China's banks are important for America too

Less well understood is the critical role that China's banks play in the global economy.

Douglas J. Elliott is a fellow in economic studies at the Brookings Institution, where he specializes in analyzing the global financial system and its regulation.

We all realize by now that China's economy matters greatly to America, directly affecting our trade, our investments, the value of the dollar, and inflation.

Indirectly, it affects us even more through its impact on our other trading partners, especially Europe, and also by propelling China forward as a global power at all levels, not just economically.

Less well understood is the critical role that China's banks play in all this.

Almost half of China's economic output each year goes into investment in infrastructure, residential and commercial construction, the building of factories, etc.

Much of this investment is financed by borrowing, making the financial system critically important to maintaining China's very high growth rates.

Banks dominate that financial system, much more so than in America's more developed economy, where banks provide only about a third of all credit. The rest comes from financial markets and from non-bank lenders.

In particular, four massive banks that are each majority-owned by the Chinese state, tower over the scene: ICBC, China Construction Bank, the Agricultural Bank of China, and Bank of China.

The fundamental purpose of any financial system is to allow the "real" economy to function better; we do not create banks because we like their buildings, with all those pillars, or enjoy the beauty of a well-turned trade.

Finance assists the rest of the economy by helping ensure there are enough funds available for everyday transactions and for worthwhile investments in the future. Further, the funding must be available at reasonable cost.

On the flip side, the financial system is intended to ensure that families and businesses can invest their excess funds to earn a good return.

Unfortunately, China's financial system is currently struggling to fulfill these fundamental goals effectively.

Credit is too cheap and too readily available for state-owned enterprises engaged in wasteful projects or which are simply bad competitors, encouraging those companies to hold dangerously high levels of debt, and risking the need for large government bailouts if the economy falters.

On the other hand, private enterprise, the most dynamic part of the Chinese economy and the major source of new jobs, has difficulty obtaining bank funding and usually has to turn to other, much more expensive, sources.

Further, bank deposit rates have been running below the inflation rate for years, sometimes dramatically so. This matters because bank deposits are where the Chinese hold much of their savings and investments.

Chinese experts and political leaders realize their economy has reached a crossroads where the old approaches have hit their limits and a new model needs to be developed.

The World Bank recently put out an excellent study on this topic, in tandem with an important Chinese state think tank. Its analysis confirms that of many other experts, showing that China needs to take another major step forward in its three-decade long process of economic reform, including substantially changing how its financial system works.

Done right, the changes can be an important part of a transition to a society that continues to enjoy high economic growth, but on a more sustainable basis.

This new model revolves around improving living standards so that Chinese consumer spending will help drive the economy, with investment in buildings and infrastructure slowing down and exports becoming less critical.

If the reforms are blocked or perverted by the strong vested interests that have developed in recent years, or if China mishandles the delicate deflating of its housing bubble, China could find itself with substantially slower, more volatile, growth and bouts of inflation, leading to social unrest which could slow the economy even further.

America's trade deficit with China could expand strongly again, growth around the world could flag, and political or even military risks from a less stable, and probably more nationalistic, China could rise sharply.