How Was China Able to Avoid a Financial Crisis for 35 Years?

February 27, 2013 

This article will deal with the period of 1949 to the present, with primary emphasis on recent decades. The world has experienced many financial collapses across this period. These include the following:

·      Stock Market crash of 1973-74
·      Latin American Debt Crisis of the 1980’s
·      Black Monday in the US, 1987
·      The US Savings and Loan Crisis of the 1980’s
·      The Japanese Asset price bubble of 1990
·      The Scandinavian banking crisis of early 90’s
·      The 1994-95 debt crisis in Mexico
·      The Asian financial crisis of 1997
·      The Russian financial crisis of 1998
·      The Turkish crisis of 2000
·      The Argentine crisis of 2001
·      The Icelandic crisis of 2008
·      The virtually worldwide financial crisis of 2007 to the present
Some of these were regional crises and did not significantly affect Asian countries. However, many did, and it is significant to note that China astounded most economists by avoiding all of them.
I will argue that China has accomplished this as a result of planned, unplanned, and cultural elements. I will give prominent weight to Chinese growth based on high investment levels supported by domestic savings, along with key financial management actions of the Chinese State’s gradualist approach to neoliberal pressures and opening of financial markets.
I will characterize a “financial collapse” as an event involving most of the following: loss of confidence in financial institutions; failure of certain major financial institutions; a massive stock market drop; sovereign debt default; currency crisis; and, the economy falling into recession. Asset price booms and busts, as in property or the stock markets, have often triggered such crises. Central to such crises are serious banking sector problems (Bordo 2010:3-4).
The approach of this paper will be to first address the nature of growth in China, since there is no collapse if growth continues unabated, as it has in China. The unique foundations to the Chinese growth story are the first major element of avoiding collapse. Key financial history will then be addressed.
Confucian China has a long culture of egalitarianism. During the period of 1949 to 1978, the Chinese party leadership maintained a strong commitment to egalitarianism in its governmental policies as it moved through its successive five-year plans.  Concern with social welfare and employment was State directed as a major focus for provincial governments and for SOE’s, and is thought to have resulted in improved health care, life expectancy, social stability, consumer confidence, consumption, and relatively steady economic growth for China, pre-reform (Bramall 2008: 549). The egalitarian and control oriented State policies and structures were only slowly and partially surrendered, during the reform era, as China began to introduce elements of neoliberal capitalism. This orientation also turns out to be a critical element in the management of the finance sector, addressed later.
The spike in births across the period of 1962 to 1968 resulted in an “echo effect,” or “demographic dividend” of working age youths beginning around 1978 (Bloom 1998). This pool of surplus labor positioned China to become the low wage factory of the world, beginning in the 1980’s. With the availability of the massive surplus labor, China essentially entered into a “labor contract” with the US, in which the US purchased low priced products from China, based on China’s cheap labor, and in return China financed a significant portion of a growing deficit in trade and budget in the US.
The neoliberal Washington Consensus had opened borders to the world by early 1980s. The trade with the US, Europe, and the rest of the world was a major contributor to China’s economic growth, resulting in fast export growth, which gave the Chinese State the foreign exchange with which to promote its strategic import technology program. This program enabled China to gradually become less reliant on cheap labor by raising productivity, moving to products requiring more skill and technology, deserving of higher wage rates, thus sustaining the strong economic growth as China’s labor rates became less competitive for the cheapest goods. Supporting this capability to meet labor productivity demands was China’s impressive educational investment of the pre-reform era (Bramall 2008: 174-212).
Dani Rodrik argues there are three essential and universal structural ingredients to growth: property rights, incentives (usually through effective trade with the world), and rule of law. He says there can be many different localized structures providing these.  He sees a kind of “Chinese Federalism” providing these in a way that would not be endorsed by neoliberal economists.
For example, Rodrik argues that the two-track pricing system gave the Chinese state for the last half of the 80s, the best of both worlds—incentives for enterprises to produce and grow, and a guaranteed price and source of revenue for the state, assuring state budget solvency. State financial strength is another pillar of protection from financial crisis.
He suggests that Chinese use of township and village enterprises and the “household responsibility system” was an effective form of property rights, albeit far from what is promoted by the Washington Consensus. China did not have an effective court system at that time, and this practice of businessmen allying themselves with local governments for property protection may have been an effective equivalent in Chinese terms (Rodrik 2005:9-10).
Summarizing regarding growth, by definition, if an economy can sustain uninterrupted growth, it is not considered to have experienced a financial collapse. This combination of inherited characteristics and intentional actions provided a uniquely strong platform for growth across the last thirty years.
While Rodrik’s characteristics may yield growth, they do not assure stability. There was strong growth in 1995 in Thailand (9.2%), Indonesia (8.4%), and S. Korea (9.2%) before the 1997 Asian Crisis (World Bank 2012), and all three had their own form of Rodrik’s universal requirements. Yet, there was a severe financial crisis and recession in each of those countries, beginning in 1997. China grew at continuously high rates and did not experience a financial collapse. A comparison of GDP growth rates in 1998 illustrates the dramatic difference in effect of the East Asian crisis: Thailand (-10.5%), Indonesia (-13.1%), and in S. Korea (-6.9%) (World Bank 2012). Contagion also spread to Russia, which defaulted on debt in 1998, and to Brazil, which had a currency crisis in 1998 (Bordo 2010:10). China’s GDP growth rate fell only from 10.9% in 1995 to 7.8% in 1998 (World Bank 2012).
The most important key to stability appears to lie in the financial sector, focused on banks, and controlled by the State. One important element of financial management was that China did not allow foreign portfolio purchase of stocks for a considerable period after its stock markets were re-launched during the reform era. Only after 2002 were foreign investors allowed to buy “A” shares in the Shanghai exchange, and even now only with approval as a qualified foreign institutional investor. This was protection from a stock market crash.
Also, China initially cultivated foreign direct investors from Hong Kong and Taiwan—these certainly understood the Chinese risks and culture better than distant Western investors who might be spooked by any disruptions. Then, as others were allowed to invest, they were initially required to joint venture with local Chinese—another restraint on withdrawing (Branstetter 2008:641). Barry Naughton describes how China’s incoming foreign direct investment differed from that of its neighbors:
Even though China was exposed to volatile flows of financial capital like other East Asian economies, China enjoyed a more reliable inflow of FDI at the same time. The investors behind FDI inflows had made a long-term commitment, and in any case their assets were not of a type that could be quickly liquidated.  The greater share of “patient capital” in China’s foreign investment left it less vulnerable to financial crisis (Naughton 2007:422).
Borrowing, and especially foreign borrowing, is yet another matter of risk of exposure to financial crisis. Reinhart and Rogoff have found a recurrent pattern across two centuries between rapidly rising private indebtedness and banking crises. (Reinhart and Rogoff 2011:1702). Foreign (“cross border”) debt is the most dangerous, because it can be withdrawn by distant interests who have little in common with the state.
According to Shaunglin Lin, from 1949 to 1957, China borrowed only from the Soviet Union and domestic bond issues; from 1958 to 1978, China issued no debt and simply monetized budget deficits; from 1979 to 1993, there was limited borrowing from the public, the Bank of China, and a small amount of foreign debt; since 1993, the government borrowed aggressively domestically. Foreign debt has also grown, but by 2001 represented only 15% of GDP, and was exceed by its foreign reserves. More than 70% of the foreign debt was of long-term nature. China is classified by the World Bank as one of the least indebted countries (Lin 2003: 76-80). Since then, debt has been kept stable to declining in terms of percentage of GDP, around 16-17%, while in 2011, Japan’s ratio was 229% and the US ratio was 100% (WSJ 2012).
In this and other ways, China chose to embrace globalization and neoliberal market opening policies on a gradualist basis—“like crossing the river, feeling one stone at a time,” as Deng Xiaoping said. The Chinese only slowly and partially surrendered control over the financial economy to provincial management and to market forces. Part of the reason was cultural—China was still hanging onto its egalitarian cultural history. Another reason was recognition of the need to retain flexibility and control to manage highly volatile international market forces.
Inflation can result in asset bubbles, which can trigger financial collapse. There were instances of inflation spikes in 1987-88 and in 1993-94, but there were no financial products such as collateralized mortgage derivates operating outside State control, to exacerbate an inflationary bubble risk.  China had control of money coming in and going out, and used controls over bank lending (rates, reserve requirements, direct orders, etc.). Inflation remained moderate on average across the long period.
The lynchpin of all this is argued to be China’s savings pattern and how the Chinese State managed the savings, banks, and financial systems. China only began to allow the development of alternative financial markets beginning with its preparation to join the WTO in 2002, but even then, negotiated additional years to gradually implement such changes. Although narrow in scope, the Chinese financial system nevertheless deepened steadily across the period from 1978 to 2010, measured in terms of M2 and bank credit expansion. By measure of M2, the Chinese system was well beyond that of India, Russia, Brazil, and even South Korea. Since this is a measure widely accepted, the facts suggest the Chinese system was probably not handicapped by the financial system being dominated by state controlled banks (Lo, Li and Jiang 2011: 271-2).
The uniquely high savings rate is key to the Chinese ability to manage finance in the above-described manner. See figure 1. Without that, China could not have so controlled its finances across this long period of years. Reasons for the high savings rate (which financed the investment in growth) may trace partially to Confucian values, partially to lack of adequate welfare state protections for old age, and partially to the value placed by Asians on savings for education of their children. Since Chinese were not permitted to place their money outside China to any significant degree, and no alternative financial institutions or products were made available, all the savings went into the banks. Across the years, the banks remained flush with deposits. The impact of these factors is summarized by Angus Maddison:
The explosive growth of household savings and the rapid monetisation of the economy were the most important elements preventing a financial crisis [….] Before the reform period, household savings were negligible but they are now more than a quarter of household income. In 1978 the money supply (money and quasi money) was less than a third of GDP, but by 2005 it was bigger than GDP (Maddison 2007: 90).
Concerns about the banks abounded across the years. Lardy expressed concerns about China’s strong growth rate sustaining in 1999, focusing his concern on the risk of runs on the State banks, which he described as “insolvent” (Lardy 1999: 163). In 2007, Naughton expressed the same concern, when the “Big Four” still accounted for 53% of total banking system assets (Naughton 2007: 456). Forbes magazine says the problems of bad loans have increased since 2008 when banks were encouraged to lend to stimulate the slowing economy (Chang 2012).
Recognized scholars have also foreseen potential financial collapse for China for years. Reasons (circa 1998-9) include losing SOE’s, exposure to NPL’s, weakness of the fiscal position of the state (Maddison 2007: 93), slowdown in growth precipitating a flight of Chinese capital (Fernald and Babson 1998: 22-3), and (in 2011) concerns over the recent construction boom, real estate prices soaring, and the uncontrolled “shadow banking system” (Krugman 2010).
Perhaps the China story is all the more difficult to understand in light of the common risk elements between China and others who experienced collapse:
Many of the considerations that have undermined confidence in other Asian financial systems apply to China: a lack of transparency; financial cronyism; banks with huge portfolios of nonperforming loans; poor regulatory systems; property bubbles; [and] heavy borrowing abroad [….] (Lampton 1998: 19).
However, there have been no runs on Chinese banks and no financial collapse. As to the absence of bank runs, there are two likely reasons: (1) there was no other place for Chinese to put their money; and, (2) Chinese people knew that the state was in control (via full or majority ownership). Thus, Chinese had good reason to feel comfortable in relying on the state to assure the viability of the banks. In fact, the state did just that, taking actions periodically, to shore up or strengthen the banking system. One example is the policies introduced by the PBC in 1994 involving capital adequacy, loan maturities, and limits to a single borrower (Dongning 2006: 29-30). Actions also included periodic injection of capital, creation of additional institutions to manage non-performing loans, and directing the focus of lending to infrastructure and other improvements which benefitted citizens and the growth of the economy.
Chinese scholars have also confirmed the critical role of the financial system:
It is a paradox that, along with this seemingly dubious financial system, the Chinese economy has performed well in terms of macroeconomic stability and long-term development. And this performance has been achieved amid the continuous financial deepening of the economy, which indicates that the financial system did play an important role in the process of economic development (Lo, Li and Jiang 2011: 267-8)
The financial system was very largely under State control. Utilizing its vast domestic savings and its banks, China was able to minimize reliance on outside debt or other forms of capital for its investment and growth. China was, to a large extent, insulated from the impact of world financial “knee-jerks.”
Of course, even with the extraordinary savings and State management of finances, China was certainly exposed to the world, especially in regard to the East Asian Crisis of 1997 and the current world financial crisis. If no action had been taken, perhaps China too could have succumbed to the contagion. According to Branstetter and Lardy, one of the effective responses to the East Asian Crisis was to stimulate more exports by reversing direction and rebating most tax on exports and accelerating rebates due. The tradeoff was against State finances (Branstetter and Lardy 2008: 639). Clearly, another action was to loosen the reins on the banks in 2008 and to make massive infrastructure investments to stimulate the Chinese economy (Economist 2012). Here again, State control of the Chinese financial system proved critical.
While neoliberals continue to argue that China succeeded so far in spite of itself, a few scholars have given major credit for China’s growth and avoidance of financial collapse to Chinese economic management defying the urging of the neoliberal Washington Consensus.  The State was involved in all aspects of finance and trade management, controlling the banks, controlling the funds flows in and out of China, and controlling the exchange rate of the currency. This is heavy state intervention in the markets, as neoliberals would see it.
Lardy spells out some of the important differences between China and those who suffered collapses: currency not freely convertible; remarkable level of hard currency reserves; inward foreign investment controlled and directed to factories and the like, not to liquid markets; debt to foreigners mostly long term; and the high domestic savings rate (Lardy 1999).
Viewed in terms of factor accumulation, China demonstrated remarkable strength in labor and in entrepreneurship, and truly excelled in capital!
As to the future, it is anyone’s guess. Justin Lin uses comparison to the history of more developed economies such as Korea and Taiwan to predict that China can enjoy at least another two decades more of 8% or better growth, but he doesn’t predict whether that growth might be interrupted (Lin 2012). China has become gradually more open to the opportunity and risk of free markets, so State ability to maintain sufficient control over the financial system may be the determinant.
Regardless of whether the State interventionist actions across the last thirty years (the “gradualist program”) were more the result of political haggling and indecision, resistance to Western pressure, or wise calculations (most likely a combination), it seems clear that China avoided financial collapse in large part because it did not yield to the Washington Consensus. China has certainly had many financial challenges, but across its long high growth period of more than thirty years, has not experienced a financial collapse.  A remarkably strong growth foundation, uniquely Chinese savings rates and State financial management over the patterns of market reform have yielded this result.
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