Reform in the financial sector should follow the track of the industrial sector. Since 1978, Beijing has allowed the non-state sector to compete with state-owned enterprises (SOEs). The result has been a dramatic shrinkage in the relative importance of SOEs, which now account for less than 30 percent of output. Market competition is eroding the power of the state to the betterment of the Chinese consumer and wage earner—and in the process increasing freedom of choice.
Individuals save nearly 40 percent of their incomes in the People’s Republic of China but receive artificially low returns because of the lack of investment alternatives and because of the ceiling on the rate of interest state-owned banks (SOBs) have to pay on their deposits. Capital controls further weaken property rights in holding renminbi.
What China needs is a dose of market liberalism, not more financial morphine in the form of government bailouts of insolvent SOBs. Ultimately, the only way for China to build a strong financial architecture is to allow private ownership of capital and protect that right with the rule of law. Trying to re-capitalize SOBs is like trying to put out a fire with kerosene. The state needs to be taken out of the financial sector, not pump more money in. It is better to recognize the costs of poor past performance and to restructure banks than to give SOBs fresh funds to once again lend to SOEs. The problem, of course, is that the Communist Party of China (CPC) has no incentive to give up the primacy of state ownership.
The CPC’s control over state investment funds, SOBs, and SOEs means that investment decisions are first and foremost political decisions. This last vestige of Soviet-style central planning may keep the Party in power in the short run but eventually will be its death warrant.
The deepening dilemma for the CPC is that if the massive misallocation of capital continues, growth will slow and there will be a political and economic crisis. But if the Party does move toward privatization, the short-term effect would be large unemployment and the long-run effect would be to put the Party out of power. In either case—maintaining the status quo or letting private capital markets emerge—the future of the Party is bleak.
Further economic liberalization eventually will require political liberalization. Although the National People’s Congress, at its March meeting, amended the Constitution to allow for recognition of the importance of the non-state sector, that sector is being starved of funds, and private property rights have no secure protection under the law.
China’s financial future will depend on allowing more open capital markets so that the Chinese people and foreign investors can have greater freedom in their choice of investments and those investments can earn competitive, market-determined rates of return rather than government-mandated returns. Recapitalizing insolvent SOBs is not the answer; privatization is. If China wants to become a major player in the global marketplace, the renminbi will eventually have to be fully convertible, and the primacy of state ownership will have to give way to a system of well-defined private property rights enforced by law.
The sooner Beijing moves toward the market, the less costly that transition will be. The U.S. can help China by supporting its accession to the World Trade Organization and by granting it permanent normal trading status. Premier Zhu Rongji’s offer to open up retail banking to foreign firms over the next several years and to allow them to hold up to a 50 percent equity stake in joint-venture banks are steps in the right direction, as is Beijing’s recent decision to allow foreign firms to list their shares on the mainland’s stock markets. Infusing foreign capital into the non-state financial sector would help grow that sector and ease the transition to a fully private banking and financial sector.
China’s future is with the market, not the plan. It is time for Beijing to recognize that truth and to free the Chinese people from the bondage of state ownership and let them experience the exhilaration of being their own masters. As Fan Gang, an economist with the China Reform Foundation, has stated, “The banking sector must be allowed to extend far more credit to the private sector, particularly in light of its importance to the economy. Private banking should be allowed and the capital markets opened to private firms. China’s basic institutional or structural reforms must be continued, despite certain adverse consequences.”