October 13-14, 2006China-Russia Conference1 Financing Rapid Growth: Challenges of China’s Financial Reform David D. Li Tsinghua University School of Economics and Management

October 13-14, 2006China-Russia Conference2 Purposes 1.Understanding the high savings/investment rate in China Specifically, how much of the investment is intermediated by the formal financial sector? 2.How high are government future liabilities? 3.What are the implied challenges facing China’s financial reform?

October 13-14, 2006China-Russia Conference3 How does China finance its high investment? 1.China’s investment rate has been very high by international standard 2.Six sources of investment 1.Government budgetary and extra budgetary funds 2.Bank loans 3.Securities issuance (including foreign securities markets) 4.Foreign investments (FDI, bonds, etc.) 5.Informal investment from households 6.Enterprise retained profits/funds (for self investment or cross- investment) Of these, 2 and 3 are sources via financial intermediation

October 13-14, 2006China-Russia Conference4 China’s high investment ratio

October 13-14, 2006China-Russia Conference5 Investment from government budget

October 13-14, 2006China-Russia Conference6 Share of bank loan in total investment

October 13-14, 2006China-Russia Conference7 Share of Securities Issuance (including foreign securities markets)

October 13-14, 2006China-Russia Conference8 The share of all intermediated investments (including foreign securities markets)

October 13-14, 2006China-Russia Conference9 Share of foreign funds in total investment (without including issuances from foreign securities markets)

October 13-14, 2006China-Russia Conference10 The share of enterprise retained funds + household informal investment ( Domestic Non-Intermediated Investments (DNI) )

October 13-14, 2006China-Russia Conference11 How high is the domestic non-intermediate investment (DNI)?

October 13-14, 2006China-Russia Conference12 How high is the domestic non- intermediate investment (DNI)? (Cont.)

October 13-14, 2006China-Russia Conference13 The share of enterprise retained funds

October 13-14, 2006China-Russia Conference14 How large are enterprise retained funds?

October 13-14, 2006China-Russia Conference15 Why the high share of DNI? - Regression of DNI/FAI

October 13-14, 2006China-Russia Conference16 A quick Summary 1.Domestic Non-Intermediated investments (DNI) are the main sources driving China’s high investment 2.Of, which, enterprise retained funds are the main component 3.DNI’s growth seems be mainly driven by the emergence of the non-state sector and pro-cyclical

October 13-14, 2006China-Russia Conference17 2. How high will government debt and liabilities be? 1.Despite the recent improvement in central government’s fiscal revenue, the long-term liabilities are likely to overpass the government’s fiscal capacity Due to: 1.“Reform by borrowing” 2.The new political economy of reform and the populist tendency of the government 3.Bailing out of banks and security firms 2.Sub-provincial governments’ fiscal health is not optimistic, eventually increasing central government liabilities 3.The government does have a lot of state-owned assets 4.The liquidity match of governments’ asset and liability is tricky

October 13-14, 2006China-Russia Conference18 An Estimate of Chinese Government Debt by 2018 (from Li and Li, Cato Journal 2003)

October 13-14, 2006China-Russia Conference19 3. Implied challenges for China’s financial reform 1.How to improve the efficiency of DNI? 1.Try to incorporate part of DNI into the domestic financial sector? 2.Improving local government behavior in assisting DNI? 3.Improving corporate governance? 2.Very tricky consequences of complete opening of capital flow 1.Increases government borrowing costs 2.Will DNI leave China? Will DNI become more fluctuating? 3.If capital control is maintained, how to management the currency reserves that are beyond liquidity needs?