Three Questions with… Victor Shih

Editors Note: UC-San Diego and the School of International Relations and Pacific Studies are host to some of the world’s leading China scholars. In this column, we sit down with these experts and ask them three questions related to their field of expertise. 

Dr. Victor Shih is the latest addition to the impressive IR/PS China-focused faculty and 21st Century Program. I sat down with him to understand the current state of China's financial sector.

1.     Walk us through the main financial reforms announced during last year’s Third Plenum. 

The Third Plenum didn't announce anything new regarding the financial sector. It was things the Chinese government has been saying all along. So, number one: they want gradual liberalization of the interest rate. Even though lending rates have been liberalized prior to the Third Plenum, there's still a pretty strict ceiling on deposit rates. And, as seen in some of the Plenum wording, they want to promote the liberalization of deposit interest rates. Before that occurs, however, the People’s Bank of China (PBOC) would like to see deposit insurance, but they've been stuck on this point. This is what I learned even the last time I went there, although supposedly later this year something regarding this point is going to come out.

The other thing they said they would do at the Third Plenum ”again something that they have said before ”is make China's exchange rate more flexible. Currently, the spot exchange rate can only fluctuate either one percent above or one percent below the daily fixing rate that's set by the PBOC. They've put out some language suggesting that they want to enlarge the space for the exchange to fluctuate either two or three percent, and then over time to completely liberalize exchange rates.

And, number three, again something they have said before, they want to gradually enlarge capital account liberalization over time. First, they want to really liberalize how people can move money into China. For a long time there were restrictions because of hot money inflows. A lot of those restrictions were eased, if not completely liberalized. So, the QFii (Qualified Foreign Institutional Investor) quota and also the RQFii (Renminbi QFii) quota, which is when you have renminbi in Hong Kong, you can invest that renminbi in China, those numbers have increased quite substantially in recent years. The Third Plenum document suggests that these quotas will get larger and larger. Also, they want to make it easier for Chinese investors to invest overseas through the official ODI investment schemes. So those are the main points addressed in the Third Plenum, but again, nothing new.

2.     What are the biggest challenges ahead for China’s financial sector?

To me, it's still how big the debt is and how high the interest rates are in China. Total credit ”debt that is owed by government, firms and households ”if added all together, is approaching 250% of GDP. You could say, well that's not so bad, look at the U.S. and Japan, which also have high debt-to-GDP ratios. Additionally, China is, of course, growing faster than these countries. But, it turns out that this level alone doesn't tell you how much trouble a country is in, or what we like to say, its debt sustainability. Debt sustainability is: do you have enough resources to pay the interest payments and the principal repayment on all the debt that you have. And, it turns out that even though U.S. and Japan are growing slower, their debt is more sustainable than Chinese debt. And, the reason is because of interest rates. In the U.S. and Japan, the government owes most of the money, and when these governments borrow they don't have to pay a high interest. For instance, a one year bond issued by the Japanese government is yielding 0.25 or 0.3 percent, whereas a one year bond issued by the Chinese government is yielding 3.5 percent. So, interest rates are about eleven times higher in China than in Japan or the U.S. Take the case of the U.S., which is a good comparison because creditor share of GDP in China and U.S. is exactly the same (250 percent of GDP), but it's a lot less sustainable in China. China is growing roughly 2.5 times as fast as the U.S., but it has to pay 11 times higher interest. You can say, look at the U.S., how did we get out of trouble? We just printed a bunch of money when the Fed conducted QE (Quantitative Easing). That's true, China could do the same thing, but even when the U.S. did that, the dollar depreciated substantially. I think that, at the end of the day, if China wants to print its way out of the problem, then the renminbi will be weakened quite substantially.

2a.  And, you don't think China will tolerate that?

Well, that's why I've been doing research on inequality, because it depends on whether rich people in China will tolerate that. In Japan, the middle class tolerated it. What happened was, the Japanese government issued out a huge amount of bonds to bail out the financial system in the late 1980. The Japanese middle class bought out all of these government-issued bonds, despite the fact that the bonds were yielding less than one percent. This was because all of their money was in pension funds and the government basically ordered pension funds to buy these zero-yielding bonds. In effect, the large middle class in Japan paid for all of the financial trouble. In China, however, the problem is that wealth is highly unequally distributed and people's money is not in state-run pension funds; money is in bank accounts, real estate or any other type of investments. And, if the Chinese wealthy see that returns are crashing towards zero, then they will have much higher incentive, and capacity, to move money offshore than their peers in Japan. If that were to happen, it could lead to a chain reaction of depreciation of currency, then capital flight that would lead to even more depreciation of currency. And then, China also owes a lot of foreign debt, so when your currency depreciates, your external debt gets higher and multiplies. This could wipe out the wealth of a lot of people that owe dollars offshore.

3.     What’s an interesting fact/policy that you think more people should know about?

I think it's what I just outlined. That interest rates in China, especially for the government, are over ten times higher than in Japan or the U.S. And to me, that's much more important than the fact that China is growing twice as fast as the U.S.

BONUS: You’re new to San Diego, but what’s your favorite Chinese restaurant so far?

I'm from Hong Kong, so I have a Cantonese taste. I would have to say Pearl Dim Sum is quite good, and I imagine their seafood is also probably good, given their dim sum.

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Maeve Whelan-Wuest

is the Co-Founder and External Relations Director of China Focus. Originally from Chicago, she received her B.A. in Geography and Chinese from Middlebury College in Vermont. Her research at IR/PS is focused on Northeast Asian security issues, particularly China's role in shaping nonproliferation and nuclear security policies on the Korean peninsula. She is also the President of the China Focus student organization, Editor-in-Chief of the Journal of International Policy Solutions, and Co-Founder and Finance Director of IR/PS Women Going Global.

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