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In 1979, shortly after economic reform began in China, Deng Xiaoping made a high-profile visit to the United States. He met with then-US President Jimmy Carter and other senior officials, and visited the offices of large organisations, effectively declaring his country open for business.
Little known, however, is that before the trip, Chinese officials had faced difficulties raising the USD30,000 from the country's banking system to cover the cost of Deng's travels. This was the result of three decades of anti-market policies; when reform began in 1978, China did not have a single commercial bank.
The dramatic expansion of the Chinese banking system
However, things have changed drastically since then. As of 2015, there were 2,214 commercial banks in China. With its total assets equalling 40% of global GDP in 2017, the Chinese banking system has essentially become the world's largest. In the 1980s, only four state-owned commercial banks – known as the Big 4 – controlled almost 100% of total bank assets. Yet, by 2015, their share had dropped to less than 40%.
Change of this scale in any developing context and any political system demands an explanation. The Chinese experience is puzzling because most autocracies have purposely limited the number of players in their banking systems and stifled competition. Moreover, contrary to the existing political economy literature, none of the formal institutions commonly associated with financial development—those that credibly constrain state power—is present. This is the motivating question of the dissertation titled, Building Markets within Authoritarian Institutions: The Political Economy of Banking Development in China by Assistant Professor Adam Liu Yao at the Lee Kuan Yew School of Public Policy, which recently received the prestigious India Exim Bank BRICS Economic Research Annual Award 2020.
Beijing's approach: Organisational spinoff
Prof Liu argues that what happened in China is an outcome not of financial liberalisation, but of political bargaining and state engineering. To solicit lower level support for a set of centralising reforms, Beijing allowed local governments to enter the banking industry as an institutional quid pro quo, leading to the establishment of what he terms local state banks (LSBs). Embedded within existing political institutions that reward and regulate economic development, intense competition in the banking sector quickly followed suit, broadening credit access while creating new challenges for central regulation.
While the LSBs are distinct profit-maximising players, their organisational structure and institutional missions are modelled explicitly after those owned by the central state. In fact, the centre even provided the foundational assets for the LSBs to take off initially. Prof. Liu calls this model of banking development "organisational spinoff."
Through it, the Chinese state has managed to capture gains from a more competitive albeit internal banking system while maintaining political monopoly over it. This has enabled the state to avoid the conventional commitment game with domestic private and foreign financiers, which would have required tying its own hands credibly to entice market entry while risking losing financial control.
The search for reliable data and reasonable assumptions
Prof Liu's study addressed a key challenge in researching Chinese banking: a lack of reliable data. Using business registration license and bank closure information, he built a dataset that contains the precise locations of Chinese banks, credit unions, and their branches, built during the reform era up to 2015. He also drew from field interviews and survey experiments to provide micro-level evidence for his argument and test its observable implications.
The study also rejects assumptions that the Chinese state is a "monolithic entity", and that local governments are merely an agent of central authorities, with state-appointed officials within the same industry sharing the same incentives and interests. Instead, the study argues that officials have different motivations, and that the central government harnessed the existing apparatus of the Chinese Communist Party (CCP) to create competition among them in the banking sector.
Prof Liu also argues that his research seeks to problematise the "one-actor approach" when it comes to modelling authoritarian states. Most existing social science works are built on the Weberian framework that sees the state as a single organization that monopolises the legitimate use of violence. Following that tradition, social scientists tend to model the state as a revenue-maximising monarch, or stationary bandit, or one representative agent. Whatever the specific terms, "the state" remains a single actor. While parsimonious, this inevitably misses how the internal dynamics of the state influence its interaction with the bureaucracy and the larger society. It also leaves unexplained why the state's institutions and policies can change without strong societal pressure or exogenous shocks.
"It's better to think of the state as an "organisation of organisations," and think about the sources and consequences of institutional change from there," he said.
A strategic dilemma
The exponential proliferation of new players in the Chinese banking system—and increasingly important role they play in fostering local economies—has also created tremendous regulatory challenges for the Chinese state in the long run, Prof Liu added. Under President Xi Jinping, the central government has sought to strengthen its grip over the financial sector again, tackling a range of problems directly associated with bank proliferation and excess competition: over-lending to the real estate sector, rising local government debt, and the proliferation of shadow banking activities.
However, "like all other developing countries where lower-level governments play a crucial role in economic development, Beijing faces a strategic dilemma, or a dual-commitment problem," he said. "That is, to credibly incentivise local agents with fiscal autonomy and access to tools for promoting development (e.g. LSBs), and at the same time, credibly exercise fiscal discipline over precisely the same set of local agents that the centre seeks to incentivise."
(Photo: Eric Prouzet)