Policymakers and commentators seem obsessed with trying to draw lessons for India from what happens in China. One area that merits attention is how Beijing is allowing extensive cross-shareholding to occur among state-owned banks and enterprises. The assessment below must be considered in the context of the excess global liquidity initiated during Alan Greenspan’s tenure at the US Federal Reserve. This tale begins in late 1997 when US central bankers became spooked by the economic and financial turmoil gripping much of East Asia. Apparently, convinced that global markets were unstable and needed more liquidity to halt a financial meltdown, he reduced US interest rates. Other central bankers caught up in the voodoo spell of export-led economic growth then lowered interest rates so their currencies would not appreciate. Decisions by many central banks to hold interest rates low for too long caused a global glut of liquidity that caused macroeconomic imbalances. The initial effect of artificially low credit costs was to inflate the dotcom bubble, before it began to slosh around the world to create bubbles in assets and commodities in its wake.
The microeconomic effects are now evident. First, cheap credit engineered by an inflated money supply sparked an unsustainable rise in consumption that induced resources to be diverted into export-based activities. This liquidity must dry up so that much of the expanded output will be revealed to be “excess capacity” and will have to be shut down just as in East Asia in 1997.
Beijing has the most to fear, as it has facilitated rapid expansion of its export sector. The extent of overleveraging is so great that a decline in the rate of growth of exports may be enough to trigger a recession. So it is doubly troubling that Chinese enterprises are buying local stocks hoping a rising local market index will boost their reported profits. In particular, China’s state-owned enterprises face fewer financial constraints than private firms that might have to distribute accumulated profits as dividends. Without regulatory oversight or sound risk management, state enterprises can more easily use earnings to buy shares or real estate or finance dubious projects. Their finances are more imperilled.
As it is, the cause and effect behind the rise in China’s benchmark stock index—up about 46% this year after quadrupling in less than two years—is quite muddled. When enterprises holding shares in other companies report improved earnings due to higher valuations of their holdings, air is put into the stock market.
With one-year loans at 6.57%, Chinese enterprises are tempted to borrow to do some punting on the stock market. Of course this violates regulatory rules, as Chinese law forbids banks from lending money for stock purchases. But falling share prices could also cause a vicious downward spiral as lower profits amplify declines in stock prices. And a regulatory crackdown could spark a mass exodus by such enterprises out of their shareholdings. In all events, cross-shareholding has raised the overall risk of China’s equity markets and its economic health.
Part of the problem is that tight restrictions on financial markets have inhibited long-term lending. In allowing state-owned banks to maintain a stranglehold on the domestic financial system, the bond market remains underdeveloped. Beijing might consider Japan’s bank-dominated financial system, weak bond market and extensive cross-shareholding before its “bubble economy” burst at the end of the 1980s. Of course, Japan was not alone—it is a common practice in Asia for governments, banks and other strategic partners to hold a large proportion of a company’s stocks. Hence, free float on most Asian stock markets is smaller than in the industrialized economies. On average, the free float on Asian markets is just more than 60%, while the figure for both the US and the UK exceeds 90%.
Under the “convoy” system, Japanese banks sealed business relationships with companies by exchanging small ownership stakes. At the peak in 1989, banks held about ¥80 trillion ($666 billion) in stock, just under 16% of the market by value. Banks as a group owned about 25% of all corporate equity; corporate cross-shareholding was above 40%. In the end, this weakened corporate profitability. Instead of being corporate guardians, Japan’s banks exercised little oversight on company operations of their debtors even when they were major shareholders. With passive investors in possession of almost 70% of the shares of Japanese enterprises, cross-shareholding became an obstacle to takeovers. And the passivity of other shareholders contributed to poor financial disclosures and masked under-performance.
When Japan’s bubble burst at the end of the 1980s, extensive cross-shareholding and bad loans almost smothered a rich banking system and advanced economy. Such events would have far worse outcomes for China with a fragile banking system and an economy that can easily be derailed by declining export growth. India and other emerging economies can learn from these mistakes to reduce the risks of systemic financial collapse.
Christopher Lingle is a research scholar at the Centre for Civil Society in New Delhi and professor of economics at Universidad Francisco Marroquin in Guatemala. Comments are welcome at firstname.lastname@example.org