By allowing private banks, China would take a big step to a free market and sustained economic growth

One of the highlights of the State Council of China's recently issued "Guidance on the financial support for the transformation and upgrading of economic structure" is to let private capital experiment in setting up private banks.

In September, China's central bank governor, Zhou Xiaochuan, said in an article in the Party journal Seeking Truth that China will give more room to private enterprises and allow them to establish banks, thus introducing competition to the state-owned and monopolized banking industry. Though we cannot predict how much room will be given, the policy is extremely good news for both investors and consumers.

As usual, when an industry opens to private capital, there will be great investment opportunities, cheaper and better products and greatly improved services.

China's commercial banks are almost entirely run and owned by government and can easily gain money by their administrative monopoly and interest rate control.

The banking industry is dominated by five large state-owned banks. The government also controls 12 joint-stock banks, which provide service nationwide. Minsheng Bank is difficult to regard as an exception, as its main investors are private entrepreneurs who do not exercise control.

Although China has 3,747 banks, according to the 2012 annual report of the China Banking Regulatory Commission, most of them are local or very small banks. The 1,927 rural credit cooperatives are more like government-affiliated agencies, which can hardly be considered modern commercial banks.

Compare this with the United States, where there are more than 10,000 banks and none of them is state-owned. Neither is there interest rate control. These banks have to provide better or different services to compete with each other. Bank failures have occurred, but the deposit insurance system prevents the loss of deposits of small savers.

As we know, monopoly harms fairness and decreases efficiency in the market, which is why governments in many developed countries regard an anti-monopoly act as part of the constitution of a free market. A monopoly by SOEs is especially harmful, as natural monopolies in the long term will probably be ruined by technological progress. Administrative monopolies therefore often impede technological progress.

Since the modern economy is dominated by financial rather than industrial capital, the banking monopoly has a huge impact not only on the banking industry but also on the entire economy.

China's economic growth pattern can be simply described as "government-led" and "investment-driven". The banking industry has played a key role in this pattern, as for a long time it has been used as a policy tool for the Chinese government to mobilize cheap social funds for government investment. This economic growth pattern has succeeded in rapid GDP growth and has greatly improved China's infrastructure.

The industry's actual controllers greatly benefited from the administrative monopoly. Profit growth has increased at a double-digit rate for years. The listed banks have gained half of the profits of thousands of listed companies for the previous year.

But this economic growth pattern is unsustainable and already has had a tremendous negative influence and possibly brought on a great crisis. Distorted market interest rates and a policy-governed lending policy have channeled many funds to inefficient investment projects. Bad debt has become a regular nightmare for the banking system.

The economic growth pattern, which is based on government investment, will widen the gap between rich and poor, increase inflation, reduce private investment opportunities, force money into usury and real estate, and produce a real estate bubble and a large amount of bad debt for banks. All these problems constitute a manufacturing crisis.

The government's industrial monopolies, high taxes and banking policy have crowded out private investment opportunities and funding sources, which has hindered the upgrading of private consumption and manufacturing. China, a big manufacturing country, is in fact only a large factory, gaining low profit by processing and assembling.

Now, the manufacturing sector is to be conceded to developed countries or transferred to other low-cost countries. It faces big problems. Without the demographic dividend, cheap land, low pollution controls and strong export demand, the economic growth pattern could have resulted in serious crises for the previous sessions of the government.

Instead, it has cornered the current government. The only way out is to change it.

The administrative monopoly of China's banking industry, based on the old growth pattern, is also unsustainable.

The stock market provides the best answer. Although the profits of listed banks continue to rise, the prices of their stock continue to fall. Now the prices-to-earnings ratio per share of most listed banks is below five, less than half of that of most banks in developed countries.

The government now has to change the economic growth pattern, which means it has to reform the banking industry. The only way to reform is to break the monopoly. Of course, at the same time, the government needs to stabilize the economy.

The old growth pattern can still function to do this, as the government will still control the big banks to fund government projects.

It can also gradually relax interest rate controls, and allow banks the time and leeway to change the old business model.

The most important reform is to let private capital open new banks and bring far-reaching influence to China's banking industry, enabling it to run different competitive policies and business environments. The old system will keep running for some time, but it would have to adapt to the new environment.

Localized community banks, Internet banks, large retailers, large commercial organizations and so on will join the competition. Some will succeed and some will fail.

The government will have to establish a new regulatory regime, set up a deposit insurance system, develop new entry conditions and establish a bank insolvency regime.

Where bank customers now complain about the negative real interest rate, red tape, excessive fees and poor service, instead they will find these banks changing and providing more choice.

People will find employment in new banks, and some employees in the old system will face layoffs or transfer to more market-oriented operations. Private enterprises will find it easier to apply for a loan and they will also enjoy better service and more choice.

Breaking the monopoly in the banking industry is very important, but not decisive. The economy is a system and needs other supporting reforms.

Banks mainly provide services for enterprises, and their profits are in part those of other industries. If these industries are also uncompetitive, what can support their long-term growth? China, in fact, needs to break more monopolies.

The author is a lecturer at the Management School of Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 10/04/2013 page12)