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Does Government Intervention in Financial Markets Slow Economic Growth?

August 9, 2011

by Michael Edesess

China’s on-again off-again financial reforms

China has had its own serious financial management issues, as a widely read book, Red Capitalism (which I reviewed for the Hong Kong Economic Journal), by Carl Walter and Fraser Howie, makes clear. Walter and Howie provide a more detailed and intricate analysis of China’s financial problems than does Goodstadt, but Goodstadt’s book minces its words less – perhaps because Walter and Howie are still doing business in China.

Until 1997, China used its banks as instruments for Communist Party policy, directing the banks to make loans for Party projects, such as infrastructure projects and state-owned industries, many of them provincial-level or local. Not surprisingly, since the loans were not subject to careful financial due diligence, a large proportion turned out to be non-performing. When the non-performing loans accumulated, undermining bank solvency, the central government recapitalized the banks and placed the non-performing loans in special-purpose entities (as Walter and Howie observe, not unlike those used by Enron), sweeping them under the rug.

Goodstadt calls those lending practices “policy lending” and “relationship lending.” Policy lending is lending to carry out Party industrial policy. Relationship lending is extending credit to powerful officials — frequently, Party bureaucrats. “As a result,” Goodstadt writes, “they profited handsomely from access to loans from state-owned banks which could be rolled over indefinitely and to public land which they occupied with impunity. The state’s assets were the foundations of the future fortunes of these officials, who were to make up the bulk of the most successful, new entrepreneurs.”

The Asian financial crisis of 1997-98 brought about a serious effort toward financial reform in China, which included efforts to end the practices of policy lending and relationship lending. But Goodstadt points out that “the global financial crisis gave a new lease of life to both ‘policy’ and ‘relationship’ lending.” This was because China’s response in 2008 to the crisis was a $586-billion economic stimulus package, which “led unavoidably to an expansion of the state’s direct involvement in the economy.” The responsibility for dispensing these funds was given to local government officials, who reverted to old lending and borrowing practices to fulfill their mandates.

Hong Kong’s regulation

Unlike the West – and contrary to common perceptions – Hong Kong’s regulatory arrangements since 1986 “are among the strictest of any financial centre and have been tightened steadily over the last decade” according to Goodstadt, “Yet, its financial system has flourished, its business volumes have grown, and it has continued to attract the world’s leading banks.” He further notes that “In the process, Hong Kong discovered that strict regulation of financial markets and their players did not stifle either growth or innovation, nor did it diminish its attractions as an international financial centre.”

Goodstadt makes it clear that Hong Kong’s interventionist regulatory practices are not so much the result of a different regulatory philosophy as the result of past experiences with repeated financial crises, a need to protect its franchise as an international financial center by protecting against instability and a need to keep on the good side of mainland China. “In the last resort, financial stability is not negotiable for Hong Kong. If its credibility as an international financial centre were endangered, its value to the Mainland would suffer immediately, and its unique role in the nation’s financial affairs would be in jeopardy. … This is the ultimate political pressure which dictates the priority of financial stability for Hong Kong.”

The major disappointment of Goodstadt’s book is that he does not flesh out the details of this strict regulation. I would have liked many examples, not just one, of how Hong Kong’s regulators acted differently from those in other jurisdictions. Yet not only does he not give specific examples, he does not even describe the organizational structure of Hong Kong’s financial oversight bodies or their history or top management. This is a very serious failure in the book, and one that I fear will limit its readership and impact, perhaps only to those who already know the financial regulatory bodies of Hong Kong (or perhaps, have read Goodstadt’s previous books).

Nevertheless, it must be recognized that Hong Kong has had a uniquely important role in the financial history of China and its relationship with the West. When I visited Hong Kong in the early 2000s – not long after the handover that marked the transition of the UK’s former colony to a Special Administrative Region of mainland China – there was much pessimistic talk about the expectation that Hong Kong would soon be eclipsed as a financial center by Shanghai. Goodstadt, in a talk on May 5, 2011, to the Foreign Correspondents Club of Hong Kong, said he lost his hair while waiting for these frequent forecasts to come true. Hong Kong is still the most important financial center in East Asia and one of the few most important in the world.