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Do Away with “U.S. Financial Model Superstition”! China Must Go its Own Way in Finance


A former official at the China Securities Regulatory Commission encourages China to develop its own financial model in order to avoid the pitfalls of the U.S. model. He argues against excessive financialization, in order to avoid harming the development of the real economy.

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The COVID-19 epidemic sweeping across the world is having a profound impact on development models of human society under globalization and on the world order. In the face of this pandemic, it is necessary to rethink national development strategy and national security strategy, as well as the corresponding issues of economic structure and industrial structure, and especially issues of financial understanding and positioning.


Looked at from any angle, finance is always at the heart of modern economic and social networks, and its mode and state of development are related to the efficiency and security of economic and social resource allocation, as well as to whether the economy and society can achieve long-term peace and stability and develop sustainably.


Over the past several decades, some in China’s financial circles have always, consciously or unconsciously, taken the United States as a model of modern finance, and have displayed a certain degree of blindness. This sort of blindness has its origins in the influence of neoliberalism. However, the performance of the United States in this pandemic has been chaotic, shocking the whole world, and causing people with different ideologies and values to wonder why this is the case.


As Joseph Stiglitz, the Nobel Prize-winning U.S. economist, said recently, “The United States has in the past always followed a neoliberal philosophy … believing that markets can solve all problems by themselves. The United States has been conducting this experiment over the last half-century, and now we must admit: The experiment has failed.” Perhaps these changes, which have occurred and continue to occur, can help some in the domestic financial community dispel the myth of the American financial model.


According to Kerry Brown, a sinologist at King’s College London, there is a mindset in Western society about Chinese culture, and the first thing that is needed is to liberate the mind. I believe that China’s financial community today also needs to liberate its mind and think about China based on China’s national conditions and on socialist values. We must have an ideological emancipation, and do away with the financial development path of “foreign superstition” and “foreign stereotypes.”


Financialization of the economy is unsustainable


In contrast to the forty-year-long financial suppression policy under Roosevelt’s New Deal, since the 1980s, the United States under the banner of neoliberalism has allowed the financial industry to deviate from the industrial service model of serving as the financing intermediary for the real economy, and in the name of innovation, to insanely chase profits through financial derivatives and financially leveraged speculative arbitrage, gradually transforming into a naked financial transaction model. By 2008, the model had “reached its peak.” The global financial crisis then erupted, hitting the global economy hard and continuing to affect it to this day.


Unfortunately, we seem not to have had time to deeply analyze and think about the deeper-level cause and effect of the 2008 global financial crisis. After only a short pause, we have quickened the pace of imitating American finance, and started the financialization of the economy.


People are rushing to invest in finance and get into finance, and large numbers of new banks, insurance companies, and other financial institutions continue to emerge. There were 238 commercial banks and insurance companies in China in 2006, before the U.S. financial crisis. In 2019, the number of commercial banks and insurance companies in China had increased to 447, an increase of 88% in 13 years. Insurance companies in particular increased even more, by 120%.


Private equity funds with betting on IPOs and speculative arbitrage as their aim have popped up like mushrooms, along with hundreds of thousands of unregistered similar businesses. Shadow banking business, financial management business of various financial institutions, P2P, “shell” company buying and “speculation” with junk shares of listed companies, etc., have run rampant, and real estate and commodities are being financialized.


In the name of financial innovation, and even under the banner of serving the real economy, financial derivatives have spread from the main stock markets to the riskier over-the-counter markets, and from financial futures to commodity futures, with risks continuing to pile up and structures becoming more and more complex. Leveraged trading, high-frequency trading, and other types of computer technology-based algorithmic trading are popular everywhere, making the financial markets more vulnerable and crisis-prone.


In recent years, no matter how the central bank opens the liquidity gates, it is difficult for money to flow into the “dry fields” of real industries. This is not a problem of the central bank’s monetary policy, but rather the enormous siphoning effect generated by the demonstration effect of money-making—more and faster—in finance and financialized real estate.


On one hand, these siphoned funds idling in the financial markets let financial institutions fill their coffers so full that, as one bank president said a few years ago, “with corporate profits so low, bank profits are too high, so we’re all embarrassed.” On the other hand, the real economy is gradually contracting, and a financial bubble has slowly inflated. China’s economic momentum has weakened in recent years, declining gradually, and one important reason is the financialization of the economy.


Here, I would like to use a set of data to briefly describe the financialization trend in China’s economy over the past decade or so. I still use the year 2006 before the U.S. financial crisis as an example for comparison. In 2006, the total profit of large-scale industrial enterprises in China was 1.8784 trillion yuan, and in 2019, the total profit of large-scale industrial enterprises in China was 6.1996 trillion yuan, with the latter having increased to 2.3 times the former.


In 2006, the total profit of China’s financial enterprises was 395.0 billion yuan, and the total profit of China’s financial enterprises in 2019 was 2.9612 trillion yuan, with the latter having increased to 6.49 times the former. The profit growth rate was 282% of the rate of that for large-scale industrial enterprises in the same period.


In 2006, the ratio of the profits of large-scale Chinese industrial enterprises to the profits of financial enterprises stood at 4.8 to 1; in 2019, the ratio was 2 to 1. Within the short space of thirteen years, the rapid shrinkage of the weight of industrial enterprise profits in the overall economy, together with the large increase in the ratio of financial enterprise profits, illustrate that the trend of financialization of the economy is already very significant.


In the first quarter of 2020, following the outbreak of COVID-19, the net profit of Chinese listed banks increased by 5.62% year-on-year when China’s economy suffered a 6.8% decline. This phenomenon is inconceivable. Viewed in terms of both historical patterns and realistic models, the financialized economy will be unsustainable, which is worrying.


Manufacturing is what keeps the economy humming


China is a large country with a vast territory, a large population, growing influence, and a very complex geopolitical environment. Unlike small countries that live off of natural endowments and can passively or actively accept the international division of labor, sitting on the sidelines, China must establish a relatively complete, self-contained, healthy, and balanced industrial system and economic ecosystem, whether from the perspective of people’s well-being and sustainable economic development, or from the perspective of safeguarding national security.


We must not give undue consideration to our comparative advantage and fantasize about the international division of labor, otherwise we will “not be able to breathe,” and not only will our economic development be unsustainable, but national security will also be seriously affected. The basic driving force of China’s economic system is the manufacturing industry. The important position of the manufacturing industry was as unshakable in the pre-industrial (handicraft) era, the steam engine era, and the electrical era as in the internet era of today.


It is the real creator of material wealth, the source and driving force of all economic activities, and other industries are in a dependent, rise-and-fall-together relationship with it. Without the support of the manufacturing industry, other industries would not be able to continue. Manufacturing is the foundation of all of the virtual economy, as well as all of the service industry, and the endlessly expansive internet economy is no exception.


Manufacturing is the core and foundation of the entire economic system, occupying a most important, key position. The completeness and maturity of the manufacturing production chain determine a nation’s strength and fate, along with its economic, public health, and defense security. The manufacturing industry is the foundation of China’s economic stability. We must do our utmost, with all our nation’s strength and without any distractions.


In order to maintain the country’s Made in China foundation, it is also necessary to clarify the relationship between the service sector and the manufacturing sector. For many years, some people have seen that in Western countries, including some developing countries whose economies are lagging behind ours, the service sector’s share of GDP is much higher than ours, so they put forward the idea of establishing China as a service sector power. Is this sort of view correct?


First of all, the increasing share of the service industry in the economic structure is due to the technical support that development of the manufacturing industry provides for the social life field, creating demand. At the same time, the growth of labor productivity and technological progress in the manufacturing industry also makes it possible to transfer labor to the service industry, indirectly supporting the development of the service industry.


In short, the development of the service industry is a natural change due to economic and technological progress and changes in social life, and should not be a goal that people deliberately pursue.


Second, in the service industry, especially the consumer service industry, labor productivity is relatively low, so developing the service industry alone would affect the level of economic growth.


We should both develop the consumer service industry to meet the growing material and cultural needs of the people, and also guide the development of higher-productivity manufacturing industries and of producer service industries that provide support for manufacturing industries. On the issue of promoting China’s industrial development, one must establish the right concept to guide the optimization and upgrading of industries.


Simon Kuznets, a winner of the Nobel Prize for economics, proposed that the key to industrial structure upgrading is the transfer of resources from sectors with lower productivity to sectors with higher productivity, thereby causing the overall resource allocation efficiency of the economy to rise. Hence, we should have the right direction when formulating industrial policies, and not go counter to Kuznets’ direction of optimal resource allocation.


Finally, the United States and other Western countries have been blindly developing their service and financial industries for nearly 30 years, and the policy of pushing “deindustrialization” has failed. Implementation of the “deindustrialization” policy has not only led to industrial imbalance and industrial softening in the United States, seriously affecting the normal cycle of the overall economic system, but also created a large “rust belt,” increasing the gap between rich and poor, and causing social divisions to emerge. When the COVID-19 pandemic was approaching, the United States, which claims to be the number one developed country in the world, was unable to guarantee even the most basic public health and safety because of the lack of manufacturing, and was in chaos.


Therefore, we should by all means avoid blindly imitating the United States in our economic development strategy, and instead firmly and steadily build a manufacturing power and a strong country.


Leaving finance to develop blindly may generate major risks


If finance is left to develop beyond its proper limits, that will not only make it impossible for it to serve the real economy, but will also harm the development of the real economy, erode China’s manufacturing, and lead to the phenomenon of finance growing at industry’s expense. The report of the 19th Party Congress proposed resolutely fighting the three critical battles [against poverty, pollution and potential risks], with the top priority being to prevent and resolve major financial risks. To this end, it is necessary to clarify two questions: First, where might major financial risks appear? Second, is the emergence of such major financial risks a cost of modern economic and social development that has to be borne?


In other words, for modern economic and social development, is there no other way than to adopt a risk-filled financial self-service model, and proceed carefully along that perilous single-plank bridge? Can it be that we must suffer the ravages of financial turmoil again and again, as the United States has done? Is it really true that the only way to prevent and defuse these shadowy financial risks is to strengthen regulation and be careful, and this is the fate of modern economies?


Let’s look at these issues one at a time.


First, where might major financial risks appear?


There are many types of financial risks that can occur in many economic activities, but significant financial risks tend to occur in financial trading markets. The financial transactions with the highest probability of risks occurring, and the highest intensity of shocks, are leveraged transactions, and financial derivatives transactions that also have leverage amplification and cross-market risk.


Second, why do we need financial trading markets?


There are various types of financial trading markets, but the most typical example here is a stock market. In order to provide direct financing services to the real economy, we need a primary market for issuing stocks. In order to provide shareholders a convenient means of allocating resources and transferring shares, they need to be provided with a secondary market for trading stocks. The financing capacity of the primary market is directly proportional to the liquidity of the secondary market, and the two are closely related. Therefore, to provide direct financing services to the real economy, there must be a stock trading market with relatively active trading.


Third, must markets for trading stocks and so have significant risks?


There is no doubt that there is uncertainty and risk in any transaction, and financial transactions are no exception, but they do not necessarily have significant risk. Historically and from a market practice perspective, traditional equity spot markets have limited risk, and significant financial risk is often closely associated with leveraged trading and derivatives trading.


Fourth, why are there leveraged transactions and financial derivatives?


The rationale for the “innovations” of leveraged transactions and derivatives was to provide liquidity to the market, dampen market volatility, and manage hedging risk.


Fifth, the market truths of leveraged trading and financial derivatives.


Securities margin trading is the main form of leveraged trading. Nominally, securities margin trading is for adding liquidity to the market, and promoting bilateral market trading and stable markets, but in market practice, it is a different matter indeed.


In a stock market, whether investors or speculators are active in the market depends on the overall market atmosphere. Speculators using financial leverage rarely enter the market during bear markets or when the markets are inactive, and are unlikely to provide liquidity to markets when they need it. When a market enters a bull market and is lively, and the problem is no longer a lack of liquidity in the market, but rather preventing the market from overheating with excess liquidity, speculators will instead use financial leverage to enter the market in a big way, quickly inflating a stock market bubble, overextending the bull market, shortening the bull market cycle, and increasing stock market risk.


When the stock market bubble bursts and the market enters a downward spiral, speculators will not only discontinue raising funds to increase stock holdings, and actively or passively close positions and sell stocks, but will also reverse their operations, using financial instruments and other derivative instruments to short the stock market, arbitraging in the opposite direction and fueling a stock market plunge.


In market practice, many of the varied and complex stock index futures and options, foreign exchange futures and options, futures options, and other main stock market and over-the-counter financial derivatives, were established nominally as risk management tools for hedging risks and smoothing market volatility. This appellation can be justified in micro situations, but it is wrong when viewed at the macro level. Financial derivatives, through the confluence of multiple internal and external factors, or even under the influence of small probability events, will undergo fission that cannot be measured or controlled, and instead of controlling risks, will cause a financial crisis.


Over the years, I have been on the lookout for specific cases of derivatives trading to prevent and defuse risks, but in making the rounds of various financial media for financial market information and historical data, I have seldom heard of anyone using derivatives to escape from the risk of disaster, but repeatedly saw the financial giants in Europe and the United States ruined or suffer severe damage due to derivatives trading.


As MIT economics PhD Richard Bookstaber, who was invited to start participating in the development of financial products and trading models on Wall Street in 1984 and is credited with triggering two of the most significant financial crises of the late 20th century, points out in his book A Demon of Our Own Design, “The structural risk in the financial markets is a direct result of our attempts to improve the state of the financial markets; its origins are in what we would generally chalk up as innovation. The steps that we have taken … have exaggerated the … complexity of financial instruments that makes crises inevitable. Complexity cloaks catastrophe.”


Passive supervision alone cannot be relied on to prevent significant financial risks. The right approach should be to put finance in a cage that serves the real economy, and use the system to restrict the financial industry from doing whatever it wants in the name of “innovation” and serving itself. As for overseas financial institutions that are good at derivatives trading and specialize in speculative arbitrage, we must also remain vigilant. We should encourage direct investment and limit investment in financial derivatives.


Capitalist cycles are not a law of socialism


History is a clear mirror. Facing today’s financialization of the economy, we should look back at history, especially at the 500 years since the rise of capitalism in the West, to see what the cycle of rise and fall in history can teach us.


The Great Age of Navigation, which began around 1500 AD, gave rises to four different “centennial cycles” that created the modern capitalist world system: the Spanish, Portuguese and Genoese city-state cycle, the Dutch cycle, the British cycle, and the American cycle.


In their early periods of emergence and growth, these hegemons all got started and grew by relying on industry. But when the industries they relied on reached a certain stage of development, profit-maximizing capital would turn to the financial sector, which seemed easier and faster, and more profitable. When industrial capital enters the financial sector on a large scale, it is certain that the 100-year cycle is at its most flourishing and wealthy stage.


However, what goes up must come down. With the large-scale transfer of industrial capital to the financial sector, industry begins to shrink, material wealth begins to dry up, the economy gradually loses momentum, and financial bubbles gradually grow large, coupled with challenges and squeezing from emerging economies. Cyclical crises inevitably erupt, and the hegemon is inevitably replaced eventually.


“You cannot step into the same river twice.” What we are engaged in today is the cause of socialism, which is a critique and inheritance of human civilization thus far, including the capitalism that coexists with us. It is a creation out of renunciation, a new mode of production, and the inauguration of a great new history. We are not copying convention, but creating a new history and law that conforms to history, tradition, national conditions, and social practice. Therefore, the “100-year cycle” is a mirror for China, and we must learn from it and find another path.


We should soberly recognize the negative effects of capitalist financial liberalization and not let it go unchecked. To avoid being misled by finance and trapped in the fate of the capitalist cycle, the most important thing is to have awareness of and confidence in the socialist system.


1.  Use the socialist system to reshape finance.
1. 用社会主义制度重塑金融。

The fundamental goal of socialism is to achieve common prosperity, that is, to seek the greatest benefit for all Chinese people, which is to maximize social benefits. Unlike capitalism, which maximizes the profits of capital, it requires finance to serve the interests of the whole society, serve real industries, and serve the people; it does not allow finance to imitate the United States under the guise of innovation, and serve itself in the name of serving the real economy.


That is not all. What is more important is that we have the advantage of a system guided by socialist development values. Guided by socialist values, we can devise something impossible in capitalist countries where the profits of capital are paramount—a new financial system to serve the people rather than capital, regulating financial services, curbing finance’s rampant development, minimizing the harm and maximizing the benefits, so that finance does what it should and not what it shouldn’t.


This is the advantage of our system. This is our source of confidence and magic weapon, and the reason we can avoid the “100-year cycle” of capitalism. However, everything depends on whether we have system awareness.


2.  In the financial field, advocate a simple philosophy.
2. 在金融领域倡导简单哲学。

We currently have a tendency to complicate finance issues. Originally, finance just provided financing intermediary services for the real economy. To improve the level of service, financial innovation is certainly possible, but the prerequisite for innovation is that it provides customers low-cost, efficient, convenient, and fast financial services.


We must make a rapid retreat, resolutely oppose the complication of finance, and have finance do what it should do—conscientiously perform the intermediary service of financing. Policymakers and regulators should adhere to socialist financial values and the bottom-line principle of finance serving the real economy, and focus research on the action and direction of policies. When faced with applications for financial institution “innovations,” we should carefully assess and empirically analyze the service modes, transmission paths, and business processes of so-called services for the real economy. We should firmly resist finance becoming more complex and serving itself in the name of serving the real economy and innovation.


3. In financial markets, treat foreign investment with caution.
3. 在金融市场谨慎对待外资。

Given the serious financialization of the economy in the United States and other Western countries, speculative arbitrage in financial transactions has run rampant. In policies dealing with foreign capital, therefore, we should encourage direct industrial investment and be cautious about financial investment and financial transactions. For the duration of the policy allowing foreign investment in the financial market, in addition to strategically restricting foreign hedge funds from entering the market, it is imperative to establish a real-time statistical and monitoring system for the entry and exit of foreign capital, especially volatile short-term capital flows, and to develop realistic response and handling plans for different situations, especially extreme situations, to prevent large market fluctuations and financial attacks.


In today’s world, networkized finance is highly complex and cannot always be thoroughly understood or clearly observed, and it also has a capacity for viral contagion, so it is very unpredictable. Therefore, regulators should have a clear “anti-virus” awareness. They must have determination and be able to withstand the lobbying of arbitrageurs, resisting the temptations and pressure brought by competition between financial centers, letting the wind blow and the waves crash, but standing their ground. We must stick to the original intent of financial services and adhere to the philosophy of simplicity.


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Cite This Page

张云东 (Zhang Yundong). "Do Away with "U.S. Financial Model Superstition"! China Must Go its Own Way in Finance [破除“美国金融模式迷信”!中国金融要走自己的路]". CSIS Interpret: China, original work published in Origin and Original Intent [本原与初心], March 15, 2022

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