China's Financial System and Economic Imbalances

In this paper, we study how the financial market frictions in the Chinese economy, especially the interest rate policies, lead to inefficient resource allocations and economic imbalances. First, the repressed low interest rate for household savings induce them to increase saving in order to prepare for future necessary expenditures. Consequently consumption share is low and the economic imbalance of consumption and saving emerges. Second, the government provides explicit or implicit guarantees for state firms, so banks prefer to lend to state firms which are less productive. Private firms get less financial resource and operate at sub-optimal levels. The lower aggregate productivity implies the lower household income and consumption and worsen the imbalance. Due to the financial market frictions, traditional consumption stimulating policies, e.g., reducing the interest rate, may actually results in the opposite: even lower consumption and a more imbalanced economy. Reforms towards market-determined interest rates can help to rebalance the economy.