China's transition to a market-based economy over the past quarter century has unleashed unprecedented economic growth, and the country's financial system had to develop fast to support that metamorphosis. But the transition hasn't been even, nor is it complete. Social tensions are rising, particularly in rural areas, where some people feel left behind by China's voyage to prosperity.

Over the past year, the country's leaders have made reducing the disparities among economic classes and pursuing balanced growth high priorities. But China must further develop and reform its financial system to achieve these goals, according to a new study from the McKinsey Global Institute (MGI). The full report, Putting China's Capital to Work: The Value of Financial System Reform, along with an interactive exhibit are available free of charge online. This research shows that China could not only raise its GDP by as much as 17 percent, or $320 billion a year, but also distribute its new wealth more evenly.

The chief tasks of any financial system are to attract savings and channel them to productive investments as efficiently as possible. China's financial system already does an outstanding job of mobilizing savings, but it could considerably improve its overall efficiency and allocation of capital. The system's main shortcoming is that it directs a relatively small share of the country's savings to the economy's most productive enterprises. The most obvious effect is the huge amount of money—more than $100 billion so far and at least that much again going forward—the government has spent and will spend in the future to reduce the level of nonperforming loans. This practice of lending freely to many poorly performing, mostly state-owned enterprises (SOEs) costs China's economy far more, however—even if these loans never turn bad.

Reforms that channeled more funds to private companies—the engine of growth in China's economy—would generate a significantly higher return for the same amount of investment, raising China's GDP by up to $259 billion, or 13 percent, a year. Such reforms would also give Chinese savers appreciably higher returns and thus raise living standards and possibly consumption throughout the country.

The potential benefits of raising the financial system's operating efficiency are also substantial. Steps such as making China's banks as efficient as those in other emerging markets, moving from paper-based payments to an electronic system, and diversifying the sources of funding available to companies could save the economy $62 billion a year, or 3.2 percent of GDP (Exhibit 1)—an amount that is almost equal to the total foreign direct investment that China receives annually.

China's regulators understandably fear that shifting funds to more productive borrowers could accelerate the pace of layoffs in the less productive SOEs and therefore cause more social unrest. But this reallocation will create massive numbers of jobs in the strongest areas of China's economy and increase tax revenues to support social programs. Indeed, by prompting rapid economic growth that is both more fairly and evenly distributed, accelerating the move to a fully market-based financial system will relieve rather than exacerbate social tensions in the long run.

Financing the most productive enterprises

Over the past ten years, private companies in China—domestic, foreign owned, and joint ventures—have grown more quickly than the country's GDP. They now account for more than half of all output and for many new jobs. Meanwhile, the share of production from SOEs has shrunk to barely one-quarter of GDP. Although many such companies have been restructured, and some are highly profitable, their productivity as a group is still half that of private companies, both in the aggregate and by industry (Exhibit 2).

Despite these trends, wholly and partially state-owned enterprises continue to receive most of the funding from the financial system (Exhibit 3). Private companies have received just 27 percent of all loan balances. Many of them must turn to China's large informal lending market, with around $100 billion in assets but higher interest rates as well.

This pattern of lending not only explains the large volume of nonperforming loans in China's banking system but also decreases the economy's overall productivity. As a result, China's investment efficiency is declining. During the first half of the 1990s, $3.30 of investment was needed to produce $1.00 of GDP growth. Since 2001, however, each $1.00 of growth has required $4.90 of new investment—40 percent more than the amount required in South Korea or Japan during their higher-growth periods.

China's productivity would rise greatly if a larger share of the funding went to private enterprises. Less productive SOEs would either have to improve their operations to attract financing or shut down. Over time this approach would close the productivity gap between state-owned and private companies and raise China's GDP by as much as 13 percent annually.¹

Chinese households will benefit as better capital allocation raises returns on savings. China's citizens save a lot by international standards—on average, from 20 to 25 percent of their disposable income.² Most of their financial assets—86 percent—are held in bank deposits or in cash. Given the low average returns and the volatility of equities and bonds over the past decade, bank deposits have been a rational investment choice.

Yet the combination of poor capital allocation by banks and the comparatively high cost of financial intermediation means that returns on bank deposits have been dismal. Over the past ten years, Chinese households have earned just 0.5 percent a year on their savings after inflation. In contrast, households in South Korea earned 1.8 percent on their financial assets during the same period. If real returns on savings in China doubled, to 1 percent, households there would gain $10 billion annually—and at South Korea's current level of returns they would gain $25 billion annually. In this way, Chinese households could afford to save less and consume more.

Despite the clear benefits of a better capital allocation, China's regulators have resisted such changes in order to preserve jobs. But developing a market-based financial system is a more attractive way to achieve and sustain higher overall employment in the long term from both an economic and a social standpoint. Although jobs will be lost at the SOEs that can't compete for financing in the open market, the burgeoning private sector will create many new jobs. Net losses are likely to be negligible even in the short to medium term. The experience of China's auto industry, which is now being liberalized, supports this assertion: restructured SOEs have shed many jobs, but total employment in the industry has increased.

Moreover, we estimate that the boost in GDP from a more efficient capital allocation will raise the government's tax revenues by 13 percent, without any increase in rates. The state could draw on these funds to support and retrain displaced workers rather than use the financial system to support social-welfare goals.

Improving the financial system's efficiency

The state's understandable concerns about economic and social problems only partially explain why China's financial system continues to allocate capital to many underperforming companies. Other important factors include the banking sector's inefficient operations and China's relatively immature debt and equity markets. Such problems not only skew the allocation of capital but also raise operating costs.

Since none of China's financial institutions even existed 25 years ago, their performance can't be expected to match that of their counterparts in mature economies. But if these Chinese institutions could measure up to systems in other emerging markets, such as Malaysia and South Korea, we estimate that China's GDP would increase by a total of $62 billion a year, with most of the savings accruing to households and companies. Greater efficiency would also improve the country's capital allocation, since the root causes of both problems are largely the same.

The banking sector

Despite improvements in recent years, China's banks continue to suffer from operational weaknesses.³ They gather only sketchy information on their borrowers' credit histories and financial performance, and independent credit-rating agencies offer only limited coverage. Despite recent efforts to improve, loan officers in many branches have rudimentary loan-pricing and risk-management skills and thus tend to be highly risk averse. When rating loan prospects, banks therefore favor SOEs—even poorly performing ones—given their scale and the government's ownership. There may also be local political pressure for banks to grant loans to enterprises that are still the largest local employers in many regions: China's huge banks—some have 20,000 branches—are decentralized and have loose governance systems, leaving some branches susceptible to lobbying by local businesses.

The dominance of banks in China's financial system amplifies the impact of this poor capital allocation. In market economies, the share of bank deposits as a proportion of total financial assets typically ranges from less than 20 percent in developed countries to about half in emerging markets. In China, banks intermediate almost 75 percent of the economy's capital—more than 1.5 times the level in most other economies (Exhibit 4). At the end of 2004, deposits with financial institutions—roughly half from households—totaled $2.6 trillion.

An inefficient banking sector also raises operating costs. A bank's main source of revenue is the spread between its average borrowing and lending rates, particularly in China, where fee-based income is low. With a spread of 3.3 percent, the country's banking system appears to be about as efficient as more mature systems: the average net interest margin for our benchmark countries—Chile, Malaysia, Singapore, South Korea, and the United States—is 3.1 percent. In reality, however, Chinese banks have needed roughly $215 billion⁴ in government money to recapitalize their balance sheets since the late 1990s. Once you add these funds to the banks' net interest margin, the true cost of intermediation in China's banking sector rises to 4.5 percent. In other words, Chinese banks require $25 billion more in annual revenues than do banks in our benchmark countries to carry at the same amount of lending. Raising the efficiency of Chinese banks to the benchmark level would eliminate this added cost. Further, banks would gain the ability to lend more money to smaller private businesses, thereby saving these companies the premium they now pay to borrow on the informal market—worth an additional $2 billion a year, by our estimates.

Payment system

The creation of the fully electronic China National Advanced Payment System could greatly reduce the cost of payment transactions throughout the economy. But the system's impact to date has been limited because many smaller local banks, and even some autonomous bank branches of the larger ones, have resisted investing the capital they need to connect to the system. Moreover, most retail payments still take the form of cash. Promoting the more widespread adoption of electronic payments would not only generate $20 billion in savings each year but also help the government by reducing tax evasion. This prize is sufficiently large to justify offering incentives to persuade retailers, consumers, and banks to make payments electronically.

Debt and equity markets

China's equity and bond markets are among the world's smallest (Exhibit 5). The capitalization of the equity markets is equivalent to just 33 percent of GDP, compared with 60 percent or more in other emerging markets. Excluding nontradable state-owned "legal-person" shares, the market capitalization of Chinese companies falls to just 17 percent of GDP. Meanwhile, the corporate-bond market is equivalent to just 13 percent of GDP (and nonfinancial companies issued only 1 percent of these bonds), against an average of 50 percent in other emerging markets.

Moreover, China's small capital markets are used almost exclusively by SOEs to raise money. Until a few years ago, state regulators selected companies for IPOs in line with the government's industrial policies, a practice the regulators still follow for bond issues. The criteria for equity listings have since become more independent, but government regulators still retain a great deal of discretion over which companies enter the market. So far, private investors have held a majority of the shares in very few companies when they initially listed, though some were privatized subsequently.⁵

Chinese companies need more fully developed capital markets to give banks competition as well as to provide companies with a better selection of financing vehicles. In our benchmark countries, companies borrow roughly 60 percent of their debt from bond markets and 40 percent from banks. In China, however, bonds account for just 1 percent of corporate debt, informal loans for 4 percent, and bank loans for an overwhelming 95 percent. If China developed a vibrant corporate-bond market and moved to the mix of bonds and bank loans prevailing in our benchmark countries, Chinese companies would lower their cost of capital by $14 billion a year.

Meanwhile, more efficient equity markets would reduce the cost of issuing and trading shares by $1.5 billion, even with today's small volumes. Chinese households would benefit from the reform of both bond and equity markets because flourishing capital markets will then underpin the development of financial products—such as mutual funds, pension funds, and insurance—that could offer more attractive investment options than bank deposits.

Priorities for reforming the financial system

The current shortcomings of China's financial system are rooted in the relationships among its components—banks, bond and equity markets, the payment system, and institutional investors. For this reason, China's regulators must implement a coordinated, systemwide program of reforms (rather than market-by-market adjustments) to improve the allocation of capital and increase the system's overall efficiency.

China needs a vibrant corporate-bond market, for example, to provide funding for large companies and infrastructure projects and to spur banks to allocate more lending to smaller companies and consumers. But the bond market probably won't flourish until banks develop more accurate, risk-based loan pricing. They will then be able to charge higher rates to borrowers and extend their lending to more productive companies and consumers. In addition, the number of domestic institutional investors must rise more quickly, since few retail investors anywhere buy corporate bonds directly. All these relationships are interconnected, so financial intermediaries, capital markets, and the banking sector will have to evolve together (see sidebar, "A reform agenda for China's financial system").

The four main regulatory bodies that oversee China's financial markets⁶ are already pursuing many essential reforms. But to realize the full potential benefits of systemwide improvements in efficiency and capital allocation, additional reforms should be implemented at the same time.

Measures to increase competition in the banking sector will play a critical role by giving institutions the impetus they need to upgrade their lending skills, management, IT systems, and governance. China's regulators have taken some steps to prepare for new competition from foreign banks, which will enter the domestic currency market in December 2006. But even the foreign banks already in China have relatively few branches—a problem that will limit their immediate impact on competition—and it will take them considerable time to grow organically. Regulators should therefore allow more private domestic banks to enter the market and relax the restrictions on foreign ownership of such banks ahead of the current schedule. They should also promote transparency by raising the sector's requirements for governance, financial reporting, and auditing.

In a more competitive environment, banks will probably lose their largest corporate customers to the capital markets and therefore have to focus on small and midsize private enterprises and on consumers. But to lend successfully to these segments, banks must assess the credit quality and risks of the borrower accurately, so they need the services of an independent consumer credit-rating bureau.⁷ To help develop a network of such bureaus—for both consumer and business lending—regulators should encourage investment in the necessary infrastructure and give all lenders and utilities incentives to report the borrowers' payment histories. To increase the number of loans to creditworthy smaller enterprises, regulators should also ease the current strict collateral rules and allow banks to accept assets other than real estate.

China's corporate-bond market has developed slowly, in large part because of overly restrictive regulations. To speed up its expansion, regulators should abolish preferential access for policy banks,⁸ allow more private companies to issue bonds, shorten the approval process to a week (the maximum in most Southeast Asian countries) from the 14 to 17 months it now takes, and abolish limits on the interest rates of corporate bonds. They should also encourage the expansion of sophisticated corporate credit-rating agencies, such as Moody's Investors Service and Standard & Poor's.

Excessive regulation holds back institutional investors as well. Regulators should therefore consider easing the restrictions on the types of investments that domestic intermediaries can make and adopt more favorable tax laws for these investments. In addition, domestic intermediaries should get permission to invest some of their assets abroad to improve returns for Chinese households, which should also be offered investment guidance and financial-planning services.

China's equity markets are effectively open only to SOEs. To help private companies and small businesses choose equity capital as a source of finance, the regulations should be changed so that more private companies that qualify for IPOs can list on China's stock exchanges, in Hong Kong, Shanghai, and Shenzhen. And to further the common progress of all the exchanges and improve the operation of the mainland's equity markets, regulators should work out clear roles for each of the exchanges.

Last, China should consider taking staged moves to modify the strict capital controls that prevent its people from investing in foreign financial markets and thus earning higher returns. These controls also protect China's banks and capital markets from competition that would spur their development. As a first step toward converting capital accounts, regulators should gradually allow domestic intermediaries to invest in some assets in Hong Kong. Over the longer term, they should consider removing more restrictions on investments abroad.

Integrating all these reforms will require coordination among China's regulatory bodies. The government has already started to consider the possibility of creating one commission to oversee the reforms—an idea that has considerable merit. Alternatively, the government might appoint a single commissioner to encourage cooperation among agencies and ensure that each of them has a reform agenda that meets the broader goal of developing the financial system.

Understandably, China's leaders want the country to make the transition to a market economy in a way that avoids the social disruption that mass layoffs by declining SOEs could cause. So far, the uninterrupted flow of financing from the country's banks has been essential in fulfilling this aim. But the faster China's modern economy develops, the more the government will be able to separate its social goals from the operations of the financial system. A more market-oriented approach will spur efficiency and create more wealth and jobs. Higher tax revenues will then help the government finance social programs directly rather than through the financial system. At the same time, efficiency gains will translate into higher returns for savers and lower costs for borrowers. The far-reaching reform of the financial system should be one of the government's highest priorities.