Financial Crises
Financial crises often accompany the development of a financial system. Conventional wisdom says that financial crises are bad. Often they are very bad, as they disrupt production and lower social welfare as in the Great Depression in the US. Hoggarth et al. (2002) carefully measure the costs of a wide range of recent financial crises and find that these costs are on average roughly 15-20 percent of GDP. It is these large costs that make policymakers so averse to financial crises.
It is important to point out, however, that financial crises may be welfare improving for an economy. One possible example is the late nineteenth century US, which experienced many crises but at the same time had a high long run growth rate. In fact, Ranciere et al. (2003) report an empirical observation that countries which have experienced occasional crises have grown on average faster than countries without crises. They develop an endogenous growth model and show theoretically that an economy may be able to attain higher growth when firms are encouraged by a limited bailout policy to take more credit risk in the form of currency mismatch, even though the country may experience occasional crises (see Allen and Oura (2004) for a review of the growth and crises literature and Allen and Gale (2004a) who show that crises can be optimal).
In this section, we consider financial crises in China. Given China’s current situation with limited currency mismatches any crisis that occurs is likely to be a classic banking, currency or twin crisis. It is perhaps more likely to be of the damaging type that disrupts the economy and social stability than of the more benign type that aids growth. The desirability of preventing crises thus needs to be taken into account when considering reforms of China’s financial system. First, we examine how China can prevent traditional financial crises, including a banking sector crisis and a stock market or real estate crisis/crash. We then discuss how China should be better prepared for new types of financial crises, such as the “twin crises” (simultaneous foreign exchange and banking/stock market crises) that occurred in many Asian economies in the late 1990s.
The cash-flow problem
After the mass privatization process ended IPFs had to survive with the acquired portfolio. Several trends were obvious in both countries. First of all, the number of IPFs decreased significantly. In Russia from the 650 licensed IPFs only 350 were active in 1995, according to a governmental estimate. There were 67 mergers among IPFs and 69 of them transformed into joint-stock companies. Overall the analysts consider that only 25-30 of them have played an important role on the stock market and managed to acquire an active portfolio with long-term perspectives of survival. Since many of the IPFs were relatively small this trend is not surprising. Many of them simply went out of business.
Many of the funds simply have not managed to earn sufficient profits to survive. One important reason for this is the illiquidity of the securities markets and of the market for the funds’ shares. Although the mass privatization programs ended, state continued to maintain control over major economic players. In Czech Republic, Banks dominated the creation of the IPFs. But they were controlled by the state which postponed the privatization of the banking sector. This impacted negatively on the efficiency of banking sector, which was unable to support the restructuring of the newly privatized companies. As a result their efficiency did not improve significantly. They were unable to pay dividends which translated in illiquid financial markets and further on the profitability of the investment funds. Read more
Government ownership
Many countries in the world neglected one of the important aspects of financial sector - the government ownership of banks. The attitude toward government ownership of banks was different across time. In 1960s and 1970s government ownership of banks was strongly supported by economists. But recent economic views support benefits of private ownership of banks.
Supportive views consider banking sector as ‘strategic economic sector’ along with utilities, education, etc. (Hawtrey, 1926) and point out that the government can improve the functioning of this sector, since the government can overcome market failures, exploit externalities and invest in socially desirable projects.
The supportive view includes three more narrow views:
1. The Social view argues that government plays the important roles in compensating of market imperfections that leave the socially desirable investments under-financed (Atkinson and Stiglitz 1980; Stiglitz 1994).
2. The development view focuses on the necessity of financial development for economic growth and stresses governments’ development goals. This view is associated with Alexander Gerschenkron (1962). He argues that in some countries private banks can channel funds for economic growth, but there are some countries where private banks are not able to attract sufficient funds to engage in financing profitable investment projects, because of public distrust to banking sector and absence of honest business practices. He stresses that government has sufficient information and incentives to promote socially desirable investments and in such countries it can help the development of lending to the private sector or simply subsidize private banks. As a consequence government ownership of banks promote the development of institutions of lending and the whole banking sector. Read more
Stock Exchanges and Market Inefficiencies in China
Since the inception of China’s domestic stock exchanges, the SHSE and SZSE, in 1990, they have been growing very fast. At the end of 2005, HKSE was ranked 8th among the largest stock exchanges in the world, with the total capitalization reaching roughly half of GDP. Despite the fast growth of the markets, however, their efficiency still leaves much to be desired. The inefficiencies from the political decisions of protectionism, poor regulation and intermediation, result in problems of adverse selection among firms seeking an initial public offering (IPO), and a moral hazard problem among already listed firms.
Firstly, even though there has never been any explicit regulation or law against the listing of non-state owned firms, the going public process strongly favors former SOEs with connections with government officials. For example, each candidate firm must obtain listing quota/permission, disclose financial and accounting information, and is subject to a lengthy evaluation process; the whole process is inefficient due to bureaucracy, fraudulent disclosure, and lack of independent auditing. As a result, most of the listed firms are indeed former SOEs. Secondly, once listed, managers in firms with severe agency problems do not have an incentive to manage assets to grow, but rather to rely on the external capital market to raise funds (mainly through mergers and acquisitions, and seasoned offerings of securities) to pursue private benefits. These problems can nicely be seen in the following case study. Read more
