China’s Financial Future

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The dismal state of China's financial system threatens future growth and stability. Non-performing loans are mushrooming and may now be as much as 40 percent of all loans; the four large state commercial banks are close to or at the stage of insolvency; interest rates are still determined by government fiat rather than market forces; and corruption fills the air. China's financial architecture desperately needs upgrading. At the heart of that process must be a move toward establishing a real private, competitive capital market--one in which profit-seeking entrepreneurs are the driving force, not government bureaucrats.

Reform in the financial sector should follow the track of the industrialsector. Since 1978, Beijing has allowed the non-state sector to competewith state-owned enterprises (SOEs). The result has been a dramaticshrinkage in the relative importance of SOEs, which now account for lessthan 30 percent of output. Market competition is eroding the power of thestate to the betterment of the Chinese consumer and wage earner--and in theprocess increasing freedom of choice.

Individuals save nearly 40 percent of their incomes in the People'sRepublic of China but receive artificially low returns because of the lackof investment alternatives and because of the ceiling on the rate ofinterest state-owned banks (SOBs) have to pay on their deposits. Capitalcontrols further weaken property rights in holding renminbi.

What China needs is a dose of market liberalism, not more financialmorphine in the form of government bailouts of insolvent SOBs. Ultimately,the only way for China to build a strong financial architecture is to allowprivate 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 withkerosene. The state needs to be taken out of the financial sector, not pumpmore money in. It is better to recognize the costs of poor past performanceand to restructure banks than to give SOBs fresh funds to once again lendto 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 thatinvestment decisions are first and foremost political decisions. This lastvestige of Soviet-style central planning may keep the Party in power in theshort run but eventually will be its death warrant.

The deepening dilemma for the CPC is that if the massive misallocation ofcapital continues, growth will slow and there will be a political andeconomic crisis. But if the Party does move toward privatization, theshort-term effect would be large unemployment and the long-run effect wouldbe to put the Party out of power. In either case--maintaining the statusquo or letting private capital markets emerge--the future of the Party isbleak.

Further economic liberalization eventually will require politicalliberalization. Although the National People's Congress, at its Marchmeeting, amended the Constitution to allow for recognition of theimportance 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 marketsso that the Chinese people and foreign investors can have greater freedomin 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 Chinawants to become a major player in the global marketplace, the renminbi willeventually have to be fully convertible, and the primacy of state ownershipwill have to give way to a system of well-defined private property rightsenforced by law.

The sooner Beijing moves toward the market, the less costly that transitionwill be. The U.S. can help China by supporting its accession to the WorldTrade Organization and by granting it permanent normal trading status.Premier Zhu Rongji's offer to open up retail banking to foreign firms overthe next several years and to allow them to hold up to a 50 percent equitystake in joint-venture banks are steps in the right direction, as isBeijing's recent decision to allow foreign firms to list their shares onthe mainland's stock markets. Infusing foreign capital into the non-statefinancial sector would help grow that sector and ease the transition to afully private banking and financial sector.

China's future is with the market, not the plan. It is time for Beijing torecognize that truth and to free the Chinese people from the bondage ofstate ownership and let them experience the exhilaration of being their ownmasters. As Fan Gang, an economist with the China Reform Foundation, hasstated, "The banking sector must be allowed to extend far more credit tothe private sector, particularly in light of its importance to the economy.Private banking should be allowed and the capital markets opened to privatefirms. China's basic institutional or structural reforms must be continued,despite certain adverse consequences."