A customer reads a book on investment in the Wealth Management Section of the Wangfujing Bookstore in Beijing. Learning financial knowledge is crucial to enhancing financial literacy. Photo: CFP

Common prosperity is an essential requirement of socialism and an important feature of Chinese modernization. Household finance can play a significant role in steadily advancing Chinese modernization.

With the continuous rise of disposable income in Chinese households, residents have sufficient surplus capital to enter the financial market for asset allocation, in a bid to gain more property income. Through the optimization of income structures, the risks posed by having a single source of income will be mitigated. This also aligns with the requirements listed in the report to the 20th Communist Party of China National Congress, which stated: “exploring multiple avenues to enable the low- and middle-income groups to earn more from production factors, and increasing the property income of urban and rural residents through more channels.” The development of China’s financial market has also provided more options for households to meet their financing needs and make better intertemporal consumption and asset allocation decisions.

Household disparities

The financial system is intrinsically pro-cyclical, fragile, and external. Residents, as key participants in China’s financial market, vary remarkably in terms of educational levels, cognitive competence, and financial literacy. These vast disparities are most clearly seen in the two dimensions of equity and efficiency during activities of household finance.

First, residents vary in terms of their capital strength, financial expertise, as well as abilities in information retrieval, thinking, and perception. These differences result in different earnings from household finance ventures, eventually leading to financial inequity. Causes for inequity include: financial exclusion, credit constraints, uneven access to financial services, and imbalanced financial literacy. A main starting point to ensure financial equity is to adopt effective approaches, including inclusive finance, to prevent the further widening of the gap in individual capacities due to external factors like the use of financial leverage.

Efficiency disparities in household finance are the ultimate embodiment of financial inequity. When it comes to family asset allocation, excess returns per unit of risk in the two-dimensional “risk-return” framework are studied more frequently, which can reflect differences in abilities of resident investors, such as market insights and financial literacy.

With respect to loan financing, factors such as credit constraints, undesired income levels, and lack of financial guarantees will exclude some potential investors. Consequently, their reasonable financing request may not be met, making the households less financially efficient and further undermining financial equity. As China promotes common prosperity through high-quality economic development, it is imperative to discuss the logic of household finance and explore the underlying economic laws from the dimensions of equity and efficiency, thereby serving the overarching goal of common prosperity.

Financial inequity and inefficiency

Finance is at the core of the modern economy, and financial resources are fundamental for economic entities to meet their optimal goals. A main function of inclusive finance is to indiscriminately help all economic entities obtain financial resources and accelerate their development. It will contribute to the realization of common prosperity by optimizing income structures, reasonably distributing wealth, and boosting development efficiency.

To that end, we must first reduce the structural differences that pose barriers to financial inclusion. Movement of funds can be thought of as the flow of “blood” in the national economy, and epitomizes the concentration of financial resources among different sectors. As a crucial sector in the national economy, households circulate funds with other sectors mainly by participating in various trading activities.

The total scale of capital flow across different sectors indicates that the ratio of financial resources shared by the household sector has long been lower than those of financial institutions and non-financial enterprises, yet it is generally higher than the ratios for government departments and overseas sectors. Additionally, the ratio of the household sector has been growing steadily, suggesting that financial resources have benefited Chinese households to a relatively high degree.

However, the scale of net capital outflow shows that the household sector has been in a state of net capital outflow since 1992. In other words, the capital used by households always exceeds their capital inflow, which differs remarkably from financial institutions and non-financial enterprises, two sectors marked by high net capital inflow. This implies that despite households’ increasing financial engagements, the sector has always been a supplier, with insignificant absorption of outside funds.

From the perspective of households’ internal structure, financial inclusion also varies from one household to another: rural households, impoverished families, low-income families, and households composed predominantly of elders have seen meager benefits from inclusive finance; households’ participation in the regular credit market has been quite low, and the accessibility and quality of financial services needs to be improved.

It is also essential to enhance residents’ financial literacy. As mentioned above, credit constraints represent a visible threshold hindering financial inclusion of households, while inadequate financial literacy can be considered an invisible threshold. Financial literacy refers to a combination of individuals’ financial expertise and ability to make sense of market phenomena, requiring individuals to build up their competence through systematic learning of financial knowledge and investment practices in the financial market.

Moreover, the non-rationality of individuals makes financial literacy vulnerable to the manipulation and control of their non-rational states. Even if the financial market’s capital threshold is lowered and credit constraints are eased, a lack of professional qualities will still restrict the financial inclusion of households and the improvement of households’ asset allocation efficiency. In essence, financial literacy is a component of human capital, and it cannot be traded or hedged. Compared with material wealth gained from asset allocation in the financial market, financial literacy is more permanent and stable.

Today, as the level of financial development is being heightened continuously, financial literacy has increasingly become a key criterion for evaluating whether a person is qualified to participate in the financial market, and it directly determines a household’s earning power and ability to circumvent risks when making financial investments. Financial literacy will play a great role in increasing property income and optimizing households’ income structure, thus adding considerably to material wealth.

In light of the status quo, non-financial enterprises, financial institutions, and government sectors are all much more efficient in securities investment than households, specifically due to information asymmetry and the professionalization of financial literacy.

In terms of information asymmetry, compared with families that are bonded by marriage or blood, non-financial enterprises, financial institutions, and government sectors are all corporate organizations, endowed with a natural advantage in information retrieval and acquisition. Families or households are inevitably at the bottom of the information transmission chain. They face great difficulties in acquiring financial information. In addition to their long-term status as major suppliers of capital, households only reap limited earnings from asset allocation.

Financial literacy has become professionalized as the Chinese economy involves financial activities at increasingly higher levels. Economic sectors need more professional teams with advanced financial insights to handle financial investments. This means financial literacy is an exclusive production factor, essential to production within economic sectors like enterprises. Investment activities such as asset allocation in the securities market therewith become behaviors linked to professional factor combination, featuring economies of scale.

Going forward

Household finance activities can raise family incomes and wealth levels, and enhance the people’s sense of happiness. Furthermore, encouraging residents to expand their financial knowledge and upgrade their financial literacy will help improve equity and efficiency as China continues to modernize.

First, it is necessary to lower the bar for information acquisition and intensify the popularization of big data to strengthen residents’ financial literacy. Compared with institutional investors, resident investors are at a disadvantage when accessing information from the capital market. In addition to institutional investors’ closed-loop systems for information production and transmission, information monopolies are an important factor impeding household finance activities. It is impossible for residents to improve their fund allocation efficiency when they don’t have access to current information.

A top priority is to increase the breadth and depth of information’s benefit to residents. This can be accomplished by extending big data’s reach to the public, and enhancing product-oriented applications and services provided by big data amid the scenario orientation of financial transactions. At the same time, resident investors should advance their abilities to analyze and process data as well as their financial literacy.

Second, efforts should be made to reinforce the construction of social networks for households and increase social interactions between residents. Households with the consciousness of enhancing family asset allocation efficiency should strive to strengthen their capabilities of interacting with other residents, thereby constructing stronger social networks and upgrading their own social capital. Social interactions can facilitate residents to acquire information as they communicate and discuss directly, or observe other group members’ investment decision-making processes.

Information acquisition through interactions among residents can also be called “observatory learning” or “social learning,” and this approach can help raise resident investors’ expectations for financial market returns. Upgrades to social capital and enhanced social interactions among friends will lead to significant improvement in the efficiency of family asset allocation. As the digital economy continues its rapid development, the construction of social networks by means of digital inclusive finance and the extension of households’ social capital by enlarging the social networks and increasing the networks’ strength will intensify residents’ information acquisition abilities.

Zhou Hong is a professor from the School of Finance at Anhui University of Finance and Economics.