Morgan Stanley Asia Chairman Stephen Roach Identifies Hurdles for China’s Overall Economic Reform, Banking Reform

Stephen Roach: “As I meet with investors around the world, they have two questions for me regarding Chinese banking reform: Number 1, “Should I buy a Chinese bank?” and Number 2, “How does Chinese banking reform fit into the broader context of the development and growth of the Chinese economy?”

I want to address the latter topic. My basic premise is that you cannot think about Chinese banking reform in isolation from a number of the broader issues that your economy faces. Banking reform in China, or in any economy, is not an end in and of itself. It is a means towards the end ? in [China’s] case, the development of a market-based system of efficient allocation of savings and capital.

Three key considerations must be addressed in the context of broader macro reforms, and these bear critically on the issue of Chinese banking reform. One: the shift from the quantity to the quality of growth. Two: the efficient allocation of capital (China is lagging in that regard and the banking system plays a key role in some of the deficiencies as well as in some of the solutions to this problem). Three: the critical shift in the Chinese economy from an investment and an export-led economy to a more balanced economy that reflects the growth of a consumer culture.

On China’s economic challenges

At the conclusion of the National People’s Congress in spring 2007, Premier Wen Jiaobao held a press conference in which he stated that, while [China’s] growth-rate has been strong in terms of quantity and job growth has been impressive in terms of quantity, problems were increasingly evident on the quality side of the macro equation. In particular, he characterized the Chinese growth record as increasingly “unstable, unbalanced, uncoordinated and unsustainable.” In the context of banking reform, you must make the concerns of your Premier uppermost in mind. Do you have the right formula? Are you looking at [reform] from a narrow point of view or a broad point of view?

In terms of being unbalanced, fixed investment and exports together now [account for] 80 percent of China’s GDP. You can’t keep going down this road. And the banking sector plays an absolutely critical role in driving the investment piece of this dynamic. You need to support the consumer sector which, last year, fell to a record low of 36 percent of Chinese GDP. I’ve never seen numbers like this, anywhere.

One way to look at the lack of stability in the Chinese economy is through China’s excessive demand for commodities around the world. Over the last five years, China, which accounts for 5.5 percent of world’s GDP, has accounted for 50 percent of the cumulative growth in base metals and oil. This situation is very inefficient and potentially very unstable because it drives the prices of these commodities up to levels at which [China], as a developing economy, cannot afford. There is a big focus by Premier Wen on improving the energy efficiency of the Chinese economy. There has been tremendous improvement in energy, or oil operative, of China’s GDP but China still consumes twice as much oil per unit of GDP as the rest of the world.

China’s [uncoordinated economy is seen in] the relationship between GDP growth and investment, the “investment efficiency ratio.” We can compare China’s economic performance over the last decade with Japan’s economic performance in the 1960s. When Japan was faced with similar imperatives on the investment front, driven by post World War II reconstruction, the nation’s investment needs were fueled by urbanization, industrialization, and infrastructure ? issues that China faces today. And yet, during the 1960s, Japan recorded far higher GDP growth than that of China over the past decade (with the exception of one year) while Japan’s investment ratio during that period never exceed 34 percent, [while] China’s is closing in on 50 percent. This is an inefficient investment result and one that is critically dependent on the bank-directed system of capital allocation.

The issue of sustainability bears critically on China’s environmental concerns ? air pollution, water pollution, CO2 emissions. The good news is that the issue is out in the open and getting talked about.

Banking reform vs. macro economic policy

Banking reform must be consistent with these four issues. The next China will be dominated increasingly by the consumer. One big impediment for the development of the Chinese consumer is the extraordinarily high levels of precautionary savings. In the 11th five-year plan, provisions were made to invest in social security and pensions, which will help reduce precautionary savings. Actions have also been taken to support rural families. The disparity between urban and rural families is clear. For the Chinese consumer, the base is becoming too narrow and must broaden out. Banking reform fits here perfectly because of those in the banking sector seek to develop an active and thriving marketplace for consumer finance [by offering] mortgages, automobile loans.

I will close with one risk that you need to be aware of. It’s not a critical risk, immediately, for banking reform but it’s a macro risk for China. Unlike many products in the world which we now say are made in China, risks are made in America.
The risk here is protectionism. Washington is moving down a very dangerous path, a slippery slope of enacting legislation that it will impose trade sanctions on [China’s] economy. And that will affect many aspects of your economy, including the performance of your banks. Initiatives have been introduced in the United States that will impose trade sanctions on China. In the last two years, nothing passed. This year, the odds are, something will pass. I have argued strenuously that this is a huge policy mistake. This is a big risk and it underscores, again, a macro environment that you need to think about in understanding the context into which Chinese banking reform fits.”

SPEAKER’S BIO

Stephen Roach
Asia Chairman, Morgan Stanley

With his often bleak economic forecasts, Stephen Roach, Morgan Stanley’s Asia Chairman, has earned a reputation as a perpetual bear. His no-holds-barred deliveries, combined with a flair for dramatically delivering hard facts in an easy-to-grasp format, have made him a media star. In recent years, Roach has been bullish on China but remains outspoken on possible pitfalls.

In June 2007, Roach became Morgan Stanley’s Asia Chairman, a promotion from his role as the company’s Chief Economist. Before joining Morgan Stanley in 1982, he spent three years as Vice President for Economic Analysis at the Morgan Stanley Guaranty Trust in New York. He began his career in Washington DC, first as a research fellow at the Brookings Institute, then as a member of the Federal Reserve Board’s research staff. Roach holds a Ph.D. in economics from New York University and a Bachelor’s degree in economics from the University of Wisconsin-Madison.