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Transcript

Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. The format for today's episode of Speaking of the Economy will be a little bit different. I'm going to hand the mic over to our three guests for a panel discussion on China's economy.

Moderating the discussion will be Richmond Fed economist Russell Wong. Our special guests are Tao Zha, an economist at the Atlanta Fed and Emory University, and Chang-Tai Hseih of the University of Chicago, both of whom have written extensively on China's economy. They're joining us today as part of the Richmond Fed's CORE Week, a collaboration between Richmond economists and visiting scholars that happens eight times a year.

Gentlemen, welcome to the show and take it away, Russell.

Russell Wong: Thanks for joining us, Professor Hseih and Dr. Zha. Today is very special. We have two experts on China sitting in the same studio.

I think the case of China is very interesting. The markets are full of distortion and imperfection. Many activities are run by state-owned enterprise[s], and we usually think these kinds of state-owned enterprise are less effective like other central planning economies. But, unlike other central planning economies, China [has] maintained a high growth rate and high capital return for four decades, which is super amazing.

One argument for high China growth is driven by the rise of the private firm. However, Chinese-based private firms have recently become the target of regulation and heavy crackdown. Professor Hseih, you very recently written an article called "Two Strong Hands." Could you tell us a little bit more about what you have in mind in that paper?

Chang-Tai Hseih: I think that there's no question the growth that China has experienced comes from the growth of private firms. In the institutional environment that you describe, the growth of the private firms comes from this unique combination, or this unique alliance, of local party officials — at all levels — with private firms.

What's happened as a consequence of that is that — and this gets me to the point about the two strong hands — local officials think about China as 10 years ago, or even as recently as eight years ago, in terms of where their alliances [are and] where their loyalty lies. It was perceived that their loyalty was at least as much to the private entrepreneurs that they were doing deals with as to the [Communist] Party. There came to be the view that this represented an existential threat to the Party.

The view was that you have large segments of the Party that you did not fully control. So, there was this view that you have to deal with this, or else you are going to go the way of the Soviet Union. And I think that understanding sort of the ghost of the Soviet Union is really important.

The way to think about what's happened was that it's not all private firms. It's only the ones that are viewed as posing a threat. These are private entrepreneurs that have enough wealth such that there's a view that they matter politically. It's part of this ongoing campaign that I've seen in the last 10 years of restoring Party control. And it's not just in terms of the private firms, but it's in terms of ideology, it's in terms of cracking down on movie stars, it's a whole long list of things. So that is the first strong hand.

The second strong hand is that the obvious danger with cracking down on private entrepreneurs is that, if these are significant drivers of growth, then that's going to hurt growth. At the same time that you crack down on the forces that pose a political threat to you, you also want to make sure that you don't kill growth at the same time, right? That's the second strong hand.

I've seen also this smaller scale campaign that I have not seen reported in the media. When I look at what's been [happening] on the ground, it's a whole bunch of things. It's about creation of bankruptcy courts, creation of intellectual property courts, business registration reform, the expansion of credit to small- and medium-sized firms. There's a long list.

The vision, if I can call it that, is to have the combination of a dynamic market economy under the control of the Party. I don't really have a view on whether this will work, but that's my sense of what the goal is.

Wong: I think we will come back to this one.

Maybe we should put [forth an] example. Evergrande is one of the biggest real estate developers in China and having a lot of trouble. It's being cracked down by one strong hand, in particular after the China government imposed three regulations, the so-called "three red lines" on the maximum debt limit and on the minimum cash holding. This new regulation is part of the bigger deleveraging campaign in the China "new normal" economy since 2015.

Dr. Zha, we know you wrote a very nice book chapter on the three development stages of China: the enterprise stage, the investment stage, and the current new normal stage. Could you tell us a little bit more about how China ended up with this new regulation and crackdown as a new normal?

Tao Zha: Thank you, Russell.

This is just following Professor Hseih's comment about the strong hand from the government. In this new normal economy, the reason that the government needs to put more regulation in there is truly about deleveraging.

By 2015 or '16, the debt-to-GDP ratio has been very, very high. The bank-loan-to-GDP ratio is 150 percent. If you take the total financing in the whole economy, it's 250 percent. That level is historically high and I think the Chinese government probably feels that it's necessary to do the deleveraging, though increasing debt, on one hand, really helps the economy and it grows very fast. That's what we call the investment stage.

The funding mostly is coming from the banks [and] coming from the government support. But in this new normal economy, debt has been accumulating so much. That's why they are imposing this deleveraging process – to make sure that the debt is managed.

This is mostly concerned about the whole system, right? Systemic risk is one of the risks. There are many other risks that Professor Hseih is talking about. But, just in terms of deleveraging, I'm more concerned about systemic risk because of the debt level.

Wong: Right, okay. It is very important background to have in mind.

Dr. Zha mentioned one potential reason why we have some crackdown or new regulation may be a concern about the financial stability [that] comes from too much debt and being too highly leveraged. Could one of the reasons why the private firm you just mentioned got cracked down because of the threats to financial stability rather than Party controls? How can we balance the two things together? They could co-exist, of course.

Hseih: They could certainly coexist. For every one of the crackdowns, I think there always is exposed some reason. At the end of the day, it is hard to figure out what is the real reason versus what is the made-up reason for this. So, let me just say a few things.

I know that there's been a lot of attention placed on Evergrande. But this crackdown on financial conglomerates really started in 2018 — the crackdown on Wanda, the complete dismantling of the Tomorrow Group and then the CEO was kidnapped from Hong Kong and is now in jail. There's a whole bunch of these things. And it's not just this, right? There's a crackdown on Didi. There's a crackdown on Jack Ma that has been well publicized. There's the crackdown on the online tutoring companies.

I would say that the common pattern that I see is the perception that these companies pose a threat. For example, the way I see the online tutoring companies is that they were widely used. It threatens the monopoly of the transmission of ideology. If kids are spending lots of time [getting tutored], they're learning things.

Let me just give you one last thing. There has been no crackdown on large foreign firms. My view is that because they're foreign firms, they can never pose a political threat. It's a bit like the story of Indonesia in the 1980s. The Indonesian system was similar in the sense that if you wanted to do business, what you did is that you made an alliance with somebody from Suharto's family. But here's the kicker – if you look at who did that, it was only the ethnic Chinese Indonesians. An Indonesian could never do it. The reason that it was only the ethnic Chinese that could make these billion-dollar deals was because they were a small minority. They were basically hated by a large segment of the population. So, even if they become really rich through this process, they could never threaten you politically.

I don't think the crackdown is about bigness, per se, because I see lots of big firms that are thriving [and] lots of heavily indebted entities for which there's no crackdown.

Wong: Yeah. So, there could be two potential motivations [for increased regulation]. On one hand, it would be about the power that Professor Hseih mentioned. On the other hand, it's about the strength [of markets] or financial stability, as Dr. Zha mentioned. Maybe we can never tell the true motivation behind [these actions], but we can talk about their effectiveness and consequences.

Dr. Zha, four years after you wrote a paper about China's new normal, maybe it's a good time to think about we have new regulation in a new normal. What do you think about these policies' effectiveness in controlling deleveraging and also controlling financial stability?

Zha: That's a very, very good question.

It's a delicate balance. You want a financial system that is running very smoothly and you want the transmission mechanism to also function very well, if a monetary authority or fiscal authority is conducting certain policies. What China has done — just like any other emerging economy and also even in developed economies — right after 2018 they created this interbank wholesale funding. The reason they created this wholesale funding is to provide liquidity between banks.

One of the issues is the state banks — the very, very big banks — have no problems of getting deposits. The small banks and medium-sized banks, and most of them are non-state banks, have all of these problems getting deposits. They are also facing, as we talked about before, sudden withdrawal. So the interbank wholesale funding liquidity established in China was actually very efficient for the state banks to give the money to the non-state banks when they are short of deposits.

One of the forms [of wholesale funding] is called NCD, a negotiable certificate of deposit. That actually functions very well and helps the non-state banks to lend out money to the firms. This transmission mechanism actually works for China.

But, as you pointed out before, there is still risk involved because if suddenly there is a very negative shock to the economy, the non-state banks [are] going to face corporate bankruptcy risk. At the same time, their deposits dry up as well, both the liability side and asset side. So, this [issue of] financial stability is actually real, right, in addition to the political issues that are talked about by Professor Hseih. They have to make sure that there is no financial instability in China. So, they have a program called a macro prudential assessment program, which was established after 2016 precisely to deal with that kind of risk.

It's a delicate balance, right? For example, if you kill these wholesale funding facilities in China, then the non-state banks will not be willing to lend money and they couldn't get the deposits either. That will be much more severe for the whole banking system.

Wong: Right. That might be one of the advantages in the United States. We know the wholesale funding market in the United States is very liquid and very deep. We have the fed funds market, we have the repo market, banks can borrow and lend to each other. And, of course, there is the discount window and the lending facility provided by the Fed. So, the funding infrastructure in the United States is super liquid, super safe.

Professor Hseih mentioned cooperation between local government and the private firm, and this synergy may be one of the reasons driving the growth experiment in China. At the same time, we see currently a focus on the very local level. Professor Hseih, do you think it's simply just a coincidence or maybe it's signaling the growth model of China too heavily relies on local government?

Hseih: I don't think it was at all a deliberate strategy.

Wong: When you say "deliberate," so it means it did not plan.

Hseih: It wasn't planned. Certainly, the role of local governments was not planned. It was something that emerged slowly.

Same about the two strong heads. I will say the first strong hand was clearly a deliberate strategy. The second strong hand is what I would call – to use Deng Xiaoping's phrase – "crossing the river by touching the stones." It was a slow process of trying to experiment with things and trying to figure out what works.

In terms of the strategy of what local governments do I think that, by and large, it is mostly gone. If you were to visit any local government 10 years ago, it was clear that most of their focus – in terms of their time, in terms of what they thought about, in terms of sort of the whole political apparatus – was about doing business. It's still something that they do, but it's now way down there compared to the other priorities that they have there. They are now much more dictates that are coming down from the central government. They're spending a lot more time hosting inspection committees. A big part of their time is spent on that. And also, I would say that the amount of discretion that they have to do things has gone way down.

Part of the risk of doing what they were doing is that now, at any point in time, if you're collaborating closely with a bunch of private entrepreneurs, it's really easy to accuse you of corruption. I think a big question is, what is going to drive growth going forward?

Wong: Right. Maintaining high growth, we mentioned earlier, is maybe another deep concern, interacting with the financial risks Dr. Zha mentioned.

Some estimations say close to one third of the GDP comes from the housing related sectors. But recently, we also see lots of new development and the business model heavily relies on pre-selling unfinished homes to residents. These seem uncommon in developed countries like the U.S. These seem to be idiosyncratic in the context of China.

Dr. Zha, we know you have some other extensive research about housing in China. Do you think the kind of risks [that] come from the housing market is manageable? What will the end game look like?

Zha: All this financial stability with the housing market, the mortgage market is all related and intertwined in China. It's actually very important.

Let's go back to this Evergrande that we talked about before. Most of the loans they got [are] from non-state banks. If you look at their balance sheet, you don't find the state banks or big banks lend money to them, even though they are the second largest real estate company in China. They are getting all those monies from non-state banks which, in a way, is good. Those banks lend money to the firms that they think [are] profitable.

But at the same time, it's a risk once those banks have some troubles. As you said before, the wholesale funding market in China is not really that deep. The Federal Reserve can provide liquidity in a very systematic, thoughtful way [while] China still experiments [with].

They wanted to promote the economy, including the real estate market. At the same time, they are really concerned about financial stability because, as I said before, the leverage is very, very high for the real estate sector as well as for the non-state banks. So, they are doing what they can to make sure that the risk is, as you said, manageable. It will be very interesting to see – are they doing too much or too little? The time will tell.

Hseih: Can I have a follow up to that?

The thing that I find really interesting about the Evergrande case is that it's hard to disentangle the story of overleveraging and speculation versus a story where fundamentally it's about a company that is starved of capital. What they were doing was effectively getting loans from their suppliers by paying them much later. So, putting aside the speculation part of it because that's also possible, it looks to me that one way to interpret that company – and it's not just them but lots of other companies — is that this was a company with very profitable projects, but they were just starved of capital. They were just trying to bring in capital from any place that they could [such as] from their customers — that's effectively the pre-sales, you're basically getting a loan from your customers.

Let me give you one example that people may not be aware of. In the first 10 or 15 years of Huawei, they were effectively doing the same thing. They had no access to capital [and] they had very little actual capital in there. The way they were doing it is they were underpaying their employees. To compensate them, they were telling them, "Okay, we will give you equity in the company." I think that's the genesis of all this confusion about who owns Huawei. They created this other holding company and they said, "This holding company owns Huawei and we will give you equity in this holding company." But when the company became really successful, they are trying to figure out a way to try to get out of the verbal commitments that they've made. That was a company in which it no longer has difficulty accessing capital because it's now a champion.

It's very typical of Chinese private firms, at least when they're small and medium-sized, [to] operate in an environment where it's really difficult to get access to capital. The genius of Chinese entrepreneurs is that they're very creative. They're very, very creative in trying to solve these problems.

The danger is it's all about crackdowns on the users without thinking about what is it about the financial system that is causing them to do what they're doing. There's no discussion about where the financial system dysfunctional, what parts of the financial system is not allocating capital in the way we think that it should. It's about going after the wrong victims, right, and not about trying to actually make the system work better.

Wong: This is super interesting.

Thank you, Professor Hseih. Thank you, Dr. Zha. We will go back to Tim.

Sablik: Thank you, everyone. Thank you, Russell, for facilitating that discussion. Professors Zha and Hseih, thank you for coming on the show.

Hseih: Thank you.

Zsa: Thank you.

Sablik: If you enjoyed today's discussion, please consider leaving us a rating and review.