By the early 1990s, considerable advance in the process of establishing new institutions, combined with ownership structures that could pave the way for a degree of decentralization of decision making
Shanghai and Shenzhen Stock Exchanges at the end of 1990.
Shares were split into two kinds: A-shares denominated in renminbi (RMB) and B-shares in US or Hong Kong dollars. Till
2000, the A-share market was not open to foreigners and the Bshare market to domestic investors. Distinction began to ne diluted in 2001.
Deregulation and liquidity infusion led to the stock market volatility of 2006-07 and 2015.
Was this an effort to get stock markets to replace banks?

Liberalization traced to 1991. Through the 1990s outstanding debt to the private non-financials sector in the country was around 30 per cent of GDP. In the early 2000s, this figure rose sharply to touch 50 per cent by 2007 and 60 per cent by end 2015. Period of rapid growth.
Initially this credit boom involved retail lending to households in the private sector, especially for housing. This ended around 2007.
The outstanding debt of households fell from about 10.5 per cent of GDP in 2007 to 9 per cent by 2010 and has since fluctuated around that level.
After 2007 bank lending to private corporate sector, including lending for infrastructural projects that involves major maturity and liquidity mismatches, has increased substantially.

Personal loans as per cent of total outstanding credit of commercial banks
1996 2000 2007
State Bank of India and associates
Other nationalised Banks
9.5
9.1
10.7
10.9
22.0
15.8
Foreign banks
Regional Rural Banks
8.8
10.5
17.1
18.8
24.8
20.5
Private sector banks
All Scheduled Commercial Banks
9.7
9.3
7.9
11.2
37.3
22.3

First, with government borrowing restricted, monetary policy by a central bank independent of fiscal dominance becomes the preferred means of macroeconomic management .
Second, the financial sector’s role in promoting growth takes a whole new turn, with lending to the private sector becoming the means to stimulating demand. In a deregulated environment debtfinanced private spending substitutes for the role of debt finance public spending in more interventionist regimes.
Third, this role is facilitated by substantially increased liquidity infusion by the ‘independent’ central bank that helps sustain a credit boom which drives private debt financed spending.
Fourth, this trajectory can be sustained only till the damage to the financial sector is below some threshold.

Move from structural regulation to market mediated regulation in which accounting standards, disclosure norms and ‘capital adequacy’ are central, alters not just the composition of the financial sector, but also the behaviour of agents, free to innovate by producing new products.
But this does not mean that the financialsector is disassociated from the growth process. Its role changes substantially but the system relies on it, however, unsuccessfully.