The World Bank report, "China 2030: Building a Modern, Hamonious and Creative High-Income Society", which was released this week, stated that liberalizing interest rates according to market principles is a priority for China's financial reforms over the next two decades, highlighting the dilemma facing the government.

China's banking system remains a highly regulated sector; policymakers set the interest rates, not the market and most of the large State-owned banks tend to offer credit facilities only to large State-owned enterprises.

In principle, there is nothing wrong with this: the authorities try to macro control the economy with monetary tools such as interest rates, and the big banks are the main vehicles by which they can achieve their objectives.

However, the big banks' reluctance to lend loans to the small and medium-sized enterprises makes it difficult for smaller companies to obtain finance.

In this context, the development of so-called shadow banking should come as no surprise. With official interest rates so low, almost 10 basis points lower than GPD growth and the large banks restricting credit to large State-owned enterprises, it is natural that there should be a significant gap on the supply side for credit and it is just as natural for such a gap to be filled by informal lending institutions. These can take the form of family and friends, as was the case in Wenzhou, or the recently institutionalized micro-credit companies. Such shadow banking thrives on the fact that smaller businesses have no other option if they want to borrow, so high interest rates, of about 20 percent and sometimes more, are often put on the loans. This is considerably higher than the official 6.56 percent, however, there is nothing unusual or unfair in this. Any lending institution will offer credit with an interest rate commensurate with the risks of the borrowers. As the informal lending institutions are offering credit to smaller companies, often relatively new and just beginning to expand, the high lending rate simply reflects the higher degree of risk.

But the problem is, of course, that such informal institutions largely fall outside the regulatory eye of the China Banking Regulatory Commission and, therefore, any mobilization of customer deposits used in part to finance their lending operations are not monitored. To avoid the situation whereby the bankruptcy of a lending institution will affect individuals' savings, legalized micro-credit companies are not allowed by law to accept deposits. However, in the world of shadow banking, the protection of customer deposits remains a gray - actually, black- area.

So what can the government do to retain control of the country's development, while at the same time fostering the development of small and medium-sized enterprises?

There is no easy answer to shadow banking for a country that still needs to find its optimum development path. But one possibility would be to encourage all large banks to allocate a certain proportion of their loan portfolio to small and medium-sized enterprises. This "forced allocation" could still be guided by central policies, for example by encouraging loans in certain economic sectors and in certain geographic areas.

Alternatively, large banks could allocate a loan to smaller banks, such as city commercial banks. These smaller banks could then re-allocate such funds to even smaller banks or directly to specific small-scale businesses, creating a cascade system of smaller and smaller entities that would have only incremental exposure.

Lastly, and most controversial, would be for the central bank to bring interest rates in line with the market, which means substantially raising the base rate, thus compressing the supply-side gap. In other words, pushing informal lending institutions out of business. High interest rates, however, will hamper economic growth, just at the time when China needs to adjust its economy, and may not be politically and socially acceptable. However, it is the practice of maintaining low interest rates that has created potential bubbles and the misallocation of capital.

All of the above solutions are somewhat problematic to implement, but something needs to be done to make funds available to smaller businesses, which create jobs and are important localized drivers of growth.

The author is head of China Program at the Global Policy Institute of London Metropolitan University and senior research fellow at Zhejiang University.

(China Daily 03/01/2012 page9)