This note surveys the overall problems facing the financial system. While the financial system has taken on many of the attributes of a market-based system the degree of state intervention remains very high by international comparison. The effectiveness of the reform largely depends on how well it performs three basic tasks: 1) to mobilise national savings; 2) to allocate credit to its most efficient uses; and 3) to encourage efficient resource utilisation in the real economy. China has done very well by the first measure, with high levels of accounts in banks and high stock market capitalisation. The reform has been less effective in allocating credit to the most efficient uses. More than 90% of funds go to SOEs, which are among the least efficient sectors of the economy. The sectors that have provided the greatest stimulus to growth in the past two decades, (agriculture, SMEs and private sector) have been locked out. Likewise the reform has not encouraged efficient resource utilisation in productive sectors of the economy. Problems of credit misallocation and weak balance sheets in the banking system are identified. The paper then highlights specific measures that need to be taken to improve the operation of banks as effective market-based credit intermediaries in line with international standards and practices. A brief summary of the problems of the capital markets, with recommendations for reform, is also presented.
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