The Perils of Financial Freedom

The People’s Bank of China should maintain reserve requirements for commercial banks to contain credit creation, rather than reject them as old-fashioned, as occurred in the advanced economies in the decades before 2008. Credit provision by shadow banks needs to be tightly regulated. The credit cycle is too important to be left to free markets.

China thus faces a difficult challenge. It must undergo a transition not to the Western model that produced the 2008 crisis, but to an entirely new model that combines elements of market discipline with strong public-policy constraints.

How smoothly that transition occurs matters for the whole world. By the early 2020’s, China’s GDP will be $20 trillion. If the credit/GDP ratio reaches 250% by then, total loans and debt securities would equal $50 trillion, which is more than three times the total of US mortgage debt in 2008. Today, much of that debt represents claims within the state sector – owed, for instance, by SOEs to state-owned banks. But, as the private sector develops, SOEs are subjected to hard budget constraints, and the external capital account is opened, this huge credit mountain will create increasing global financial vulnerability.

One hopes that the Chinese authorities understand the dangers as well as the benefits of free financial markets better than advanced-economy policymakers did ahead of the 2008 crisis. If not, another crisis – far more severe than the last – may become inevitable.

Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Copyright: Project Syndicate, 2014.