The Chinese banking system has improved significantly over the past decade, but in one critical respect, it appears to have regressed. The People's Bank of China controls interest rates in a way that has led to significant financial repression--low and now negative real return on deposits--as inflation has risen in recent years. This distorted interest rate structure is a significant obstacle to further reform of the financial system and to sustaining China's rapid economic growth. Financial repression costs Chinese households about 255 billion renminbi (US$36 billion), 4.1 percent of China's GDP, and a fifth of it goes to corporations, one-quarter to banks, and the government assumes the rest. Financial repression reduces the cost to the government of sterilized intervention to sustain China's undervalued exchange rate relative to the cost it would face if interest rates were liberalized. But the financial repression that facilitates an undervalued exchange rate imposes substantial, if partially hidden, costs on China's economy. It has led to lending rates that are far too low, resulting in excess demand for bank loans and increased use of quantitative targets to control credit growth. These have led to a less efficient allocation of capital through the banking system and to a huge underground financial market. Financial repression is also contrary to the government's long-term goal of developing a commercial banking system. It has also depressed the growth of household income, undermining the government's goal of transitioning to a growth path that relies less on investment and net exports and more on domestic consumption. Finally, financial repression seriously hinders the development of a fully and efficiently functioning capital market.
