Fixing China's Financial System

China's growth spurt over the past two decades is a marvel. Rapid development has lifted millions of Chinese out of poverty while stoking the economies of China's trading partners in East Asia and around the world. But China faces a crisis because its bullet train of an economy is running on the rails of a primitive, often corrupt financial system. There are no market mechanisms in place to prevent runaway overinvestment and the misallocation of capital. Stock and bond markets are untrustworthy. Government banks that supply most of the nation's credit direct it to well-connected party officials and others who know how to work the system.

Overinvestment in such sectors as steel, cement, autos, and residential real estate is rampant. Huge bailouts of the banks by Beijing are going to waste because as soon as the old bad loans are taken off their books, the banks go out and make what may well become new bad loans.

These aren't easy problems to fix. Decades of Communist rule have resulted in an entrenched bureaucratic class that benefits from cronyism and outright corruption. And inefficient state-owned enterprises can't be shut down abruptly because they employ tens of millions of people.

Fortunately, China's leaders understand the challenges. President Hu Jintao, Premier Wen Jiabao, and People's Bank of China Governor Zhou Xiaochuan are well-informed and capable reformers.

For starters, China's leaders intend to restructure the banks so that their interest rates are set by market forces instead of fiat. Freely floating rates will help curb the economy-wide overinvestment that occurs when rates are too low.

Beyond that, they want the banks to assess borrowers on the basis of profit potential, not politics or personal gain. Doing so will direct credit toward the dynamic new companies that are China's future. Properly functioning stock and bond markets will help as well.

In the meantime, though, China is in danger of overheating. So as a stopgap, Beijing will need to resort to old-style command and control -- and impose stern penalties on those who persist in imprudent lending. The reward for the banks that whip themselves into shape will be the opportunity to list their shares on Western stock exchanges.

China also may need to revalue its currency, which is pegged to the dollar. A modestly stronger yuan could help tame inflation by lowering the cost of oil and other essential imported commodities.

This is a crucial moment in China's transition to a market economy. With wisdom and political fortitude, the nation's leaders can keep the economic miracle alive.

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