Commentary

A New Financial Architecture for China

The Asian financial crisis has provided a wake-up call for China. The lesson of that crisis has been that pegged exchange rates and crony capitalism are a recipe for disaster. So far Beijing has escaped a financial meltdown, but unless firm steps are taken now to move toward a new financial architecture - based on the market rather than the plan - China’s financial future will be bleak.

Capital controls have shielded the People’s Republic of China from the discipline of global market forces. Beijing has therefore not had to take the hard steps necessary to place the financial system on a sound footing. Although the Guongdong International Trust and Investment Company (GITIC) was allowed to go bankrupt, imposing loses on foreign investors, hard-liners are opposed to privatization of state-owned enterprises (SOEs). China’s goal is to “recapitalize” state banks and financial firms, not privatize them. Setting up asset management companies and allowing debt-for-equity swaps, however, will not do much good if the state continues to hold majority ownership and to control the flow of investment funds. What needs to be done is to take assets out of the hands of politicians and put them into the hands of the people. What China needs is not more planning but more markets and more freedom. The writing is on the wall: several of China’s largest state-owned commercial banks are technically insolvent, nonperforming loans may be as much as 40 percent of all bank loans, and corruption is endemic. At the heart of the problem is the primacy of state ownership. Although the Chinese Constitution now recognizes the importance of the nonstate sector, including private businesses, the Communist Party of China (CPC) has not deviated, in principle, from the Marxist-Leninist ideal of government control of the means of production.

Since the CPC allocates the bulk of investment funds to state-owned enterprises (SOEs), the nonstate sector, which now accounts for over 70 percent of industrial output value, is being cut off from additional funds. With the Chinese people saving almost 40 percent of their income, there is ample capital for private development - but only if competition with the state-owned banks (SOBs) is allowed.

If individual savers were given private investment alternatives earning market rates of interest, the nonstate sector would put funds to higher-valued uses than under the present state-run financial system. For China to become a world-class financial center, Beijing must give up the last vestige of Soviet-style central planning and move to a real capital market - one driven by the search for profit rather than party politics. Such a change, however, requires the privatization of banks, nonbank financial firms, and SOEs - or at least the open growth of the non-state sector in all those areas and the removal of barriers to foreign ownership and competition. As economists Dwight Perkins and Wing Thye Woo point out, “The government needs to fundamentally restructure the banks and to create an environment in which responsible nonbank institutions can thrive.” In particular, “The urgent problem is to allow the legalized private financial sector to establish itself adequately so that private sector investment can begin to take over as the engine of growth.” It is unlikely that the CPC will allow such radical changes to occur any time soon. The reason is obvious: doing so would undermine the power and principles of the party. Yet, the CPC faces a dilemma - if it does nothing to advance private ownership, the economy will become increasingly inefficient and growth will slow, which will weaken the party; but if the CPC allows liberalization, the people will prosper and most likely demand political reform. In either case, the future of the party is in jeopardy. That is why hard-liners are so nervous.

The PRC has taken some small steps toward opening its financial sector to competition. In April, Premier Zhu Rongji offered to allow foreign investors the opportunity to engage in full-service retail banking operations over the next several years, provided they take on a Chinese partner and hold no more than 50 percent of the equity. More recently, Beijing announced that foreign firms will be allowed to list their shares on the mainland’s stock exchanges. Infusing foreign capital into the nonstate financial sector will help grow that sector and ease the transition to a fully private banking and financial system.

The sooner the PRC rids itself of the ossified state investment planning apparatus, the faster it will set the basis for sound growth and prosperity. The United States can help by supporting China’s accession to the World Trade Organization and granting it permanent normal trading status. But, in the end, China must free itself of the deadweight of SOEs and SOBs and move to the market, or suffer the consequences.

James A. Dorn is a China specialist at the Cato Institute in Washington, D.C.