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China’s unprecedented growth has transformed the lives of its people and impacted economies across the globe. The financial system supported this growth by providing cheap loans to boost investment and, in a virtuous cycle, rapid growth insured that these loans could be repaid. However, in recent years, this virtuous cycle has turned vicious. The financial system has continued to lend freely and cheaply as the economy has slowed, and the risk of crisis has mounted. In response, the government has initiated the most ambitious financial reforms in twenty years. Financial markets, businesses and governments are concerned about these risks and are struggling to understand what the reforms will mean for China and the rest of the world.

Debt and Distortion: Risks and Reforms in the Chinese Financial System addresses the need for an up-to-date and accessible, yet comprehensive analysis of China’s financial system and related reforms. It will take a systematic look at China’s financial system: how it worked in the past and how it will work in the future; why reforms are needed; what risks they bring; and their impact on China and the rest of the world. By analyzing the topic in terms of a few fundamental distortions, this book makes an otherwise complex topic accessible while simultaneously providing new insights. These distortions provide a simple framework for understanding the nature of the Chinese financial system and its future prospects.

Reform in China will transform the world’s second largest economy and impact everything from Peruvian copper mines to the London housing market. Business people, government officials, financiers and informed citizens would all benefit from understanding how changes in China’s financial system will shape the global economy in the coming decades.



Current Economic Model


1. Growth Model

China’s growth over the last 35 years is unprecedented. It has created more wealth and lifted more people out of poverty in a shorter time than any other country in history. In this chapter, we explore the economic system that made this possible. This is a necessary prerequisite for analyzing the financial system for three reasons. First, the financial system evolved to support the economic system that brought this growth, and it is impossible to understand the financial system without understanding the system it was designed to support. Second, we need to understand why such a successful system needs to be reformed and, by extension, why the financial system needs to change to accommodate that reform. Finally, financial reforms will undermine the existing drivers of economic growth and replace them with new drivers. This transformation will be difficult and risky, and the challenges and dangers will need to be understood in advance and incorporated into the reform plans.

Paul Armstrong-Taylor

2. Financial Risks

Almost all financial crises stem from excessive accumulation of debt. Although the specifics of crises may differ, they share common features that make it possible to describe the common underlying dynamics. Perhaps the central thinker on such dynamics was Hyman Minsky. His work, relatively unknown during his lifetime, has received a great deal of attention since the subprime crisis. The basic idea is that debt tends to amplify both booms and busts. During a boom, borrowing increases profits, encouraging the buildup of debt; during the bust, it exacerbates losses, leading to a rapid reversal in economic performance. The next section provides a more detailed explanation of how this happens and why it can be hard to manage.

Paul Armstrong-Taylor

3. Financial Repression

Between 2003 and 2011, Chinese interest rates were very low. Figure 3.1 shows that between 2003 and 2011 Chinese real interest rates on loans, that is, interest rates net of inflation, stayed below 5 % (except for a brief spike in 2009) and averaged 2.9 %. This graph uses the consumer price index (CPI) to adjust for inflation. Michael Pettis has argued that rather than CPI, we should deflate interest rates using the GDP deflator (a broader measure of inflation that considers all sectors of the economy rather than just consumers). Using this measure, the real lending interest rate between 2003 and 2011 was just 0.7 %.

Paul Armstrong-Taylor

4. Government Guarantees

All investment involves risk since cash must be given up for uncertain future returns. The more uncertain these returns are, the greater the risk. Riskier projects are not necessarily worse than safer ones if they offer the prospect of higher returns. The challenge for both individual investors and the economy as a whole is to trade off risk and return in an optimal way. While minimizing risk may seem like a good idea, it will also tend to lead to lower returns and slower growth. Excessive risk, on the other hand, exacerbates economic swings by generating strong returns in good times and major losses during bad ones.

Paul Armstrong-Taylor

5. International Distortions

A cheap currency helps boost both exports and investment. The more renminbi foreigners can purchase with their currency, the cheaper China’s exports will seem to them, and the more they will buy. This increases the output and profits of Chinese exporters, leading to growth and stimulating more investment. Along with low interest rates and government guarantees, a cheap currency has been a key contributor to China’s rapid growth.

Paul Armstrong-Taylor

6. Overview

China’s financial system has been built around three interlocking price distortions: the interest rate (price of liquidity) has been suppressed by interest rate ceilings, the price of risk has been suppressed with government guarantees, and the price of the renminbi has been suppressed via accumulation of foreign exchange reserves. Each of these distortions promotes investment and has helped to generate China’s impressive growth performance.

Paul Armstrong-Taylor

Domestic Reforms


7. Banking

China’s financial system is dominated by banks. Approximately 90 % of the country’s financial assets are held in the banking system, so any consideration of financial reforms must start with the banking system.

Paul Armstrong-Taylor

8. Shadow Banking

The Chinese shadow banking sector has grown rapidly since 2010. Figure 8.1 illustrates this growth. While bank credit has grown modestly, other forms of credit (a broad measure of shadow banking) has grown rapidly. As a result, China’s total credit has increased by 50 % of GDP in just 5 years. This rapid growth has raised concerns about financial risks – particularly in the shadow banking sector. In this chapter, we will explain the growth of shadow banking, assess its risks, and assess reforms of the sector.

Paul Armstrong-Taylor

9. Stock Markets

During 2014–2015, China’s stock market experienced the inflation and bursting of a stock market bubble. In the year until 22 June 2015, the Shanghai Stock Exchange (SSE) Composite Index rose by 150 %%; over the next 10 weeks, it fell by over 40 %. The rise and fall of the technology-heavy Shenzhen stock market was even more dramatic. During the boom, millions of new investors opened trading accounts – lured by high returns and government encouragement. As boom turned to bust, these investors lost money and maybe a little faith in both the stock market and the government. The bubble raised questions about the maturity and stability of China’s financial system. The government’s aggressive intervention to halt the crash raised questions about its willingness to allow market forces to operate.

Paul Armstrong-Taylor

10. Bond Markets

The bond market has not attracted as much attention as the stock market, but its development is just as important. Aside from the direct benefits the bond market brings, it also supports other financial reforms. Developing the bond market will affect bank and local government borrowing, and if China plans to develop the renminbi into a reserve currency, large and liquid bond markets will be necessary. However, the experience of other countries shows that developing bond markets can be risky.

Paul Armstrong-Taylor

11. Local Government Debt

For three millennia, China’s central government has struggled to control local leaders, and the degree of centralization has varied. At times, for example during the Zhou dynasty (1050–256 bc), fiscally and militarily independent feudal princes operated mostly beyond the control of the emperor. At other times, such as the Qin dynasty (221–206 bc), a strong emperor used hierarchical bureaucracy to centralize taxation and military power. These models of government can be seen as different solutions to two challenges faced by any government of a large, diverse country such as China.

Paul Armstrong-Taylor

12. Real Estate Market

China’s real estate sector is closely tied to its financial system, so any attempt to assess financial risks involves some assessment of the state of the housing market. Both traditional and shadow banks have been active in lending to borrowers who are directly or indirectly connected to the real estate markets. These borrowers include homeowners and construction companies, but also local governments, who rely on land sales for repaying their loans, and many suppliers of raw materials and home appliances. If China does have a real estate bubble and it bursts, the consequences for the financial system, and the general economy, will be severe.

Paul Armstrong-Taylor

International Reforms


13. Exchange Rate Liberalization

China has intervened in the currency markets to control the renminbi’s exchange rate. Previously, this intervention involved holding the renminbi below its true value, which boosted the tradable goods sector (both exporters and firms competing against imports) at the expense of consumers of imports (including households). This intervention distorted the economy by favoring manufacturing over services and firms over households. In addition, the intervention, in which the People’s Bank of China (PBoC) sold renminbi and bought dollars, led to the accumulation of huge foreign exchange reserves. The growth in reserves complicated monetary policy and led to policies that created further distortions. Finally, the exchange rate policy was unpopular with some of China’s trade partners, particularly the USA, which complicated international relations.

Paul Armstrong-Taylor

14. Renminbi Internationalization

What does it mean to internationalize a currency? In essence, an international currency is one that performs the functions of money for foreigners outside of the domestic market. A currency has three functions: a unit of account, a medium of exchange, and a store of value. A currency is used as a unit of account when we report a value in terms of it: for example, the GDP of the USA in 2013 was $16.8 trillion, or a Big Mac costs 17 RMB. A currency is used as a medium of exchange if we can exchange it for other products: for example, if we use dollars to buy oil or renminbi to buy Chinese exports. Finally, a currency is used as a store of value if people hold their wealth in assets denominated in that currency: for example, investors owning US dollar bonds or holding savings in a Chinese renminbi account.

Paul Armstrong-Taylor

15. Capital Account Liberalization

China's financial system has been insulated from international markets by capital controls. These capital controls restrict international portfolio flows, that is, investment flows other than direct investment, into and out of China. As part of its financial reforms, China plans to relax these controls to allow capital to flow more freely into and out of the country. Such reforms are often dubbed capital account liberalization as the capital account is the part of the balance of payments that deals with international investment flows.

Paul Armstrong-Taylor

16. Asian Infrastructure Investment Bank and the New Silk Road

The Asian Infrastructure Investment Bank (AIIB) attracted global attention when the British government opted to join, over the opposition of the USA. This was seen as a major coup for the Chinese and an embarrassment to the Americans. However, while the AIIB was a diplomatic victory for Beijing, it is not clear that it will be as economically important as many expect.

Paul Armstrong-Taylor



17. Political Conflicts over Reforms

Ever since Deng Xiaoping opened up China’s economy, there has been a conflict within the Chinese Communist Party (CCP) between reformers and conservatives. Financial reforms can be seen through this lens. Even most reformers accept the overriding goal of policy as a means to solidify the CCP’s hold on power, but they disagree on whether financial reform is the best way to achieve this goal. Xi Jinping (who on economic policy at least appears to be a reformer) believes that stable economic growth is a necessary condition for political stability and that financial reform, including loosening the government’s control of parts of the system, is essential to ensure this. His opponents believe that China’s economy can continue to thrive under the control of the government and worry that if the party loosens its control over the economy, it will also weaken its political power.

Paul Armstrong-Taylor

18. Strategies to Overcome Opposition to Reform

Hu Jintao, Xi Jinping’s predecessor, talked about reform, but his failure to implement it was near total. Xi Jinping is determined to avoid the same fate. If he is to implement necessary economic and financial reforms, he needs to develop strategies to overcome opposition. A unifying theme of these strategies is the need to centralize political power under his control and, if necessary, to crush opposition.

Paul Armstrong-Taylor

Risks and Consequences


19. Domestic Risks

Financial risk comes in many forms, but it is nearly always related to debt in some way. By analyzing the size and distribution of debt within the system, we can gain some understanding of the risks to which it is exposed.

Paul Armstrong-Taylor

20. International Consequences of Reform

As China transitions to a new growth model, its economic relationship with the rest of the world will change. Under the old investment-based model, China was the major source of demand for many commodities; under the new consumption-based model, demand for commodities will decline, but demand for consumption goods and services will increase. This will create both challenges and opportunities for other countries. Countries that have benefited from China’s hunger for commodities will have to find new sources of demand or transition their economies away from commodities. This will hit many developing countries, but also some developed countries. On the other hand, countries with strong consumer-oriented industries stand to benefit from China’s transition. Opportunities in healthcare and education, to the extent that they are opened to international competition, could prove particularly lucrative.

Paul Armstrong-Taylor

21. The Future

As I write this in September 2015, global financial markets have slumped on fears of a slowdown, even a crisis, in China. I think this is as overly pessimistic as the prophecies of a “Chinese Century” were overly optimistic. China is slowing, but this is both expected and desirable. It is undergoing a necessary transformation from which it will emerge with slower but more stable growth. The financial reforms that we have discussed in this book are an important part of that transition. It will not be easy, and there may be minor disruptions on the way, but there is no reason to think that China cannot succeed.

Paul Armstrong-Taylor


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