In what ways, and to what degree, has the financial system mattered, and what roles has it played, in the Japanese economy since about 1990, in the Korean economy since about 1980, and in the Chinese economy since its reform process began in 1978? These topics are taken up in this extract from How Finance is Shaping the Economies of China, Japan, and Korea. Ultimately, the fact of rapid catch-up growth in each country is the best evidence that financial intermediation has, somehow, been successful. Finance does matter.
Japan, Korea, and China provide outstanding examples of very successful catch-up economic development and growth, major financial development, and gradual financial liberalization of initially highly repressed financial systems. Our book, How Finance is Shaping the Economies of China, Japan, and Korea, provides an analysis of that financial development process, and how it has intertwined with the process of real economic growth in complex and nuanced, as well as obvious, ways. This essay extracts some of the more important points of the book.
Three general implications for financial development can be derived from the experiences of the three countries.
First, financial development improves a country’s resource allocation, but financial liberalization and increased financial intermediation do not necessarily result in a highly efficient allocation of financial resources. Japan’s ongoing “lost decade” illustrates this.
Second, financial repression in the early stages of economic catch-up may not necessarily be negative, and may even be positive. The Chinese case demonstrates this.
Third, financial liberalization requires the development of good, prudential, market-supportive regulatory systems and their effective implementation. Financial regulatory failures or forbearance worsen economic performance. History is replete with examples.
An underlying theme of the research and writing of the book is “Does finance matter?” Policymakers in Japan, Korea, and China have certainly believed that it does. They have been deeply involved in the functioning, development, and, to one degree or another, control of their financial systems. They have learned, more in Korea and Japan than so far in China, that financial intermediation in the long run is best based on competitive financial markets, as well as control over inflation, macroeconomic stability, an appropriate institutional framework and structure, and effective prudential regulation for institution and system safety.
Policymakers have also understood that finance can be a powerful instrument to achieve many specific objectives. Thus, to one degree or another, government policies in all three countries have channeled funds to finance investment in government-priority sectors and activities that were not a good use of funds.
The role of the government in the financial system has always been recognized as fundamental. The government sets the rules and norms, as well as establishes the legal framework for the creation and operations of markets, institutions, and financial instruments. The central bank determines the money supply and seeks to achieve price stability, and provides prudential supervisions and oversight together with the other regulatory authorities. But there has been debate, going back at least to the 1960s, on the appropriate extent and stringency of regulation.
The global financial crisis of 2007-09 has caused a rethinking of development strategies in general, and the role of finance in particular. Specifically, there has been a recognition that the benefits of open markets and a liberalized financial system are not costless. Moreover, particularly in the early stages of development, there are circumstances where financial repression may initially lead to better near-term results. The trick is knowing when and how fast to liberalize.
This is clear in the chapter by Hyun Song Shin and Young-Hwa Seok, which addresses the problems created by foreign short-term capital flows1. These flows can and do create domestic liquidity conditions that result in housing (property) and other asset-market booms and exacerbate problems in the real economy when the bubbles burst.
Initial Catch-Up Growth and Finance
China, Japan, and Korea are at different stages of their real and financial development. They have distinct histories, institutions, political systems, and societal characteristics. Thus, the financial development and transformation of each country has been fundamentally a domestic story. Still, their economies share basic commonalities in rapid catch-up development and in economic structure. Further, international short-term financial flows have had important effects – in particular, during the period covered, the Asia financial crisis of 1997-98 and the global financial crisis of 2007-09.
Catch-up essentially is based on disseminating better technologies. It is achieved by high rates of new investment, including effectively adapting foreign technologies to domestic factor endowments. The process requires incentives and institutions capable of – and eager to – seize these opportunities. That is, catch-up needs businesses to carry out the investment and educational systems to enhance human skills. And, it requires a government strongly committed to economic development and possessing the ability to create a supportive environment.
The catch-up processes of our three countries have been fundamentally similar: rapid, relatively labour-intensive industrialization based on high rates of fixed investment in factories, buildings, housing, and infrastructure, and on an increasing role of exports and imports in generating domestic demand and paying for imported resources and equipment. None of these countries is resource-rich relative to its populations and development level.
In each case, but in quite different ways, with China the outlier, real economic development and growth has been deeply intertwined with the development of the domestic financial system and its financial intermediation process between savers and investors.
In the early stages of their post-World War II financial and economic development, the financial systems in all three countries were subject to significant degrees of government controls and financial repression. Entry was limited, and government policy and administration guidance was extensive. This was particularly the case in China, with its controlled, planned economy and state ownership of the financial institutions.
Bank deposit and loan rates were regulated – and set low relative to inflation in order to provide incentives for investment. Given the lack of alternative financial assets and foreign capital controls, policymakers assumed correctly that the elasticity of demand for funds by investors would be greater than the elasticity of supply by savers. Bank deposits, including time and savings deposits, grew rapidly.
All three countries began with strong controls over foreign capital inflows and outflows. With domestic financial development, the gradual easing of foreign capital controls was necessary, both for domestic reasons and in response to the deepening of the global economic and financial systems.
In other words, the financial systems in all three countries initially were significantly repressed.
In all three countries, financial deepening was substantial – that is, finance grew even more rapidly than the economy.
In the early stages of catch-up, technology and productivity gaps were so large that investment was very productive and highly profitable. Fixed investment rose and became a large share of GDP, particularly in China. Domestic savings rates rose concurrently. Domestic saving financed most of the investment; foreign borrowing was minor for Japan and China, though at times important for Korea.
Financial intermediation between savers and investors was essential. Knowledge and information about good investment projects and about the capabilities of the potential investors were significant limitations. Access to credit, given the high profit opportunities, was probably as important as the cost of funds. However, financial intermediation has not been especially efficient in allocating savings to the best investors. This is something for which government (politicians, policymakers, and regulators) and investors share responsibility.
From their beginnings, the financial systems in all three countries were fundamentally bank-based, and they still are. Capital markets have developed in all three countries, somewhat reducing the dominance of banks, but their role is still relatively modest. This is true even in Japan, as Lincoln discusses.2
Stock markets developed earlier and further than bond and other fixed-income markets. By 1990 both Japan and Korea had active, quite well-developed stock markets. Stock markets in China barely existed in 1990, but have grown rapidly as state-owned enterprises have listed.
The stock markets have been a source of funds, though usually not a predominant one, for Japanese and Korean companies. In all three countries stock markets have increased information available on companies and provided market assessments of company value. Chinese stock markets are considered quite speculative and Korea’s less so, as reflected in the level and volatility of their turnover ratios.
As financial development has progressed, interest rate controls have eased in Japan and then in Korea, but not much yet in China.
Catch-up growth and the demographic transition have been deeply intertwined with the process of financial development in all three countries. Demography affects financial development in several ways. These include the percentage of the population in the labour force and the age distribution of the population (different age groups have different savings and spending patterns). Demographic maturity can be defined as when a country has zero or negative population growth, even allowing for immigration. Demographic maturity and economic maturity are interconnected, but the linkage is not tight.
China’s demographic projections are that population growth will cease before economic maturity (defined as a high per-capita GDP) is achieved. This is caught in the observation “China will grow old before it grows rich.” However, per-capita GDP growth can continue even after population growth ends, as Japan has demonstrated.
Measuring Financial Liberalization
Huang et al empirically demonstrate that, for China in the first two decades after 1978, financial repression made a positive if modest contribution to GDP growth.3 However, by the beginning of this century, remaining repression had become a negative, slowing GDP growth. One explanation is that financial repression in an economy moving from a command to a market system made it easier for the government to maintain macroeconomic stability. Given China’s policies of controls over foreign capital flows and a pegged low exchange rate when the economy was booming, delaying financial liberalization and maintaining financial repression was one approach to try to contain inflationary pressures.
Park makes a valuable contribution in the measurement of financial liberalization, using Korea in the period 1990-2007.4 He considers four indexes, ranging from single measures of financial liberalization to an index utilizing six variables. His analysis finds that liberalization increased the inequality of the distribution of wealth, and thereby of income.
We know that finance is important. However, it is difficult to estimate empirically the comprehensive effects of finance on the real economy and its performance. Over time, it became clear to policymakers and market participants in all three countries that the efficiencies derived from a more market-based allocation of credit were so substantial that liberalization had to proceed. For Japan and Korea in the earlier postwar period, that process is addressed in Patrick and Park.5
Certainly, in broad terms the financial systems in Japan, Korea, and China have been very effective in supporting catch-up growth. Growth of GDP and per-capita GDP were rapid. Savings were mobilized and allocated to investment. Investment rates were high, and most investments were productive. Price stability was achieved. Financial institutions and instruments developed and grew, and financial institutions and markets became more efficient in establishing values (prices) and handling transactions. Of course China’s planned, command economy heritage is very different from the private ownership, market-based systems of Japan and Korea, and China is only part way along the process of catch-up growth and financial development.
Ultimately, the fact of rapid catch-up growth in each country is the best evidence that financial intermediation has, somehow, been successful. Finance does matter.
About the Authors
Yung Chul Park is distinguished professor in the Division of International Studies of Korea University. He served as president of the Korea Development Institute (1986-87), the chief economic advisor to the president of Korea (1987-88), and the president of the Korea Institute of Finance (1992-98).
Hugh Patrick is Robert D Calkins Professor of International Business Emeritus at Columbia Business School, where he also serves as Director of the Center on Japanese Economy and Business. He also is co-Director of Columbia University’s APEC Study Center.
Larry Meissner is an economist with a specialty in financial development.
1. Seok, Young-Hwa, and Shin, Hyun Song. “Banking, Capital Flows, and Financial Cycles”
2. Lincoln, Edward J,. Ongoing Financial Deregulation, Structural Change, and Performance, 1990-2010, Chapter 3.
3. Huang, Yiping; Wang, Xun; Wang, Bijun; and Lan, Nian. Financial Reform in China, Chapter 2.
4. Park, Yung Chul. Financial Development and Liberalization in Korea: 1980-2011, Chapter 4
5. Patrick, Hugh, and Park, Yung Chul, editors. The Financial Development of Japan, Korea, and Taiwan. Oxford University Press. New York. 1994.