China's Antiquated Financial System: The Creaking Grows Louder Nelson Ching / Bloomberg via Getty Images Pedestrians walk past the People's Bank of China in Beijing, China, Dec. 23, 2011. In April, Chinese Premier Wen Jiabao took aim at China's powerful state-owned banks. According to Reuters, he said at a discussion with local businesses: "Frankly, our banks make profits far too easily. Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital. That's why right now, as we're dealing with the issue of getting private capital into the finance sector, essentially, that means we have to break up their monopoly. Wen's attack on China's big banks, followed two weeks later by the Chinese central bank's move to widen the renminbi-to-dollar trading range from 0.5% to 1%, raises the question of whether China is about to accelerate bank and financial system reforms. Against the backdrop of the spectacular fall of Chongqing Communist Party boss Bo Xilai, who upheld the heavy hand of the state-owned enterprises in the economy, and the dramatic escape of political prisoner Chen Guangcheng, are liberal reformers now gaining momentum as China undergoes its next leadership transition this fall? Experts say further financial liberalization is in the cards, as both domestic and external pressures mount. "The fall of Bo Xilai pushes up reform forces in the Chinese party, government and society, and that's a good sign," says Hoest Loechel, professor at Frankfurt School of Finance and Management in Germany and a visiting professor at the China Europe International Business School (CEIBS) in Shanghai. Pieter Bottelier, senior adjunct professor at the Johns Hopkins University School of Advanced International Studies (SAIS) and former World Bank chief of resident mission in Beijing, predicts: "Liberalization of bank interest rates could come very soon, by the end of the year, linked to further internationalization of the renminbi (RMB)." He notes that the People's Bank of China (PBOC) says the time is right for China to open its capital account in phases, starting over the next three years, transitioning to full financial liberalization in five to 10 years. (MORE: China's Yesterday's News. Who are the Next High-growth Superstars?) To date, the state-dominated financial sector has funded the extraordinary growth in China's real economy, averaging 10% a year over the last 30 years. "The striking thing about China's reform model is that they have used the financial sector as a tool to achieve reform in the real economy," says Bottelier. But, says Gary Liu, deputy director of the China Europe International Business School's Lujiazui International Finance Research Center in Shanghai, this system can also end up holding back the domestic economy."Soon, this lag in financial sector reform will drag down growth in the real economy," especially as China aspires to transition from a low-wage, investment-led, manufactured export-based economy to a higher-margin, consumption-led, knowledge-based economy. "If you want innovation, one precondition is an efficient financial system," Liu notes. That's why the U.S. is so strong in innovation, because U.S. companies, at whatever stage of growth, can borrow money - from private equity, banks or the stock market. In China, many small- to medium-sized enterprises (SMEs) have to bribe government officials to get loans. Though China's top banks have acquired private shareholders via initial public offerings over the last decade, the government still controls bank deposit and lending rates, and maintains ownership stakes and considerable control of banks. The Big Five - the Bank of China, the Industrial and Commercial Bank of China, China Construction Bank, Bank of Communications and Agricultural Bank of China - together dominate the sector with a 50% market share of total assets, according to Loechel. Under China's controlled deposit and loan rates, banks receive a guaranteed spread of about three percentage points. In turn, the banks lend at favorable terms to state-owned enterprises, often for large infrastructure investments. About 90% of Chinese companies" financing comes from bank loans, according to the World Bank. Internal and External Pressures Meanwhile, ordinary household savers are on the short end of the stick. Factoring in inflation, they earn negative interest rates of about 2% from their deposits. With China's bank deposits totaling 80 billion RMB last year, that negative return amounts to $1.6 trillion RMB, notes Liu. Raising interest rates on household savings deposits would boost domestic consumption, drive growth and help alleviate social inequality. Household-funded nation building can work as long as the economy is growing. But it can foment discontent when the economy starts slowing, say experts. "This kind of financial system can generate tremendously high levels of economic activity because it forces the household sector to subsidize borrowing costs very heavily," says Michael Pettis, a professor at Peking University's Guanghua School of Management, specializing in the Chinese financial system. As long as growth rates are high and the investment is not being wasted, this system is sustainable and wealth generating, but ... once we shift into a phase where investment is being misallocated, the system tends to generate unsustainable levels of debt. Adds Wharton finance professor Franklin Allen: "The economy can keep growing at 7% to 8% per year by building infrastructure in Tier II and II cities, but China probably wants to start some reforms to make sure the economy doesn't fall any further when that infrastructure development is completed." Meanwhile, external pressures are building, too. The biggest driver is China's desire to internationalize its currency, says Allen. China must lessen its dependence on the U.S. dollar and euro, viewing both as becoming less reliable as a store of value for China's massive foreign reserves. To internationalize the RMB, "China needs to open up the capital account, and let money in and out more easily," Allen says. 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