CEIBS Economics Professor Xu Xiaonian On Resolving China’s Excess Liquidity

Xu Xiaonian: “What is the essence of liquidity? Too much money issued? Too much foreign trade surplus? Loose monetary policy? In fact, China’s current excess liquidity is the natural result of our bank-based financial system. Fundamentally, it is due to the overflow of savings into banks which are unable to turn them into investments. The reason behind the overflowing deposits is that we have a single channel for wealth accumulation: bank deposits. This is due to government control of the investment, real estate and financial markets. Therefore, China’s excess liquidity is structural excess liquidity.

China’s financial system is in transition, which should turn the current bank-based system into a market-based system emphasizing the role of capital markets, direct financing, and non-bank financial institutions. This is not a novel idea. However, based on my research, my conclusion is that the key to realizing such a transition is deregulation of the financial system.  

The Chinese economy largely depends on bank credits; in China, the ratio of bank credit to GDP is over 110 percent compared with 80 percent in Japan and under 50 percent in the U.S. China’s bank-based financial system is unable to provide diversified financial products, which leads to the excess liquidity in the banking system. China’s loan-to-deposit ratio has decreased since the mid 1990s, reaching 65 percent as of late 2006, as compared to 95 percent among commercial banks in the U.S. Thus, Chinese banks are less efficient ? only 65 percent of deposits become loans, while 35 percent end up as low-yield national bonds or Central Bank reserves.

How can China eliminate excess liquidity through financial reform? A popular suggestion is to develop direct financing. This is a good idea but the problem is how to realize direct financing.

I propose promoting the diversification of financial markets and financial institutions, including private, small- and mid-sized credit and trust institutions. Financial institutions should include private equity, and China should develop its corporate bond market as soon as possible. We must loosen administrative control over the financial system and ease entry, allowing a range of non-bank financial institutions to take root and grow. This would channel surplus bank deposits into the economy as investments.

China’s need for corporate investment autonomy, deregulation 

Chinese firms have experienced more than 30 years of economic reform, but they still lack autonomy in investing. They still need administrative approval in order to choose a financing method and to determine their investment timing and pricing.

This lack of autonomy seriously hinders a company’s operations, leaving them with only production autonomy, purchasing autonomy. We call for the elimination of the governmental application and approval system that controls corporate financing and investing decisions. We should first loosen regulations, then eliminate them.

If we cannot loosen financial administration and develop non-bank institutions and non-bank products, we will face long-term excess liquidity in the banking system just like other East Asian countries. Excess liquidity will cause bubbles in the real economy and the capital markets, similar to Japan.

The current bubble in real economy caused by excess liquidity is not reflected as inflation but as foreign trade reserves. Excess liquidity leads to over-issuance of loans, which causes the over-capacity in manufacturing. Manufacturing over-capacity leads to increased exports, which expands China’s foreign trade surplus. Foreign trade surplus leads to the increasing foreign reserve. We’ve already seen the bubble in the capital market. Once the bubble breaks, it will have a huge impact.

Still, I am not a pessimistic. Even if the capital bubble breaks in China ? and I believe it will break ? the economic impact will not be as huge as in Japan at the end of 1980s. Why? Because our bank reform began several years ago and our bank system is healthy. After reform, its flexibility and profitability will have significantly improved. What’s more, under the current administration system, banks are strictly restricted from investing in real estate and capital markets, so even if the bubble bursts, it will not cause turbulence in the banking system. But this does not mean we can postpone financial reform; financial reform should be further implemented to eliminate excess liquidity as soon as possible.” 

SPEAKER’S BIO

Xu Xiaonian
Economics Professor, CEIBS

Before becoming a professor at CEIBS in 2004, Xu Xiaonian worked as Managing Director and Head of Research for China International Capital Corp (CICC). Under Xu’s direction, CICC ranked as China’s No. 1 domestic brokerage firm in 2002, according to China’s institutional investors, while Xu himself was named “China’s best economic analyst.” Xu’s other previous positions include serving as a senior economist with Merrill Lynch, a consultant to the World Bank, assistant professor of Economics and Financial Markets at Amherst College, and research fellow with China’s State Development Research Center. In 1996, he received China’s highest economics award, the Sun Yefang Economics Prize, for his research on China's capital markets.