Bank Reform Is Crucial For China

China's effort to engineer a soft landing for its overheated economy is slowing growth much more than planned. The growth rate may actually be as low as 7%, below official statistics and lower than last year's rate of 10.2%. Exports are off, and, most worrisome politically, unemployment is rising in the huge state enterprise sector, which still comprises half the economy. In the past, these workers found jobs in the burgeoning private sector. Not now.

China's banking system has finally begun to charge market rates to uncompetitive state enterprises, but it is also squashing the thriving private sector. The decision to base credit policy on risk rather than politics is an important break with the past, but it is imperative for China to go further. Reforming its financial system is the key to the delicate task of shrinking the state sector while expanding private industry. China needs more sophisticated financial tools to do the job of moving its vast working population into the market economy.

To make do with what they have, Chinese banks are using a variety of techniques to address the issue of risk in lending to state enterprises. Some are borrowing at low rates from other state banks and relending at higher rates to public-sector businesses. Others are lending at very short maturities and, when repayment isn't forthcoming, are adding penalties that hike the cost of borrowing.

But these are still cumbersome techniques at best. What China needs is a market-based system of banking that can differentiate risks on a broad scale. It should be able to tighten credit policy to combat inflation while still providing some liquidity to the more competitive sectors of the economy. With next year's pivotal Party Congress approaching, the last thing the political leadership needs is a wave of joblessness destabilizing the country.