Financial Repression in China and India

Raghuram Rajan, Economic Counselor and Director of Research, International Monetary Fund says that “uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown” and that the inadequacies of the Chinese financial system are to blame for this:

It is unlikely the chairman of a state owned corporation, cash rich because he no longer has to meet his social obligations to workers, will prefer to return cash to the state via dividends rather than retaining it in the firm, particularly when banks are under orders to restrain credit growth. And with financial investments returning so little, far better to reinvest cashflows in real assets. Indeed, liquidity plays a greater role than profits in determining real investments.

Similarly, the chairman of a private firm knows that financing from either the stock market or the state-owned banks is very uncertain. So he too will be unlikely to pay dividends, preferring instead to retain the capital for investment. Again, instead of storing this as financial assets and awaiting the right real investment opportunity, given the poor returns on financial assets, he has an incentive to invest right away.

These tendencies imply a lot of reinvestment in existing industries especially if cashflow in the industry is high, which inexorably drives down their profitability. And they imply relatively little investment in new industries. The inadequacies of the financial system would thus explain both the high correlation between savings and investment and the oft-heard claim that over 75 percent of China's industries are plagued by overcapacity. They also suggest why uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown.

This is an interesting argument against financial repression. It is useful to remind ourselves once in a while that the occasional stock market scandal that we have seen in India since the beginning of economic reforms is a small price to pay for getting rid of financial repression. It is also necessary to recall that as a percentage of GPD, the annual losses to Indian households from financial repression were higher than the amount involved in even the biggest of the stock market frauds since 1991. For example, during 1980-81 to 1989-90, time deposits at commercial banks averaged over 25% of GDP. I have estimated that financial repression in the 1980s was about three percentage points. This implies that holders of time deposits at banks lost 0.75% of GDP annually. If we add the losses on other repressed financial assets (especially life insurance and provident funds), the total would certainly exceed 1% of GDP annually. By comparison, the total amount of fraud in the scam of 1991-92 (involving Harshad Mehta and others) was about 0.75% of GDP. The total amount of fraud in the scam of 2000-01 (involving Ketan Parekh) was less than 0.2% of GDP.

Posted at 2:26 pm IST on Mon, 16 Jan 2006         permanent link

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