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Changing China’s incentive scheme in the new growth model


Tackling the issues: focus on wrongdoers, while preserving the institutions

I have previously argued that President Xi Jinping is forcefully changing the political and economic incentives that have been in place in China over the last three decades. He started by changing the macroeconomic policy objective from single-mindedly maximising growth to targeting multiple policy goals, including maintaining GDP growth, alleviating poverty, reducing financial risk and protecting the environment.

By replacing the previous objective with a more complex set of goals, President Xi has created a high-pressure political environment to ensure strict compliance with central decrees. Under this framework, people, not institutions, are being made to pay the price for wrongdoing. Xi’s thinking is that in this way, the incentive to take a bribe or excessive risk potentially leading to more misconduct, policy mishaps or even a financial crisis will be reduced.


President Xi is serious about rooting out graft

Official data shows that China’s anti-graft watchdog punished almost 37 000 officials in the first six months of 2018 for violating frugality rules. The most common offences included the misuse of government-owned vehicles, awarding unauthorised bonuses and exchanging gifts.

President Xi personally led the 25-member Politburo in investigating a vaccine scandal (first exposed in July 2018) at Changchun Changsheng Bio-technology, which made and sold nearly half a million sub-standard vaccines for children. At the time of writing, more than 40 party cadres, including ministerial level officials, have been the subject of disciplinary action.

The purge of individuals for misconduct is a prominent part of Beijing’s approach to de-risking the financial system. It is a diametrically opposite approach to that taken by many Western countries in the aftermath of the 2008 subprime crisis: in China, individuals, not the institutions they worked for, have been made to pay for excessive risk-taking and financial misconduct. The regulatory tightening since 2017 has not led to the collapse of any major financial institutions, but many financial-sector executives have been jailed.


Changing the incentives…

This has raised the question of regulatory forbearance. It is clear that Beijing does not want any major financial failures for fear of triggering a systemic crisis and, more importantly, damaging public confidence in the Communist Party. But this does not mean regulatory forbearance. The Chinese approach to correcting the incentive distortion is to threaten people running the financial institutions with an abrupt end to their careers rather than with the failure of the institutions they run.

Official data shows that 107 people in the financial sector were banned from the industry or had their professional qualifications cancelled in first quarter of 2018, a 360% jump from the same period last year.

The anti-corruption campaign is a key component of the crackdown on financial risk. In April 2017, the removal of the chairman of the China Insurance Regulatory Commission (CIRC), Xiang Junbo, signalled the start of a purge of people accused of misconduct. So far this year, there have been numerous major prosecutions of financial executives for corruption and illegal activities. Notable examples include:

  • In January, the banking regulator of Sichuan province fined the local branch of Pudong Development Bank RMB 462 million for hiding non-performing loans; the head of the branch and two deputies were banned from the industry for life.
  • In March, Wu Xiaohui, the chairman of insurance company Anbang, was prosecuted for illegal fundraising and fraud. The firm has since been taken over by regulators.
  • In April, the chairman of state-owned China Huarong Asset Management, Lai Xiaomin, was expelled from his job after the government began investigating him.


… the Chinese way

Instead of closing them down, all of these problematic institutions have been kept afloat and their creditors have been asked to maintain funding lines. However, the key people running these firms have been banned from the financial industry or, more often, faced criminal charges.

Beijing has sent a clear message to Chinese financial executives: that they will not benefit from the leniency shown to their Wall Street counterparts in the wake of the Great Financial Crisis (GFC). Few individuals were prosecuted or made to pay for malpractice post the GFC, although financial institutions and governments had to bear heavy costs.

Experience shows that incentive distortion, which is undeniably prevalent in the Chinese system, lay at the heart of the US subprime crisis. Distorted incentives are also intrinsic to the financial intermediation process and financial innovation, which are evolving rapidly in China.

The West chose to deal with the financial mess by making institutions pay for their mistakes. In China, the financial institutions survive, but the people responsible for the risky practices are made to pay. The aim is the same – to correct the distorted incentives. Any success of China’s heavy-handed approach will go a long way to improve the structural underpinning of Chinese assets by correcting the incentives and building better governance.

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