Credit expansion and development – A Schumpeterian and Keynesian view of the Chinese miracle

Herr, Hansjörg Article Credit expansion and development – A Schumpeterian and Keynesian view of the Chinese miracle Intervention. European Journal of Economics and Economic Policies Provided in Cooperation with: Edward Elgar Publishing Suggested Citation: Herr, Hansjörg (2010) : Credit expansion and development – A Schumpeterian and Keynesian view of the Chinese miracle, Intervention. European Journal of Economics and Economic Policies, ISSN 2195-3376, Metropolis-Verlag, Marburg, Vol. 07, Iss. 1, pp. 71-89, https://doi.org/10.4337/ejeep.2010.01.08 This Version is available at: https://hdl.handle.net/10419/277177 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Credit expansion and development – A Schumpeterian and Keynesian view of the Chinese miracle Hansjörg Herr* In neoclassical thinking, insuffi cient development is considered the result of a lack of resources, and an ineffi cient allocation. Deregulated markets have to guarantee a better allocation of resources as well as a net resource infl ow to augment the domestic physical capital stock. From a Schumpeterian-Keynesian perspective, it is not the lack of physical resources and optimal allocation which prevent development. It is fi rst and foremost the lack of a suffi cient credit-in- vestment mechanism which leads to the perpetuation of underdevelopment. It is shown here that the Schumpeterian-Keynesian perspective gives a much more plausible interpretation of the Chinese development than the neoclassical perspective. It is also shown under which regulations and conditions a credit-in- vestment process in developing countries is possible. JEL classifi cations: E12, E44, F36, F43 Keywords: credit, economic development, Schumpeter, Keynes, China 1. Introduction Looking at GDP growth, absolute poverty reduction, inflation and exchange rate stability, China has become one of the most successful developing countries in the world since * Berlin School of Economics and Law. For helpful comments I thank two anonymous referees. Correspondence Address: Hansjörg Herr, Berlin School of Economics and Law, Badensche Str. 50 – 51, 10825 Berlin, Germany, e-mail: [email protected]. Received 10 January 2009, accepted 28 July 2009 © INTERVENTION 7 (1), 2010, 71 – 89 72 Intervention. European Journal of Economics and Economic Policies the beginning of its reform process in 1978. Nevertheless, there are also negative economic developments like the escalating inequality of income distribution as well as poor working conditions and ecological problems. In addition, since 2005 China has developed one of the most disturbing current account surpluses in the world – along with Japan and Germany. Irrespective of these problems it is a theoretically challenging question as to how China managed to trigger and sustain a long-lasting growth process which, in principle, could also have been combined with a more equal income distribution and a more careful handling of nature. China did not follow a big-bang strategy, which had been recommended by international institutions and followed by countries like the Soviet Union; nor did it follow the philosophy of neoclassical development models upheld by the Washington Consensus and the saving-gap model. Indeed, the Chinese miracle is difficult to imagine without a strong developmental state, and the non-acceptance of long-term deficits in the current account. But Chinese development is not unique in this regard. It is in keeping with the tradition of an Asian development model, as exemplified by Japan after World War II, and later by other Asian countries such as South-Korea, Singapore, and Malaysia. A key role in this model is played by the financial system (Stiglitz 1996, Stiglitz/Uy 1996). In this respect China is no exception. Th e second section provides an overview of economic development in China. Th e third section deals with the Schumpeterian-Keynesian credit-investment-income-creation process. Th e fi nancial system in China and its role for development is analysed in the fourth section, followed by concluding remarks in the fi fth section. 2. Th e Chinese economy 2.1 Macroeconomic stability Between 1978 and 2008 annual real GDP in China (mainland, without Hong Kong) increased at a spectacular rate of nearly ten per cent on average, and GDP per capita grew by over eight per cent per annum (see Table 1). Taking one US dollar a day as a measure, over the past decades China has been the country with the largest absolute reduction in poverty in the world, despite an alarming increase in income distribution inequality. An overall, gradual development strategy was chosen with far-reaching government interventions. For example, in the sequence of reforms, privatisation was put at the end of transition, while for decades property rights remained rather unclear. Prices were liberalised in several steps and quantity planning faded out slowly. China joined the World Trade Organisation in the year 2001. After 1978, international trade was largely regulated, however, regulations were reduced slowly. Even today it would be misleading to speak of a completely liberalised trade regime in China. Hansjörg Herr: Credit expansion and development 73 Table 1: Basic macroeconomic data for China 1978 – 2008 Year GDP growth* GDP per capita growth* Gross capital formation as % of GDP Final consumption expenditure as % of GDP Exports of goods and services as % of GDP Infl ation rate (CPI)** FDI net infl ows as % of GDP Current account balance as % of GDP 1978 11.7 10.2 38.2 62.1 6.6 0.7 0.0 n/a 1979 7.6 6.1 36.1 64.4 8.6 n/a 0.0 n/a 1980 7.8 6.5 34.8 65.5 10.7 7.5 0.0 0.1 1981 5.2 3.9 32.5 67.1 12.7 2.4 0.1 0.8 1982 9.1 7.5 31.9 66.5 12.3 1.9 0.2 2.0 1983 10.9 9.3 32.8 66.4 10.9 1.5 0.3 1.4 1984 15.2 13.7 34.2 65.8 11.3 2.8 0.5 0.6 1985 13.5 11.9 38.1 66.0 10.0 9.3 0.5 -3.8 1986 8.8 7.2 37.5 64.9 11.8 6.5 0.6 -2.4 1987 11.6 9.8 36.3 63.6 16.4 7.3 0.9 0.1 1988 11.3 9.5 37.0 63.9 17.1 18.8 1.0 -0.9 1989 4.1 2.5 36.6 64.5 16.7 18.0 1.0 -1.0 1990 3.8 2.3 34.9 62.5 19.2 3.1 1.0 3.1 1991 9.2 7.7 34.8 62.4 21.0 3.4 1.2 3.3 1992 14.2 12.8 36.6 62.4 22.5 6.4 2.7 1.3 1993 14.0 12.7 42.6 59.3 23.3 14.7 6.2 -1.9 1994 13.1 11.8 40.5 58.2 24.6 24.1 6.0 1.4 1995 10.9 9.7 40.3 58.1 23.1 17.1 4.9 0.2 1996 10.0 8.9 38.8 59.2 20.1 8.3 4.7 0.8 1997 9.3 8.2 36.7 59.0 21.8 2.8 4.6 3.9 1998 7.8 6.8 36.2 59.6 20.3 -0.8 4.3 3.1 1999 7.6 6.7 36.2 61.1 20.4 -1.4 3.6 1.4 2000 8.4 7.6 35.3 62.3 23.3 0.4 3.2 1.7 2001 8.3 7.5 36.5 61.4 22.6 0.7 3.3 1.3 2002 9.1 8.4 37.9 59.6 25.1 -0.8 3.4 2.4 2003 10.0 9.3 41.0 56.8 29.6 1.2 2.9 2.8 2004 10.1 9.4 43.2 54.3 34.0 3.9 2.8 3.6 2005 10.4 9.8 43.7 51.8 37.3 1.8 3.5 7.2 2006 11.6 10.5 45.5 48.0 40.1 1.5 3.0 9.4 2007 13.0 12.5 42.6 47.1 42 4.7 4.3 11.1 2008 9.9 8.5 40.8 48.2 27.3 5.8 4.1 9.9 * In constant prices, change to previous year. ** CPI (Consumer Price Index), change to previous year. Source: China Statistical Yearbook (2009), World Bank (2009) 74 Intervention. European Journal of Economics and Economic Policies Overall, China has managed to defend macroeconomic stability – measured in terms of infl ation rate and GDP growth. Although infl ation started to get out of control in the late 1980s and especially in the early 1990s – with an infl ation rate of over 24 per cent in 1994 – the country nevertheless managed to reduce the infl ationary pressure without falling into recession. After the Asian crises, China suff ered from a mild defl ation for a few years, but this was also overcome and GDP growth was only slowed slightly in the process. After 2007 the infl ation rate increased again as a result of higher food and energy prices, and a booming economy. Compared with other developing countries, the overall positive performance in terms of infl ation rates and GDP growth led to a relatively high degree of confi dence in the domestic currency and the domestic fi nancial system. An erosion of the domestic monetary system never evolved. 2.2 Capital controls Up to today, China has implemented a comprehensive system of capital controls, which has been relaxed somewhat only in the past few years. Th e logic of the capital control system is simple: all types of capital fl ows are controlled with the exception of foreign direct investment (FDI) infl ows (Prasad/Wei 2005). Th is means that without permission Chinese banks, fi rms, households and public units are not allowed to take foreign credit or invest abroad. Compared with other developing countries – and measured as a percentage of GDP – China does not have a low level of international capital fl ows. However, capital infl ows have been dominated by FDI and capital outfl ows by central bank interventions in the foreign exchange market. Th ere have been illegal capital outfl ows – especially in the 1990s during and after the Asian crisis in 1997 – and illegal capital infl ows. In particular, after 2002 China suff ered from too high capital infl ows: from high FDI infl ows, fi nancial infl ows connected with FDI like credits between foreign parent companies and subsidiaries in China, and illegal capital infl ows. All in all, however, capital controls have worked. To a large extent, China has been able to structure capital fl ows in its own interests, and in addition to follow a domestically oriented monetary policy with overall low real interest rates, a privilege not shared by many developing and even developed countries in the world (Herr 2008b). Even compared with developed countries China has very low restrictions for FDI infl ows. For example, the USA and Europe restrict FDI infl ows to a much greater degree than China, arguing that technological and military secrets require protection. After 2005, China began to secure natural resources with FDI outfl ows (e.g. in Africa) or to obtain technology and export channels (e.g. in the United States or Europe). State funds from China and other developing countries that are used to buy banks and fi rms in Western countries are only partly welcomed. Looking at FDI, successful Asian countries in the past – like Japan or South-Korea – did not attract FDI in their development phases as they wanted to keep all keystone companies in national ownership. Obviously China was eager to catch up technologically very quickly, and/or was too backward – compared to Western countries – to imitate in the way Japan or other now relatively developed Asian countries did. Hansjörg Herr: Credit expansion and development 75 In searching for the growth drivers in China it becomes clear that growth has been stimulated fi rst and foremost by high investment. Growth rates in gross capital formation as well as the proportion of gross capital formation as a percentage of GDP (see Table 1) have been extremely high. Over the whole transition period, the high investment dynamics was almost exclusively fi nanced by domestic sources and in domestic currency. It would be misleading to consider FDI the main factor behind the high Chinese investment and economic development. FDI undoubtedly added to the dynamics of the Chinese economy, but the main eff ect of FDI has to be seen in the transfer of technology and management skills, and the opening of export channels. Firstly, while FDI infl ows were almost non-existent in the 1980s, GDP growth was as high as in later decades when FDI infl ows increased sharply. Secondly, from 1993 to 2008 FDI was on average about 7 per cent of gross capital formation in China (see Table 1). Th is is relatively high, but FDI did not dominate investment. Th irdly, real FDI is probably much smaller because most FDI came from Hong Kong. To a certain extent this refl ects that capital from the rest of China fl ows illegally to Hong Kong and comes back as FDI to exploit tax breaks and other privileges given to foreign investors. Fourthly, usually only a small part of FDI is part of gross capital formation, since the biggest parts usually refl ect mergers & acquisitions and hence only changes in ownership. Finally, not all FDI has positive eff ects. For example some FDI, especially from Hong Kong and Taiwan, was low tech and therefore exploited only poor working conditions. After 2004 FDI infl ows also added to the real estate bubble in coastal regions. 2.3 Th e fi nancial system and the pillars of the Chinese economy Quantity planning was gradually relaxed and faded out during the 1980s. However, quantity planning was substituted by politically infl uenced quantitative credit expansion and credit allocation. Until the end of the 1990s there was an offi cial credit plan that fi xed the credit volume and infl uenced credit allocation in the banking system. Even after the abolishment of the credit plan, credit rationing by the central bank and policy credits remained important. Th e Chinese economy is built on several important pillars. a) As the fi rst pillar, state-owned enterprises (SOEs) stimulated growth via high investment. China did also use SOEs for infant industry protection and to fi nance loss-mak- ing SOEs for social purposes. Th e SOE sector depended heavily on the offi cial fi nancial system. At the core of the offi cial fi nancial system are state-owned banks, especially the so-called »Big Four«, which dominate the offi cial banking sector. 1Banks in the offi cial fi nancial system concentrated credit expansion on SOEs. However, over the years credits to other types of enterprises became more important. Naughton (2007: 478) reports that, although not included in offi cial fi gures of the formal fi nancial sys- 1 Th e four banks are the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Construction Bank and the Bank of China. 76 Intervention. European Journal of Economics and Economic Policies tem, local government exercised control over substantial fi nancial funds. At least indirectly, local authorities substantially infl uenced investment via control over local state-owned investment corporations and investment funds, which also provided fi - nance for enterprises. In addition, fi rms directly issued debt-securities to private entities. In offi cial statistics, »other« fi nancial resources of investment of unclear origin make up about half of all formal bank lending. Part of this informal fi nance went to the SOEs, the rest to other sectors (see Figure 1). Not much is known about the distribution of these funds and the informal credit markets. At the beginning of reform the SOE-sector dominated, with a share of over 80 per cent of industrial production in 1980. Over the years this share declined considerably (National Bureau of Statistics 2009, China Statistical Yearbook 1996). In 2007 state-owned and state-holding industrial enterprises comprised six per cent of all industrial enterprises, employed over 20 per cent of the industrial workforce, and produced 29.5 per cent of industrial output (Gabriele 2009: 9). Th e SOE sector developed in diff erent phases. In the 1980s SOEs were profi table on the whole due to their monopolistic position. Th is changed in the 1990s when the booming private sector and foreign companies intensifi ed competition in the goods market. In particular, small SOEs with backward technology accumulated losses, and were fi nanced by state banks for social reasons. In the late 1990s the Chinese government started the policy »keep the big, dump the small«. Many lossmaking small SOEs were shut down, and the bigger SOEs were successfully restructured. After ten years of restructuring the SOE sector became profi table and in many respects more dynamic than the private Chinese-owned enterprises sector. For example, most domestic research is located in SOEs (Woetzel 2008, Gabriele 2009, Lo 1999).2 It looks as if the SOE sector will remain the backbone of domestically-based Chinese industrial development for some time. Figure 1: Financial system and investment sectors in China 2 Sachs/Woo (1994) also support the argument that Chinese SOEs increased effi ciency in the 1980s. However, they argue that during that period private companies performed better. Hansjörg Herr: Credit expansion and development 77 b) In the early 1990s China started to open up for FDI, with foreign ownership in the enterprise sector starting to expand quickly. First only joint ventures were allowed. Since the end of the 1990s the number of wholly-owned foreign enterprises increased quickly. In 2007, so-called Foreign Funded Enterprises produced 21 per cent, and Enterprises with Funding from Hong Kong 10.5 per cent of industrial output (China Statistical Yearbook 2008). Th ese enterprises have had access to both foreign funds and the formal fi nancial system in China. c) A third pillar consists of private market-based enterprises owned by Chinese. Th ese enterprises have usually been small or medium-sized. After 1978 a Manchester type of capitalism – with waves of new enterprise foundations and bankruptcies – developed in this sector. Th is is generally the sector with very poor working conditions, no safety net, and a low level of legal enforcement. Th is is also the sector with virtuous and vibrant private entrepreneurialism which boosted GDP growth (Huang 2009). However, it would be wrong to consider this sector as the main engine of development. It was the interaction between the state-controlled sector and the private, purely market-based sector which is behind the dynamic Chinese development. Development in the purely market based sector was not only positive. Productivity in this sector is in most cases very low. It also led to a largely deregulated labour market, and is one of the reasons for the high level of unequal income distribution in China at present.3 For a long time the Chinese private enterprise sector had very limited access to the offi cial fi nancial system, which served SOEs fi rst. Th ese enterprises fi nanced their investment mainly out of profi ts, or by means of credit from the informal fi nancial system. d) Th e last sector is the agricultural sector. In the late 1970s China switched from collectively organised agricultural production to a family-based leasing system, creating a system of very small farms. In the fi rst fi ve years after the reform agricultural production increased substantially, but after this period this sector lost its momentum, and hasn’t yet recovered. Farmers have access to the formal fi nancial system. However, moneylenders and unregistered banks play a signifi cant role, especially in the agricultural sector credit clubs. In 1986, for example, household surveys revealed that informal credits in this sector surpassed formal lending (Naughton 2007: 478). 2.4 Th e exchange rate regime and the current account In the 1980s China experimented with several exchange rate regimes. In 1981 a dual exchange rate regime was established which fi xed diff erent exchange rates for diff erent types of transactions. In 1985 the primary exchange rate for international trade was allowed to fl oat. Beginning at the end of the 1980s, this exchange rate started to depreciate sharply and lost 3 Th e traditional development model in East Asia went hand in hand with a much more equal income distribution. In China this has not been the case. Th e Chinese government became worried about the development in the labour market and assigned the state-controlled unions to control legal enforcement and improve working conditions (Zenglein 2008). 78 Intervention. European Journal of Economics and Economic Policies nearly 50 per cent of its value – vis-à-vis the US dollar – by the end of 1993. In 1994 the two exchange rates were unifi ed, and pegged unoffi cially to the US dollar, with the value of the fl oating exchange rate chosen for the peg. Th us China pegged its exchange rate at a level which made Chinese products internationally competitive. Th is peg was successfully defended until 2005, when China started to peg the renminbi (RMB) to a currency basket and a crawling peg regime with moderate periods of appreciation vis-à-vis the US dollar. After 1978 China began following a policy of avoiding long-term defi cits in the current account. Indeed, since the second half of the 1990s high growth rates of exports and permanent current account surpluses have characterised Chinese development. Th e moderate surpluses started to explode in 2003, and let China join Japan and Germany as the countries with high exports and current account surpluses.4 Next to high investment, exports became the second most important engine for demand and growth in China after the mid 1990s. It is frequently argued that cheap Chinese wages are responsible for high Chinese export surpluses. But what remains vague in this argument is how wages are measured. If real wages are meant, the question is why countries like Uganda – with similarly low wages – have huge current account defi cits. If nominal wages are taken, it is the exchange rate which makes the wages of a country low in comparison to other countries. In China, the People’s Bank of China (PBoC) – the Chinese central bank – has been steadily intervening in the foreign exchange market to prevent or slow down an appreciation of the Chinese RMB. To date, China has accumulated the highest foreign exchange reserves in the world, amounting to around 2 trillion US dollars in 2009 (SAFE 2009). Th us, the PBoC is the cause of the high Chinese current account surpluses. Since the end of the 1990s China has amassed a huge double surplus, a surplus in the current account and a surplus in the capital account, stemming from FDI and speculative capital infl ows.5 Without the PBoC’s interventions in the foreign exchange market, and without changes in capital fl ows, China would be pushed into a constellation with a current account defi cit. Th ere is no doubt that China’s current account surpluses are harmful for economic growth in other countries – as are the high surpluses of Germany and Japan. Germany realises most of its surpluses in Europe which is becoming a major problem for the European Monetary Union (Herr/Kazandziska 2007), while Japanese surpluses are as problematic for the world economy as the Chinese. It would seem highly desirable for the world economy to fi nd an eff ective mechanism to halt destabilising current account imbalances. China is merely one part of a larger problem that needs to be solved. As a result of capital controls, and a policy to avoid current account defi cits, China has never suff ered from a currency crisis after the start of the reform period in 1978. In early 2009 Chinese foreign debt of around 300 billion US dollars was only about 15 per cent of offi cial foreign reserves (SAFE 2009). Even the Asian crisis in 1997 only reduced the Chinese growth rate indirectly, while as a re- 4 Resource-rich countries like Russia and the Arabic countries also realised very high current account surpluses after 2003. 5 Th e explosion of the Chinese current account surplus in recent years may refl ect some illegal capital infl ows as exporters artifi cially increase export prices to transfer funds to China. Hansjörg Herr: Credit expansion and development 85 control. Many of the non-bank fi nancial institutions were closed, and China implemented a partially segmented fi nancial system and commercial bank share-holding was limited. For a full two decades after the start of reform in 1978 formal credit allocation was to a large extent policy-driven. Th e credit plan fi xed the overall credit volume of the »Big Four«, including the regional allocation of the credit volume. Th ere was a form of negotiation between the provinces and the central government in Beijing as to how much of the national credit cake should go to the various provinces and how much would be retained in Beijing. On a provincial level, credit allocation was negotiated between the local government, the local branches of the commercial banks, the local branch of the PBoC, and fi rms. Th e local government was by far the most powerful player in this credit allocation mechanism. In addition, politics strongly infl uenced the credits given by joint-stock commercial banks, city banks, credit cooperatives, and of course the policy banks. Th e bulk of the formal credits went to SOEs, but private enterprises – especially those with good relations to cadres – had access to the formal credit system.14 Credits were allocated according to different priorities and motivations: Firstly, they were used to fi nance investment in selected industries, fi rms and regions. Th ere was defi nitely not a coherent national development plan for industrial policy, but there was the general attitude on all levels to support development and effi ciency. Th is credit expansion in the formal fi nancial system became the backbone of the dynamic quantitative and qualitative investment development in China. It has stimulated high investment with all of its multiplier eff ects for the other sectors of the economy (Herr/Priewe 1999). Secondly, loss-making fi rms were fi nanced to prevent their bankruptcy, which would have led to a rapid increase in unemployment and poverty. As in all planned economies, China’s social safety-net was built around the fi rms. A big-bang strategy to close all lossmaking SOEs would have led to substantial social and political distortions. Financing lossmakers can be interpreted as the unavoidable costs of maintaining social coherence. Banks took over fi scal functions. Th e non-performing loan problem escalated in the second half of the 1990s. SOEs came under increasing pressure from the growing Chinese private sector – which did not have to pay for a welfare state system – and from a growing foreign investment sector that usually used superior imported technology. Th ese developments led to the accumulation of non-performing SOE loans. Th e resulting fi nancial pressure triggered the privatisation of the least productive small and medium-sized SOEs (Lau 1999). Th e restructuring of the SOE sector in the 2000s was successful. Together with repeated policies to transfer bad credits to special government controlled institutions, and re-capitalisations of the banks, it was possible to reduce the problem substantially. Offi cial Chinese data reveal that for 1995 the non-performing loans of the »Big Four« amounted to 21.4 per cent. After that it increased gradually until 2000 to 29.2 per cent. In 2001, it was reduced to 25.4 per cent and by the end 14 Nitsch/Diebel (2008) called this allocation mechanism »Guanxi Economics«. 86 Intervention. European Journal of Economics and Economic Policies of 2007 it was only 6.17 per cent (China Banking Regulation Commission 2008).15 Th ese fi gures may not divulge the full extent of the problem, but they show that the problem is under control. And we should not forget that – to a large extent – non-performing loans present quasi fi scal defi cits, as banks took over government functions to fi nance the social safety-net in SOEs, especially in the 1990s. Lastly, non-performing loans are denominated in domestic currency. Th is stands in sharp contrast to many over-indebted developing countries, where debts are held in foreign currency. In 1998, the credit plan was offi cially abandoned, with the aim of a more market-based credit allocation. Banks were forced to act more like normal banks in market economies, and the private sector became a more important customer for the banks. In addition, the capacity of local governments to infl uence credit allocation was reduced. Th e PBoC, for example, abolished 31 provincial branches and established nine regional branches with a higher degree of independence from local governments (Cao 2001). However, the transition process in China is gradual, and the process varies in diff erent provinces and counties. Local governments still maintain substantial control over credit allocation. Also, for good reasons the PBoC is still not using the interest rate as the main tool to carry out monetary policy. Credit volumes of the »Big Four« are controlled indirectly and where needed, directly. However, compared with the decades before, the power to prevent credit expansion going to asset markets like the real estate market has been eroding. Th is means that the danger of asset price bubbles in China increased. Th e quantitative dimension of the informal credit market in China is not completely clear. However, it seems evident that the informal credit market supported Chinese dynamics as it delivered fi nance to fi rms which were excluded from the formal credit market. 5. Conclusion Th e secret of Chinese success seems to rest on a productive combination of government interaction and market forces. China has managed to create a sustainable Schumpeterian- Keynesian credit-investment-income-creation process which has led to economic prosperity. Th is process was domestically driven by political credit expansion and allocation, and by a dynamic private sector including foreign enterprises. Th e expansion process has been externally protected by strict capital controls, and a policy of avoiding current account deficits, high foreign debt and high dollarisation. Th e typically distortion of domestic fi nancial systems within developing countries – with chronic capital fl ight and dollarisation, in addition to a chronic lack of long-term and cheap fi nancial funds for almost all enterprises – cannot be found in China. 15 In 2004 the relation of domestic credit to GDP in China was 166.9 per cent. Th e drastic reduction of the ratio to 120 per cent in 2005 refl ects that balance sheets were cleared of non-performing loans (World Bank 2006 and 2007). Hansjörg Herr: Credit expansion and development 87 Th e Chinese development model was very much shaped by the transition process from a planned economy to a market economy, and the gradual process which characterised the transition. In the meantime, the transition is over and China has become a capitalist country. However, its capitalist model is a specifi c one, and a version of the Asian type of capitalism which was so successful in Japan and many other countries after World War II. It is important to stress this point to avoid interpreting the dynamic of the Chinese economy as being due to the transition, which will be over as soon as the transition is over. It is not clear how China will develop in future. At least up until the subprime crisis – which hit the world after 2007 – it looked as if the Chinese elite had the intention of establishing a US-type of liberal market capitalism in the long run. Th is may have changed after the subprime crisis, and China is probably now searching for ways to further develop its own unique variety of capitalism. China could then become an important player in the search for new successful development models, together with other developing or emerging markets like India or Brazil. Other developing countries can learn from China. Of course, certain Chinese institutions of credit allocation might be diffi cult to copy – or may not be desirable. Also, some dimensions of Chinese development – the unequal income distribution, the ecological problems or the extreme current account surpluses after 2003 – are negative and unnecessary. Development in China would have been possible without such negative development. And it is imperative for every country to look for their own solutions, as one approach never fi ts all. However, China is an excellent example of the success of a domestically based fi nancial system protected from the world market, serving the enterprise sector and supporting high economic growth. At the same time China did not follow a strategy to isolate itself from the world market. Certain types of capital fl ows, especially FDI, were allowed and even stimulated. China quickly has become an important player in the international division of labour. Export promotion and competition in international markets has been the main strategy in this area, and not import substitution which in many cases protect the weak and do not support strong enterprises. China also teaches us that a policy which does not focus on a static concept of optimal allocation – in the tradition of neoclassical thinking – can be extremely successful. Chinese policies to stimulate growth may not look acceptable through a neoclassical lens, but they have been successful in fi nancing and supporting animal spirits and entrepreneurship in the private and public enterprise sectors. A Martian looking down on earth would be very surprised by world famous institutions like the International Monetary Fund and the World Bank, employing as they do so many experts who have not recommended the Chinese development model (Rodrik 2005). 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