Banking in China is inefficient and ill-equipped to handle the country’s emerging complex market system, says a new report commissioned by the Asia Pacific Foundation of Canada.

The question is whether the banking system can fundamentally change in ways that effectively serve the industrial and social needs of China, to foster balanced growth and economic stability.

“Bank Reform in China – What it Means for the World,” the latest in the Canada in Asia publication series, contends that capital misallocation, poor risk management and weak linkages in macro-monetary mechanisms are impediments to the enormous value that could otherwise be created if reform were to rid the system of financial inefficiencies.

In view of China’s emergence as a global economic power — in industrial output, exports and, increasingly, international finance — the world at large has much at stake in China’s domestic banking reform.

The report, prepared by Donald Brean, Professor of Finance and Business Economics at the University of Toronto’s Rotman School of Management, focuses on banking and finance as a complex and critical aspect of a made-in-China version of economic and social reform.

In its dramatic shift from Marx to markets, China has successfully developed markets for agriculture, goods for export and domestic consumption, labour and capital. However, the country’s financial sector has retained features of the old central planning regime, an incentive-poor system that hinders an estimated boost of US$320 billion annually to China’s GDP.

The report outlines the nature of banking in China and provides an overview of the ongoing bank reform process, raising the question of whether the transition from the old banking structure to a new system is appropriate for China — and indeed, whether Chinese banking is headed in the same direction as those banking systems in Western economies.

Although the world has witnessed many episodes of extraordinary economic growth that flamed out in financial crises, Brean sees substantial reason to be optimistic that China will avoid collapse. He foresees that China’s historical reliance on banking as opposed to financial markets will continue. However, that particular institutional basis of financial development will meet the needs of China’s immense industrial and social system only if meaningful incentives are instilled into China’s banking system – including incentives for operational efficiency and risk management. In this respect, foreign banks, including Canada’s, have technical and managerial skills that are sorely lacking in China but which are potentially transferable.

The full report is available at: www.asiapacific.ca/analysis/pubs/listing.cfm?ID_Publication=605