John Joshua

China’s Economic Growth: Towards Sustainable Economic Development and

Social Justice
Volume I: Domestic and International Economic Policies

The New International Financial System

The Importance of Finance to Economic Growth

There are diverse views on the importance of finance to economic growth; whereas
some economists, such as Schumpeter (1934) or McKinnon (1973), see finance to be
of vital importance in promoting economic growth, others, such as Robinson (1952),
have argued that finance follows economic growth. King and Levine (1993)
investigated whether the development of finance is positively associated with
economic development in over 80 countries between 1960 and 1989. They found that
‘higher levels of financial development are positively associated with faster rates of
economic growth, physical capital accumulation, and economic efficiency
improvement’ (p. 719). As they moved in their analysis from slower-growing to
faster-growing countries, they found a greater importance of banks as compared to
the central bank, an increase in the ratio of private sector credit to gross domestic
product (GDP) and an increase in financial depth; all were strongly associated with
economic growth. They argued that to highlight the importance of finance as a way of
facilitating innovation will give greater support to a Schumpeterian vision of creative
destruction as finance facilitates this innovative process.
Economics is often taught in an ahistorical fashion. The market is subject to constant
changes but what is taught is mostly an abstract form of the competitive market of the
past. Recent dislocations within the financial markets cannot be explained by
resorting to outdated models of business cycles or standard economic theories
because the development of economies is an ongoing process, and advanced
economies are going through structural changes and have now entered a new stage of
finance capital. Financial capital ought to facilitate productive capital so that they
both grow in tandem. However, during the finance capital stage, this capital has come
to grew independently from productive capital; hence, there is a need for regulatory
constraints, which, however, have been largely dismantled. During the finance capital
stage the primary source of profits has become the price inflation of assets; hence,
resources are drawn away from productive investments into financial investments, so
reducing the role of the productive economy, as the financial sector has become more
profitable overall.
Before the 1980s, real investments and corporate profits constituted about 9 per cent
each of GDP. Nowadays, whereas productive investment is about 4 per cent of GDP,
corporate profits have increased to about 12 per cent of GDP; that is, corporate profits
have been drawn out of the productive sector into the financial sector. When there is
a downturn in the economy, central banks often follow this up with a policy of
quantitative easing. Under these schemes, central banks buy securities either from the
government or from the market to increase the supply of money and thereby lower
the rates of interest. The aim may be to stimulate the market; however, such funds
usually end up in the financial sector, where they are used to buy non-productive
rather than productive assets. In other words, they inject cheap money into the
financial sector to stimulate the productive sector by granting low-cost credit;
however, most of these funds then become available for the buying of speculative
assets, which then eventually create new booms and busts in the market. Subsequent
monetary easing may then be followed with bigger bubbles and bigger eventual busts.
Monetary policy, in consequence, can be seen as redistributing largely income from
the bottom income-earners to the top income-earners, in contrast of the New Deal era,
which attempted to reduce income inequality. Income inequalities have widened
since the early 1980s in most advanced countries, especially in China.
The Domestic Financial System and Financial Institutions
Policies of financial liberalization commenced in 1978 in support of turning China
into a more market-oriented economy. It was a gradualist approach. During the 1980s
and 1990s, the prime intention was to attract foreign direct investment (FDI) to
facilitate the transfer of technology from investing countries and to promote exports.
There were two important inducements given to foreign investors: the regions in
China which opened their borders to FDI provided tax incentives; and foreign
enterprises investing in China were given the guarantee that they or their joint
ventures with Chinese firms would not be nationalized. During the 1990s, FDI
increased substantially. In 2002, a new four-tier classification was initiated whereby
FDI was either permitted, restricted, banned or encouraged, depending on the
particular region or sector.
After 1978, the Ministry of Finance relinquished its control over the People’s Bank of
China, and the ‘big four’ state commercial banks were reorganized between 1978 and
1984. The Bank of China was made responsible for foreign exchange and investment,
the Agricultural Bank of China for banking transactions within the rural sector, the
People’s Construction Bank of China for fixed investment, and the newly-created
Industrial and Commercial Bank of China for the remaining commercial business.
Until 1979 the then People’s Bank of China was the only bank in China. After that,
various spin-offs were established. Three state-owned commercial banks were partly
privatized (see International Monetary Fund [IMF] 2006, Table 9). China has also
adopted a gradualist approach in the matter of financial liberalization. Following
some financial liberalization during the 1980s and 1990s, FDI increased substantially
during the 1990s; however, the main source for the financing of investments is
internal funds.
China committed itself to opening up the banking system within five years after 2001
when it joined the World Trade Organization (WTO); however, foreign banks were
expected to compete only within the larger coastal cities. Foreign banks have been
allowed to operate in China since 2007 in accordance with the country’s commitment
to the WTO. Foreign ownership of Chinese banks is limited to 25 per cent, while a
single investor is limited to a 20 per cent ownership stake. Foreign banks were able to
open branches in the Special Economic Zones during the 1980s. The first joint-
venture investment was set up in 1995 by Morgan Stanley and the People’s
Construction Bank of China. Stock exchanges were opened in 1990 in Shanghai and
in 1991 in Shenzhen. As this shows, the financial deepening occurred gradually.
Since 1992, foreigners have also been able to invest in China’s stock market.
The International Financial System and Financial Institutions
The financial institutions created after the Second World War have become largely
outdated as they no longer reflect shifting global power relationships. The
international financial system was regulated during the 1950s and 1960s; this was the
same period that showed the highest growth in American history. Financial crises
then did not exist. The West has imposed an inequitable global financial order as
there is no relationship between countries’ GDP and the distribution of international
reserves. China’s GDP measured by purchasing power parity in 2014 was 17.6 billion
dollars while that of the US was 17.4 billion dollars, and the gap between the
economies of China and the US is growing.
Funds borrowed by developing countries from the IMF and the World Bank can
generally only be used to buy goods and services from the West; if dams or other
types of infrastructure are being built with those funds, the required professionals
come invariably from the West. Developing countries should be able to buy the
required goods and services in the most competitive market; the West is usually not
the cheapest market, and the salaries of those experts who have come from the West
are usually higher than those from elsewhere.
The special drawing rights (SDR) consist now of five currencies. According to the
IMF Executive Board, which completed the 2015 Review of SDR Valuation on 1
December 2015, the new value of the SDRs are effective from 1 October 2016 and
are for the US dollar 41.73 per cent, the euro 30.93 per cent, the yuan 10.92 per cent,
the yen 8.33 per cent, and pound sterling 8.09 per cent for the period from 2016 to
2020.
The under-represented group in the IMF includes emerging economies, in particular
the BRICS (Brazil, Russia, India, China and South Africa). The overrepresented
group consists of the G7. Furthermore, the quota and voting shares of IMF members
do not correspond to their increasing contribution to the global economy.
The Newly Evolving International Financial System
Even though China is the world’s biggest economy, its voting power at the IMF is
considerably less than that of several countries that contribute less to global GDP
than does China. As a result, China has initiated the creation of the Asian
Infrastructure Investment Bank (AIIB), which has 57 members, 20 of which are
located outside of Asia; hence, the AIIB is not just a regional organization, but a
global one. The membership of the AIIB has increased quickly because its members
have a close trade association with China so that such an association will be
beneficial to them. It is likely that Japan may eventually see it as prudent to join as
well since such an association will be mutually beneficial for China as well as for
Japan.
Furthermore, given that the World Bank presidency is always held by a citizen of the
USA and the IMF managing director is always a European, such positions could be
more equally distributed amongst all the organizations’ members. As long as some
economies hold a power of veto in the IMF decision-making process, it cannot be
assumed that the IMF will pursue a fair outcome for all its members. The AIIB,
therefore, is seen as creating a countervailing effect to the IMF as well as to the
World Bank. As financial powers are thus divided, eventually more and more
countries will trade in their own currencies, rather than in the US dollar. As the
United States is declining rapidly in economic power, it is inevitable that the US
dollar will decline in its importance; hence other countries, especially China are
filling the gap.
There are several other new innovative banks besides the AIIB: the BRICS
Development Bank, the Development Bank of the Shanghai Cooperation and the Silk
Road Fund all focus mainly on the construction of infrastructure. The establishing of
the New Development Bank created by the BRICS will impact adversely the flow of
cash from developing countries to the West. China has also set up new exchanges for
gold. Asian governments can provide funds to countries who experience financial
difficulties, and the AIIB can fill the gap; alternatively, an Asian Monetary Fund
could be established which may protect the interest of Asian nations more than does
the IMF. The IMF responded inappropriately to the Asian financial crises; its rescue
package came too late and the conditions were far too harsh. As the IMF refused to
reform the international financial system and does not represent the interests of
emerging economic powers and developing countries, the AIIB was largely created in
response; the representation of emerging countries in the IMF does not reflect their
contribution towards the global economy. Collectively, the BRICS countries have
only a 14.7 per cent voting share, insufficient to exercise a veto, which requires 15
per cent.
The creation of a multi-polar global economy may eventually lead to the creation of
regional monetary blocs; for example, the ASEAN+3, that is, the ten Association of
Southeast Asian Nations (ASEAN) countries plus China, Japan and South Korea,
could eventually create an Asian Monetary System to promote regional monetary
cooperation. Under such a system, each currency may be pegged to a common basket
currency based on a basket of weighted ASEAN+3 currencies. Bilateral exchange
rates could fluctuate within a band around a central exchange (see Lee 2014, p. 59).
However, Barro and Lee (2011), cited by Lee (2014), argued that East Asia does not
currently provide favourable economic conditions for such a currency union;
however, economic development in the future may be more conducive towards an
East Asian Monetary System.
China will be building high-speed railways, ports and power systems, together with
various other constructions, mostly in Asian and African countries, whose economic
growth will likely increase. Their exports will facilitate the repayments of loans for
infrastructure. Under the AIIB scheme, infrastructure will be financed by
governments rather than through private funds to serve rent-extracting opportunities
which produce a flow of interest payments towards various corporations. On the other
hand, the Trans-Pacific Partnership effectively transfers government to the corporate
and financial sector (refer to the discussion in Chapter 7 about the newly emerging
trading blocs). The aim of the New Silk Road is essentially to further Eurasian
integration without Western controls on trade and financial regulations. The building
of infrastructure will be facilitated by large loans and trade is expected to follow.
It appears that the financial sphere is in the process of being split into two opposing
worlds: one guided by neoliberal dogma and the other guided by public investment in
infrastructure to facilitate economic growth. A market cannot operate freely when it
is guided by special vested interestsexerting rent extraction. Public investment in
infrastructure may not only produce economic growth, but at the same time may
lower the cost of living. Whereas classical industrial capitalism thought to create a
flourishing economy to promote a better quality of life with abundance for most,
neoliberalism instead often advocates austerity guided by a rentier economy.
China, together with Russia, could create a gold-backed currency to pre-empt the
financial repercussions when the hegemony of the US dollar comes to an end. China
has also set up in Xian, with numerous countries situated along the ancient Silk Road,
a gold sector fund led by the Shanghai Gold Exchange. Countries situated along the
old Silk Road, from China to the Middle East, are holders of a huge amount of gold.
China has set up the world’s largest gold fund and has set aside US$ 16 billion to buy
gold, which amounts to about 500 tons, or approximately 20 per cent of global
production. China also lends more money to Latin America and African countries
then the IMF and the World Bank together.
The AIIB was created partly because China was prevented from obtaining her
rightful place within international financial institutions such as the IMF; so created
her own bank and most economically relevant countries then followed. China,
together with other countries, has created various alternatives that challenge the
dominance of the US dollar and thus have an impact on the American economy.
When Western economies were dominant, they constructed little infrastructure; their
short-term aims were to accumulate profits, but short-term interests are often
detrimental to long-term stability. The strength of the creation of various huge
infrastructure projects lies in their promotion of long-term stability without
sacrificing short-term interests. The importance of the AIIB has certainly been
recognized by Western economies; hence, they have joined the AIIB as founding
members, starting with the United Kingdom, against the opposition of the USA.
China is able to facilitate business investments through various associations with
financial institutions, such as the BRICS Development Bank, the Shanghai
Cooperation Organisation (SCO) and the AIIB, amongst others, and thereby will be
able to increase its exports and ensure a supply of raw materials to feed into its
economic expansion. The new emerging global financial system is reflected in
associations such as the BRICS, which may well serve as the creation of more
‘bricks’ to build further future economic integration. The One Belt, One Road project
may further initiate new economic integration and the development of Eurasia and
beyond. In fact, it may facilitate various joint ventures between the Global North and
the Global South, so that the concept of an opposed North–South becomes outdated
and superseded by a new concept of a Global North and Global South through the
integration of the economies of Southeast Asia, South Asia and Eurasia with West
Asia and East Africa. The New Development Bank, the SCO development bank and
the AIIB constitute a new global financial infrastructure.
The BRICS decided to establish a financial system parallel to the Bretton Woods
system to better their own interests. They launched the New Development Bank with
initial capital of US$ 50 billion at Ufa, the capital of Bashkortostan in Russia. The
BRICS’s New Development Bank has been operative since the end of 2015; the
initial capitalization has been increased to US$ 100 billion. It may become an
important alternative to the IMF and lead to developing countries eventually
disposing of the US dollar as a reserve currency.
The New Development Bank intends to finance the construction of infrastructure and
various developmental projects throughout the developing world. The New
Development Bank run by the BRICS nations and the AIIB were established to
provide funds for infrastructure and various development projects. The AIIB will be
at the centre of the One Belt, One Road project. All this will facilitate China’s
expansion of its exports of goods as well as technologies. The China Development
Bank intends to invest over US$ 890 billion into the One Belt, One Road scheme to
provide funds to more than 900 projects in about 60 countries. With such projects, the
Chinese government may be able to prevent the growth rate from falling—something
that an economy guided purely by private investment cannot accomplish on such a
huge scale.
China is in the process of a major unifying project through the highspeed rail link that
will integrate emerging economies across Eurasia and may connect such countries
with the European Union, which is China’s biggest trading partner. China and Russia
are upgrading the TransSiberian Railway with an investment of US$ 280 billion. The
twentyfirst-century Maritime Silk Road will intensify future trade between China and
South-East Asia. China has become a huge net exporter of capital through the
establishment of various financial institutions such as the AIIB, the BRICS
Development Bank, the Development Bank of the Shanghai Cooperation and the Silk
Road Fund. China has established, in conjunction with the other BRICS nations, a
development bank which will strengthen the SCO, of which Iran and Pakistan have
applied for full membership.
As foreign trade is conducted less and less in US dollars, the value of the US dollar is
expected to decline. At the same time, the supply of the US dollar has been increasing
because of quantitative easing conducted by the Federal Reserve. As production goes
offshore and as the USA increasingly relies on imports, a decline in the exchange
value of the US dollar will lead to domestic inflation, which will inevitably induce a
lower standard of living in the USA. In contrast to the general belief, quantitative
easing cannot stimulate the economy, though it may improve the balance sheets of
the banks. Furthermore, the cash created through quantitative easing ends up
overwhelmingly in profits, thereby exacerbating already extreme income inequality.
The Yuan as an International Reserve Currency
On 30 November 2015, the IMF accepted the yuan as an official reserve currency of
its basket of reserve currencies. The yuan is one of the five official reserve
currencies. According to the official weighting, the yuan is third, after the US dollar
and the euro; the two other reserve currencies are the yen and pound sterling.
Emerging economies were especially hard hit by the financial shock spill-overs
during the crises that hit the global economy in 2008–2009. As international trade
and income increases, there is also a greater demand for international reserves. Lee
(2014) argued that alternative currencies are important in strengthening the global
reserves system because a multicurrency system would reduce ‘the ever-growing
balance-of-payments deficit pressure on a single reserve currency issuer’ (p. 43).
Lee (2014) suggested that as China exports to virtually all countries, it ‘reinforces the
Renminbi’s potential role as an international medium of exchange’ (p. 50). He
further argued that China’s macro-economic
stability and low level of inflation ‘bodes well for the Renminbi as a store of value’
(p. 50). However, the efficiency and transparency of China’s financial system still
lags behind the country’s economic development, and the Chinese capital market is
still underdeveloped. Lee (2014) made the point that ‘open and efficient financial
markets are an indispensable precondition for reserve currency status’ (p. 50). When
the yuan has been established as an international reserve currency, there will be an
upward pressure on the exchange rate of the currency due to stronger demand for it.
The yuan will appreciate because liberalization of the capital account will cause a
strong capital inflow with an increase in demand for the currency. As the yuan
appreciates, there will be a loss in competitiveness in international markets. China’s
share in global GDP stood at 9.4 per cent in 2010 at market exchange rate; it is the
world’s largest exporter of merchandise with 10.5 per cent of the world’s total and is
second in the imports of merchandise at 9.2 per cent of the global total (Lee 2014,
p. 53).
The international financial system is moving towards a multi-currency reserve
system, which will be less distorted than the present one-currency system because it
will be more representative of the economic powers of emerging nations. However,
exchange rates can be changed by shifts in portfolio between different currencies and
thereby may destabilise any multi-currency reserve system. Hence, there may be a
good reason to outlaw the movements of international currencies by speculators
seeking profit as they can severely damage the economies of middle-sized countries
in particular. However, pre-empting speculative attacks on a country’s currency
would need an international effort. It may be argued that an international reserve
currency should be truly international; that is, a truly international currency would be
detached from the economic conditions of any country. The SDRs could also be used
more widely in international trade and international investment.