China and Vietnam have been the two fastest growing economies in the world in the past 25 years. Each started out as a planned economy in the model of the Soviet Union, and each achieved disappointing economic results. In each country there was a clear break with the past and a shift to a more market-oriented economic system, ratified by a decision of the Central Committee of the Communist Party. In China the key meeting was held in 1978 and launched gaige kaifang (reform and opening up). In Vietnam reform was launched a number of years later at a Party meeting in 1986 under the banner of doi moi (renovation).
In each country reform of the financial system was one important element of reform, an aspect that is difficult and prone to risks. It is useful to examine their record of financial reform, the similarities and differences, and to draw some lessons -- lessons that would be helpful for developing countries in general, and potentially for DPRK in particular. DPRK has some important similarities with China and Vietnam in the early stages of their reform. If DPRK were to pursue market-oriented reform, then the financial lessons of China and Vietnam could be quite relevant.
China and Vietnam both have to be judged as successful in transforming their financial systems from mono-banking to a more market-oriented system that supports a real economy that is also largely market based. A couple of general lessons can be taken from their experience. They have pursued reform gradually, over a period of decades. Second, some of the characteristics of their reform were dictated by country conditions. That said, there were considerable degrees of freedom in various choices and it is interesting that the two countries often made different choices. Some of the potential lessons from financial reform in China and Vietnam come from comparing their different choices and results. So, what are some of the potential lessons for DPRK?
In the area of commercial banking, both China and Vietnam separated commercial banking functions from the central bank and established several state-owned commercial banks. Much of their reform was then concentrated on making those banks operate efficiently, while remaining under state-majority ownership up until today. They both developed policy banks to take over the function of directing credit to particular sectors (agriculture, infrastructure, foreign trade). They both allowed a small amount of entry into and competition among banks. The interesting area of difference is how they treated foreign investment in commercial banking. Vietnam was more open to foreign banks setting up operation. This foreign entry provides healthy competition and stability to the sector. China up until 2015 has resisted foreign banks operating independently in China and has restricted them to about 1% of the market.
While China did not want foreign banks operating independently, it did, however, see the benefit of bringing in big international banks as strategic, minority partners of the four SOCBs. By taking off the balance sheets the non-performing loans, recapitalizing the banks, and bringing in the strategic partners, China was able to improve the performance of the SOCBs and lay the foundation for successful IPOs in Hong Kong. Vietnam was not willing to bring in foreign banks as strategic partners and as a result its domestic IPOs have not been successful.
In the area of monetary policy and inflation control, China provides better lessons than Vietnam. Both countries relied initially on quantitative controls, initially lending quotas for individual banks and later, required reserve ratios that could be raised or lowered to affect the amount of lending. Over time, interest rates have begun to play some role in managing monetary policy. China went through a learning period during which the growth rate of credit and money was too high, and inflation as measured by the GDP deflator, above 10%. But from 1997 until today, China generally kept the growth of M2 below 20% and inflation, in single digits. Vietnam was often trying to push the growth rate higher through faster growth of credit. In Vietnam the growth rate of M2 generally has been above 20% per year, often well above that rate. This has made Vietnam prone to boom-bust cycles in which real growth and inflation both accelerate, but inflation becomes dangerously high. Reining it in then leads to a sharp drop in the growth rate.
In the area of interest rates, the two countries took different paths and there is something to be said for finding a middle ground between the two. Vietnam did not have the option of severe financial repression because people simply would not put domestic currency deposits into banks at sharply negative real interest rates. Early in its reform Vietnam attempted a big bang liberalization of interest rates: it allowed all kinds of different economic entities to offer uncontrolled interest rates to the public. This short experiment ended in disaster because interest-rate liberalization in a poorly regulated environment led to abuses and failures of credit cooperatives. China was at the other extreme, keeping controlled interest rates quite negative in real terms and sticking with interest rate controls long past the point at which they were necessary.
This interest rate policy is one factor behind China’s highly investment-intensive growth model. There is much to be said for an interest rate policy that splits the difference between China and Vietnam. Control interest rates in the early stages of reform but ensure that they are at least moderately positive in real terms. Introduce greater flexibility and market-determination at a pace faster than China did, but probably not during the first decade of reform.
One of the most important monetary lessons from China, Vietnam, and the earlier East Asian industrializers (South Korea, Taiwan) is to not let the currency become over-valued, and preferably to keep it modestly under-valued. If a low-inflation environment can be achieved, such as in China, then pegging to a major currency such as the dollar has some appeal as an anchor, provided the pegged exchange rate makes the country highly competitive, as in China’s case after 1994. However, it is a fact of life that the dollar will vary in value against the Euro, Yen, and other currencies in an unpredictable way. It is a more reasonable policy to try to stabilize the real exchange rate and to allow some modest appreciation over time in order to account for productivity gains. In es sence this involves pegging to a basket and allowing some adjustment over time.
In the cases of China and Vietnam, they each made some mistakes in exchange rate management, in different directions. China, by sticking with its dollar peg in a period when the dollar was depreciating, let its currency become too under-valued resulting in large trade surpluses that complicated monetary policy and were not in the country’s interest. The authorities then had to allow fairly sharp appreciation in order to get back close to external balance. It would have been better to have smooth appreciation of the real effective exchange rate rather than the roller-coaster of devaluation from 1998 to 2005 followed by sharp appreciation after 2005. Vietnam allowed even larger swings in the real effective exchange rate, principally because of big shifts in capital flows (discussed below). Vietnam would have been better off either limiting capital inflows through capital controls or sterilizing inflows when they occurred.
In the area of capital markets, neither China nor Vietnam gets particularly high marks. Each country wanted to severely limit access of firms to the capital markets so that they could use the markets to partially privatize a few key state enterprises. The end result was thin markets, prone to bubbles. It only took a small amount of investor interest to push up prices quickly, leading to inevitable corrections.
Finally, in terms of opening the financial system to the global market there are two distinct issues. It makes sense first to open up financial services to direct foreign investment. Experienced international firms investing in commercial banking, insurance, and other sectors bring stability and competition to these markets. China has missed the opportunity to get these benefits, while Vietnam has been more open. The other issue of international finance concerns opening the capital account to inflows and outflows of portfolio capital. These flows, often referred to as “hot money,” can often be destabilizing and hard to manage at an early stage of development. China was smart to severely limit these flows. China sterilized even direct investment inflows. It may have gone over-board, particularly with the reserve accumulation during the years of severe currency under-valuation, but overall it provides interesting lessons on external management. Vietnam was more open to hot money flows. It is tempting to make use of these flows when foreign interest rates are low, but they do appreciate the real exchange rate and cause problems of volatility. One of the striking differences between China and Vietnam after decades of reform is that China is a big net creditor internationally whereas Vietnam is a big net debtor. The optimal policy for a developing country probably lies in between: making use of FDI but limiting other flows, and accumulating reserves as necessary to prevent large appreciations of the currency.
In summary, the main tasks of financial reformers in transition economies can be summarized in six “no’s”:
·No banking crisis
·No double-digit inflation
·No negative real interest rates
·No over-valued currency
·No stock market bubble
·No hot money inflows.