REFORM

AND DEVELOPMENT OF CHINAS FINANCIAL SECTOR

What About Us?

Avenues for Private Savings in Post-Reform China
Michael A. J. Tanenbaum 4/27/2009

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 2 I. Introduction In a 1998 article in Foreign Policy magazine, Professor David M. Lampton wrote, China is a giant screen upon which outsiders project their hopes and fears. Expectations of economic gain coexist with worries about financial crisis; shrill alarms about Chinese power with dire forecasts of collapse; visions of democratic change with caricatures of current reality (Lampton, 1998, p. 13). Over a decade later, the characterization of China as a canvas remains apt. The worlds professional and amateur community of China-watchers observes the Asian giant through their lenses of personal experiences and individual concerns, with opinions diverging to a cacophonous equilibrium. However, the foundational basis of the worlds concern with China stems from an opinion on which all laymen and specialists agree: since 1978 China has undergone tremendous economic change. Chinas post-1978 economic reforms have touched every sector of the economy deeply. Within this process of reform, the Beijing government has rightly identified the financial system as vital to the emergent success of China as a prosperous nation. Despite halting advances, thirty years after the start of Deng Xiaopings reforms, the Chinese financial system finds itself largely marketized, better able to distribute the economys capital than ever before, and on a clear trajectory toward further alignment with the principles and practice of Western finance. Within financial systems, myriad financial institutions and individual actors pursue profit by connecting savings with investment opportunities. Financial institutions utilize the economys saved funds and guide them toward profitable investment projects, or savers place money into projects themselves through direct finance. In return, savers receive a return for the use of their funds. In the case of China, there exists a deep literature on how post-1978 macroeconomic policy changes have boosted Chinas financial system efficiency. Often neglected, however, are the impacts of those top- down policy shifts on individual retail savers, and the palette of financial options those savers are free to employ. This paper examines the evolution and growing diversity of private savings options facing the retail saver from 1978 to the present. Because the financial systems raison d'tre is the material betterment of society through the productive direction of capital, the impact of Chinas financial system reforms on individuals ability to earn healthy returns on savings deserves close scrutiny. Despite major system level changes, the portfolio of savings options available to the Chinese retail saver remains severely restricted. Even accessible avenues yield substandard returns. In a March 2007 speech in Shanghai, former U.S. Treasury Secretary Henry Paulson, noted,
Inadequate reward to savings hurts the Chinese people. While China's people work every bit as hard if not harder than people in other economies, they are not yet as well off. Today, Chinese citizens have $2 trillion or 16 trillion RMB at today's exchange rate deposited in banks, earning on average a 2.5 percent return. After inflation and taxes, the real return on bank deposits is probably negative. People in many other parts of the world have more choices of where and how to save, and routinely earn a much better return often in the high single digits even in economies that are not growing nearly as fast as China (Paulson, 2007).

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 3 This paper argues that despite significant marketization and liberalization of economic behavior at the firm level, the individual Chinese saver has yet to experience a similar relaxation of restrictions on opportunities for his savings. The discussion begins with an investigation of Chinese savings patterns, to demonstrate the need for efficient savings avenues. Second, the paper examines avenues presently available to Chinese savers and how savers cope given the restrictions on their economic behavior. In the third and fourth sections, the paper studies the interaction of savings patterns with available vehicles, with implications for policy reforms that would allow greater utility from household savings. The fifth section discusses changes to the macro economy since 1978 with an eye to their impact on the individual savers financial liberty, concluding that individual financial liberty lags behind the financial freedom enjoyed by firms. II. Hedging Predictable Calamity: A Holistic Explanation for Chinese Savings Patterns a. By the Numbers To understand Chinese savings vehicles, one must first understand Chinese savings patterns. Qin and Ren note that even when adjusting for measurement differences, Chinese households save 15.87% more of their disposable income on average than U.S. households. Using standardized measurement metrics, the average Chinese household savings rate from 1992-2001 was 22.69% (Qin & Ren, 2008). Furthermore, from a peak of over 20%, household savings has settled at roughly 16% of GDP using 2005 data. By comparison, as figure 1 shows, Chinese household savings as a percentage of GDP in 2005 were roughly 11.2% higher than U.S. household savings in 2002 (Kuijs, How will China's Investment-Savings Balance Evolve?, 2006, pp. 6-7). It is important to note that these figures do not account for the negative savings impact of the U.S. subprime mortgage and ensuing financial crises.

Figure 1 - Source: Kuijs, "How will China's Saving-Investment Balance Evolve?"

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 4 b. Explaining Chinese Savings Patterns Explaining Chinas unusually high household savings rates is a more difficult exercise. One contention often cited by the popular press argues that Chinese, and Asians generally, come from a culture of savings, whereby there exists a cultural preference for savings over consumption. As a result, Asian societies savings rates are several times greater than their Western counterparts. Though this argument fails intuitively who would prefer to defer consumption for the sake of it? journalists and stumped economists continue to fall back on cultural savings arguments. In a seminal 1994 paper, Carroll, Rhee, and Rhee effectively debunk the cultural savings argument. In a brilliant natural experiment, Carroll et al. examined the savings patterns of immigrants to Canada from different regions. If culture is a major factor in the savings decisions of an individual, then presumably adult immigrants from high savings societies would continue to save at a higher rate than immigrants from low savings countries or native Canadians. Their analysis found, that saving patterns of immigrants do not vary significantly by place of origin. Instead, independent of their origin, recent immigrants save less than Canadian-born citizens, and that over time the distinction between the behavior of immigrants and that of native-born citizens diminishes (Carroll, Rhee, & Rhee, 1994, p. 687). If culture cannot account for Chinese savings rates, alternative explanations are needed. Kuijs cites the extant literature as focusing on for four main reasons, commonly seen as having had a particularly significant role in China (Kuijs, How will China's Investment-Savings Balance Evolve?, 2006, p. 8). They are: demographics, income growth, a shift of health and education expenses from the government to the individual, and a lack of financial sector development. The demographic changes underway in China are mostly the result of the one-child policy, instituted in 1979. Using the Life-Cycle Hypothesis (LCH) developed by Franco Modigliani, we can observe the impact of demographic shifts on Chinese gross household savings behavior. The LCH predicts that individuals will seek to smooth consumption over their lifetime, saving little when young, increasingly more as they work and get closer to retirement, and draw down on their savings after retirement. In a 2004 paper by Modigliani and Cao, analysis of empirical data found that Chinese savers follow the predictions of the LCH. Given the lower birth rates for the past 30 years, the number of working adults relative to young dependents has increased. As a result, savings have increased as this glut of workers collects for retirement. When these workers retire, savings rates will decline as they draw on pensions and savings. Furthermore, children are the traditional source of old-age support in China, but there is justified doubt that one child can bear the burden of maintaining two aging parents (Modigliani & Cao, 2004, p. 165). The LCH also accounts for the second reason for high Chinese savings income growth. The LCH argues that savings are not dependent on GDP per capita, but rather GDP growth. As figure 2 demonstrates, Chinese household savings ratios are highly correlated to income growth over time.

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 5

Figure 2 - Source: Modigliani and Cao, "The Chinese Saving Puzzle and the Life-Cycle Hypothesis"

Additionally, the post-1978 reforms introduced a greater degree of uncertainty for Chinese workers, because of the disappearance of guaranteed employment and social services. The breaking of the iron rice bowl incentivizes precautionary savings as a protection against an uncertain future employment outlook (Chamon & Prasad, June 2008, p. 5). Another motivation for savings lies in the certain future need to fund education and healthcare expenses. Because of, the uncertainty and lumpiness of those expenditures, households seek a savings cushion (Chamon & Prasad, June 2008, p. 15). In Chamon and Prasads sample, the fraction of households for which health expenditures exceed 20 percent of total consumption expenditureshas risen from 1 percent in 1995 to 7 percent in 2005 (Chamon & Prasad, June 2008, p. 15). In the pre-1978 economy, the state was responsible for health and education expenses. Lastly, the financial sector has yet to develop a consumer credit market. As a result, instead of borrowing to finance large purchases, Chinese households are more likely to rely on their savings (Chamon & Prasad, June 2008, p. 15). In 2005, Chinese consumer credit stood at about 17% of GDP, which is similar to other developing countries, but much lower than the developed world (Kuijs, How will China's Investment-Savings Balance Evolve?, 2006, p. 9). Because consumers cannot easily access credit for large purchases, they must accumulate savings over time to pay the full purchase price in cash up front. This results in larger bank deposits for longer periods as savings accumulate.

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 6 III. The Best of Whats Around: Chinese Savings Choices Given Present Options a. Bank Deposits

As of 2006, over 90% of Chinese net financial investment was in savings deposits (Kuijs, How will China's Investment-Savings Balance Evolve?, 2006, p. 7). The central government maintains a ceiling on interest rates paid on savings deposits, as well as a floor on loan interest rates, to ensure banks have a healthy profit margin. As a result, most Chinese savers earn zero or negative returns on savings deposits after inflation (Wu, 2005, p. 221). The artificially low return savers receive on demand deposits forms the foundation of Nicholas Lardys definition of financial repression. He notes that in 2002, the Peoples Bank of China (PBOC), fixed the maximum interest rate banks could pay on demand deposits at 0.72 percent, a rate that remains unchanged. But inflation, as measured by the consumer price index, ticked up by almost 9 percentage points, from that point, making the real return on bank savings deposits close to -7.28% (Lardy, 2008). b. Equities

Beyond bank deposits, other available avenues for savings include real estate, Chinese equities, and to a much more limited extent, insurance. Chinese all across the country trade in equities, but are limited to only those shares traded in the domestic markets. Desire for better returns over bank deposits and the large number of unsophisticated investors in China leads to extreme price volatility, in the forms of bubbles and bursts (Lardy, 2008).

Figure 3 - Shanghai Composite Index 2000-2009

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 7

Figure 4 - Shanghai Composite Index, 1992-2009

Looking forward, there is little doubt that Chinas stock market, in spite of the November 2007 market correction, remains in bubble territory (Bottelier, The Evolution of Banking and Finance in China - Domestic and International Aspects, 2007, p. 8). The risks associated with overvalued Chinese equities, though, are uncertain. On the one hand, buying on margin is officially prohibited (and believed to be rare) in China, which reduces systemic risk in the event of further collapse. However, Bottelier estimates that over 60 million households own stock, so any significant price decline could hurt household balance sheets (Bottelier, The Evolution of Banking and Finance in China - Domestic and International Aspects, 2007, p. 8). As the figures above highlight, the Chinese equities markets are subject to huge swings over short periods, which no doubt has deleterious effects for many households. c. Real Estate When China implemented the reform and opening policy (gaige kaifang zhengce) in the late 1970s, net average living space per capita in China was roughly 4% of U.S. levels in 2001 (Gibson, 2009, p. 3). Despite adding vast amounts of new housing from 1949-1978, the demand for residential space far outpaced supply. Part of the reason for this disequilibrium lay in the fact that state-owned enterprises (SOEs) were responsible for providing housing for employees, and they had little incentive to spend more on improving employee housing than necessary. With the SOE reforms begun in the late 1980s, enterprises were no longer responsible for providing social benefits to employees, such as housing, healthcare, schools, etc., which had been a tremendous burden on SOE profitability (Bottelier, Class Lecture, 2009). The 1988 National Housing Reform Plan made the privatization of Chinese housing a national priority. The government instructed SOEs to sell their existing housing stock to employees at a reasonable discount, as incomes were still too low to clear the market of residences. The government also guaranteed the right of individuals to sell and bequeath purchased properties at this time. Lastly, rents were increased sharply to make residential ownership more attractive. Neil Gibson aptly phrases the governments attitude, writing, Whether the Chinese people liked it or not, they were going to be the recipient of a significant transfer of wealth (Gibson, 2009, p. 6).

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 8 Unfortunately, in recent years real estate has been subject to its own bubble. With the approval of the Guarantee Law in 1996, households could use their apartments as collateral for mortgages to buy newer, bigger apartments. The original apartment would often be kept as a rental property (Gibson, 2009, pp. 10-11). This trend resulted in cascading demand, creating a speculative housing bubble. Everyone from school teachers to cab drivers felt they could play part-time landlord (Chen K. , 2004). SOEs themselves began to invest in land as they sought a destination for retained earnings in excess of profitable investment opportunities (Gibson, 2009, p. 15). Fearful of a real estate collapse similar to the Japans in the early 1990s, the Chinese government deliberately pricked the real estate bubble in early 2007. The central government implemented new restrictions on access to mortgages, and the building community responded by slowing growth (Bottelier, Class Lecture, 2008). Though choosing to prick the real estate bubble represented sound economic policy, it arrived just before the global economy was due for collapse with the onset of the U.S. subprime mortgage crisis. c. Insurance Insurance continues to grow at exponential rates in China, but penetration remains quite low. Only one percent of GDP in China is spent on insurance yearly (Lloyd's , 2007). The 2007 PricewaterhouseCoopers update on the state of foreign insurance companies in China found that, although the insurance market as a whole is beginning to mature, the individual consumer does not seem convinced about why there is a need for insurance. Considerable efforts on awareness building and education are required (PricewaterhouseCoopers, 2007, p. 15). Until consumers themselves are convinced of the need for insurance, it will remain an underdeveloped avenue for personal savings. IV. Steps toward a Better Tomorrow: Policy Initiatives to Achieve Greater Utility for Savers In Lamptons 1998 Foreign Policy article cited above, he asks, Will Beijing recapitalize its banks and operate them on sound financial principles?...And will China tackle the problem of state enterpriseswhose bad debts to the banks are the principal cause of thesystems current woes?... Can China meet these challenges and avoid serious political dislocation? Nobody can be sure (Lampton, 1998, p. 19). Eleven years later, we know the answer: China can and did reform the banks and SOEs with great success and without serious political dislocation. In comparison to the very serious and difficult task of recapitalizing the banks and reforming sclerotic SOEs, reforming the retail savings system is relatively easy, as retail savers can be counted on to respond to the incentives with which they are presented. a. Expanding Health Insurance Using cross-sectional microeconomic data, Chamon and Prasad argue, that the elimination of the risk of health expenditures exceeding 20 percent of income (through a catastrophic insurance scheme) would have lowered the median saving rate in 2005 by 3.5 percentage points (Chamon & Prasad, June 2008, p. 25). Indeed, their analysis finds, The increasing private burden of education and health expenditures seems one of the strongest candidates for explaining the increase in saving rates

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 9 (Chamon & Prasad, June 2008, p. 25). Instead of each household saving enough to cover massive medical expenses, significant welfare gains may be obtained from the implementation of social health insurance programmes by improving risk-sharing mechanisms and by allocating the resources of households more efficiently over time (Chou, Liu, & Huang, 2004, p. 295). As a comparison with a similarly high savings society, the introduction of National Health Insurance reduced saving by an average of 8.613.7% in Taiwan (Chou, Liu, & Hammitt, 2003). Recognizing the ability of health insurance to stimulate spending and the need to boost consumption in rural areas, the Chinese government announced in January 2009 that it will spend over US$120billion over three years to boost healthcare infrastructure and expand health insurance coverage (Fairclough, 2009). Though the plan does include some funds to subsidize insurance premiums, there is still ample room to encourage the creation of low-cost private health insurance schemes covering only catastrophic accidents and illnesses. For example, according to the National Development and Reform Commission policy release of 6 March 2009, only 150 billion RMB was to be allocated to the broad category of medical treatment, public health, education, cultural, and societal development projects (PRC National Development and Reform Commission , 2009). b. Legitimizing Underground Finance In her groundbreaking study of underground finance in China, Prof. Kellee Tsai wrote, As of the end of 2000, less than 1 percent of loans from the entire national banking system had gone to the private sector. Business owners take their exclusion from formal sources of credit for grantedhow has China's 'economic miracle' been financed? The short answer: informal, and often illegal, finance (Tsai, 2002, pp. 2-3). Within China, there are a multitude of informal, unregulated sources of credit for small and medium sized businesses, ranging from interpersonal lending to full underground banks. Lardy quotes the sum of informal loans outstanding at, RMB10 trillion, equivalent to almost a third of the loans extended through the banking system (Lardy, 2008, p. 5). If presently illegal sources of credit could be legalized and regulated, Chinas savings would decline for two reasons. First, savers would be able to earn more competitive returns on deposits at these institutions. Second, these lenders would provide exactly the sort of flexible access to credit that would make precautionary savings unnecessary. For example, if savers had the option to tap the equity in their homes, savers would not need to keep large deposits of liquid assets as a hedge against major expenses. These lending houses would also continue to provide financing and credit for goods purchases, obviating the need to hold cash to cover any durable goods purchase. c. Obstacles to Proposed Reforms As stalled reforms demonstrate time and again, the sensibility of a reform project carries little weight if concurrent political-economic concerns lie in opposition. As noted above, the prospect of increasing retail savers savings options holds great promise for solving several of Chinas pressing economic issues and raising utility for society as a whole. Understanding the concerns of entrenched interests preventing positive change provides a useful framework for moving towards reform.

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 10 Contrary to popular belief, the key beneficiary of the tight savings controls in China is the government. Lardy argues that while government ceilings on interest rates paid on deposits and floors on loan interest rates guarantees a comfortable operating margin for banks, much of that benefit is eroded by government policies which force banks to hold central bank bills. To maintain the stability of the Yuan against foreign currencies, the PBOC has intervened significantly in the foreign exchange markets. To prevent inflationary effects from the introduction of Yuan, Chinas central bank sterilizes much of the new Yuan issues by selling central bank bills to the Chinese banks. These central bank bills pay very low interest, and are therefore an implicit tax on banks. Furthermore, since 2007, the central bank has increased the reserve ratio banks are required to hold to further reduce the money supply. The opportunity cost of this overcapitalization of Chinese banks is another implicit tax on banks. Lardy estimates that the cost of these implicit taxes for banks in 2007 was 230billion RMB (Lardy, 2008, p. 3). Financial repression is a key tool to ensure that central bank notes can be placed with the Chinese banks for sterilization purposes. Any attempt to reform and liberalize savings options, therefore, must be concomitant with reform of Chinas exchange rate policy. V. For the Firm, the Lions Share: Macro-Level Financial Changes and the Retail Savers They Forgot Though the Chinese financial system has made great strides in just a few short decades towards integrating with the world economy, the Chinese leadership favors stability over the chance for improved growth. Despite institutional reluctance, China has achieved significant changes in the nature and operation of its financial system. Though essential for and a key contributor to Chinas unprecedented growth, these macro level changes have failed to improve the retail savers financial liberty to the same degree that they have opened the operating space of financial firms. In Understanding and Interpreting Chinese Economic Reform, Jinglian Wu notes in a single paragraph the tremendous changes facing the financial sector as the effects of the 1978 reforms began to play out in the financial marketplace. In 1981, the Ministry of Finance legalized bond issues. From 1980-1985, China witnessed the emergence of commercial paper. In 1986, the PBOC began to allow financial institutions to trade assets. In 1987 and 1988, China established secondary markets for bond trading. By 1990-1991, China had two fully functioning stock markets in Shenzhen and Shanghai (Wu, 2005, pp. 219-220). In a single decade, the central government oversaw the creation of a domestic financial system. As a benchmark, one could note that the private sector was only formally recognized in the constitutional amendments of 2001 (Steinfeld, 2002, p. 384). Chinas process of firm-level financial opening has continued as China prepared to enter the WTO and in the fulfillment of WTO commitments throughout the 2000s. Financial sector reform in China enjoyed the dubious honor of an area the Chinese government seemed intent on protecting from foreign competition. Writing in 2001, John Langlois noted in The China Quarterly, The financial sector provisions of the agreements provide for significant points of entry to the Chinese markets by foreign participants. But they embody protectionist principles China evidences a reluctance to permit foreign competition in the financial sector (Langlois, 2001, p. 610). Langlois attributes this reluctance to a desire by the Chinese government to hold on to the reigns of capital for political reasons (Langlois, 2001, p. 611).

Avenues for Private Savings in Post-Reform China M. Tanenbaum - 11 Despite the governments aversion to financial sector liberalization, the terms of Chinas WTO accession included (1) lifting geographical restrictions for where financial firms could operate; (2) allowing foreign financial firms to compete for Chinese clients; and (3) ease the licensing requirements for banks and financial institutions. By 2006, however, foreign financial players held only 2% of the domestic Chinese market and faced significant obstacles when trying to open new branches (Moody's Investors Service, 2006). Despite these drawbacks, a 2007 industry survey by PricewaterhouseCoopers found that most foreign banks operating in China had strong intentions to stay and further integrate with and participate in the Chinese domestic market (PricewaterhouseCoopers, 2007). While large companies and major financial players are operating in China with increasing freedom and enjoying a wider range of debt and equity financing, the retail saver faces the same choices available to Chinese savers for centuries. Besides bank deposits, equity holdings, and real estate, which were financial options available to Chinese pre-1949, there has been little movement. Indeed, as Prof. Tsai notes, the main source of finance for most SMEs comes from underground, non-sanctioned, largely unregulated financial institutions. Indeed, foreigners observing Chinese society in the early 20th century noted the existence of credit cooperatives and local financial organizations established for business or agricultural financing (Mallory, 1931, p. 492). The methods of payment and practices were well established, and bolstered by official legal obligations, collateral, and a system of guarantors (Gamble, 1944, p. 46). Most interesting is that these systems of shared savings and credit continued to exist in some capacity even after the establishment of the PRC and well into Maos tenure as paramount leader (Jones, 1967). VI. Conclusion Avenues for retail savings have failed to reap the benefits of financial modernization in other areas of Chinas economy. The benefits of pooled risks, consumer credit, and the myriad financial combinations that retail savers and individual consumers enjoy in other societies remain denied to mainland Chinese. In contrast, the concerted lobbying of international financial actors and foreign governments have brought significant change and increasing openness in the participation of foreign firms and liberalization of Chinas financial markets. Though Sec. Paulsons comment that Inadequate reward to savings hurts the Chinese people remains clear, what remains unclear is the timeframe within which retail savers in China can expect change and increased liberty. Given that expanding the Chinese retail savers portfolio of options holds great promise for addressing outstanding economic and financial concerns, one can only hope that horizon is near.

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