Ebook Interest Rate Liberalisation in China and the Implications for Non-State Banking
China has taken a cautious approach to financial market liberalisation, adopting to delay major reforms until after the liberalisation of goods and other factor markets was complete. While the reform program may be following the generally preferred sequence, evidence suggests that the financial sector is lagging well behind other parts of the economy. A modern, well-functioning financial system is an essential part of a market economy, and China has come to the stage where further financial market reform is critical to its ability to achieve greater structural change in the economy.
Banking rather than capital market reform is most pressing at this stage, as capital markets are relatively small. One of the main issues on the agenda is the need to liberalise interest rates to remove the price distortions that exist in the banking sector. China’s central bank, the People’s Bank of China, has recognised the importance of this task, but been cautious about the pace of reform.
The main barriers to liberalising interest rates have been a weak banking sector, which is weighed down with bad loans, and the lack of financial infrastructure, such as an effective supervisory system. Solving the non-performing loan problem is likely to require a major recapitalisation of the state-owned banks (SOBs) and state-owned enterprises (SOEs), which will take time. However, serious side effects have been created from the decision to maintain strict controls over the interest rate, and the pressure for change is now compelling.
Interest rate controls have served to maintain the market dominance of the state banks, which have long directed most of their lending to the state-owned enterprises. This practice has distorted the behaviour of lenders and borrowers and restricted competition among financial institutions. Non-state financial institutions have been slow to emerge, resulting in an inefficient use of funds and serious structural imbalances in the financial sector. Furthermore, there are ‘moral hazard’ problems that are likely to delay the deepening reform of the SOBs and SOEs.
Without a proper market mechanism that allows financial institutions to set prices according to the demand and supply of funds, banks and other financial institutions will not be efficient intermediators of funds. Only a small share of lending is available to the private sector, which is now the most dynamic part of the economy, contributing more to industrial output than the SOEs.
The mismatch between the lending and financing needs of the emerging private sector highlight the urgency of resolving the problems in the financial sector. Further reform, including interest rate liberalisation, will undoubtedly help channel funds to private firms, leading to more efficient investment decisions and consequently raising production and economic growth.
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