Release of medium-to-long term outlook on respective agenda based
on the analysis of pending macroeconomic issues

Public Finance

Research Monograph

China’s Regional Economic System and Risk Factors

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  • Author Dongsoo Kang, LEE. Junsang, Hongshik Lee
  • Date 2013/12/31
  • Series No. Research Monograph 2013-09
  • Language Korean
SUMMARY Recently, the Chinese regional economic system has been pointed out as one of the crucial factors that may contribute to potential economic crisis. Historically, regional severance and competition have been the dominant characteristics of China. In addressing the issue, China has resorted to regional autonomy and competitive spirits to move its economy upward and forward. “Getting Rich First Theory” advocated by Deng Xiaoping was a primary example and also a key determinant that led China to successful transition into a socialistic market economy since the reform and opening-up policy. In stark contrast to the China’s success, deeply rooted structural problems such as overinvestment, excess capacity, market partitioning, large fiscal deficit of regional governments, real estate bubbles in newly developed areas, and numerous other problems characterize the side-effects which are strongly associated with its regional economic system.

In this regard, the regional characteristics of Chinese economy requires in-depth examination in analysing the overall performance and future prospects. In particular, regional endowment conditions, budget constraints, policy objectives of multi-layered structure of local governments, the incentive mechanism between the regional governments and central government merits particular attention. This is due to the fact that strong correlation exists between the so-called chronic problems of Chinese economy; overlapping investment, credit expansion through local governments’ fiscal deficit and loan platform, and high likelihood of real estate bubble bust; and incentive schemes of local governments’ staffs, which include evaluation and compensation and promotion system. A seemingly contradictory phenomenon that China is “good in macro but bad in micro” originates from the lack of understanding of regional economic structure and local governments which form the micro–basis of Chinese economy. Thus, this study focuses on the microstructure of Chinese economy with a special attention to its regional properties, in order to unearth the future direction of China’s macroeconomic performance and its impact on Korean economy. More specifically, it begins with sectoral issues such as private and public finance, industry, regional real estate markets, using the bottom-up method in studying the overall macro-economy and concludes with a review on the likelihood of a systemic crisis and potential paths.

Recently numerous experts have raised deep concerns over the hard-landing of Chinese economy caused by the considerable size of shadow banking which is estimated to account for over 55% of its GDP. In fact, the origin of such explosive growth of shadow banking can be traced back to China-specific regional economy system. After the 2008 global financial crisis, Chinese government adopted a expansionary fiscal policy, introducing a 4 trillion yuan stimulus package, of which large portions were mobilized with local government loan platforms. These financial instruments are referred to as special purpose companies(SPCs) that base their assets on real estates and enterprises owned by local governments. Because the National Budget Act prohibits the issuance of local government bonds, local governments have used its own loan platforms as a tool to finance for regional development projects. Throughout this process, the competition among local government officers to build regional economy has had a profound effect on massive enlargement of local government loan platform facilities.

The commercial banks which provide funds for regional development raise money through wealth management products(WMPs). The WMPs are usually sold to high-yield investors who are not satisfied with low deposit rates. Thus, investors, intermediaries and local governments have reached a consensus to expand credits driven by fiscal expansion to alleviate economic contraction after the 2008 crisis. However, fiscal soundness of local governments has deteriorated and the probability of bubbles in real estate markets have risen.

In a nutshell, a large size of shadow banking represents a crisis in Chinese economy of which the results are derived from central government’s insufficient supervision and local governments’ desirefor growth. Likewise, China's regional economic properties are the starting point in figuring out the potential risk factors in the entire economic system as well as internal operating mechanism. The reason are as follows. First, local governments are rudimentary economic entities that implements activities related to production, investment and credit supply. Second, complex relationship between central and local governments leads to an inconsistent policy implementation, being heavily dependent upon economic and political situations and political leverage of local governments. Third, large regional income disparity across regions may affect final decisions far beyond economic considerations.

In the long-term perspective, the study on China's regional economy is of primary importance in contemplating its economic sustainability. The high economic growth of 10% which has been sustained for over the last thirty years since the reform and opening-up policy will inevitably be curtailed to around 6 to 7 percent soon. The Xi Jinping Administration, as a matter of fact, demonstrated a policy stance that is distinctively different from the earlier leaders, as he puts more emphasis on qualitative aspects such as environment, technology innovation, income distribution, livelihood of the public, etc. away from quantitative growth. This stems from the awareness that the past model focused on quantitative growth is deemed no longer sustainable but may also bring considerable risk. In the transition to a mid-growth era, adjustment in terms of regional economy represents a primary importance. The regional competition which has led high-powered economic growth in China should be overhauled to adapt to the mid-growth era. Regional economic separation which ignited regional competition should be dismantled and replaced by regional integration for economic efficiency and efficacy. The policy scope of central and local governments should be readjusted towards the direction of market principles for local government staffs. As for the increasing incidents of socio-political complaints, local governments should not only build capacities for trouble-shooting but also exert more efforts to raise transparency in policy implementation.

The smooth transition of China to the mid-growth era asks the central government for reforms on incentive mechanism of local governments and better control for their policy distortions. In this sense higher efficiency of local governments and better coordination of roles between central and local governments are decisive factors for economic stability and sustainable growth in China.
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