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By Christer Ljungwall
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China’s gradual reform strategy has involved a number of policy distortions and constraints that may affect the country’s maneuverability to withstand and recover from external and internal shocks. There are immense structural problems that policymakers need to address, not the least in the financial system, which is in weak condition and has distorted domestic demand; the prevailing pattern of investment financing could lead to a surge in new NPLs, and excess capacity in certain sectors could bring on deflationary risk in the medium-term.
With increasingly unfavorable world growth prospects and distinct signs that the Chinese economy is negatively affected, there is immense pressure for the Chinese government to act in anticipation of the many uncertain factors that are present today and are likely to surface in the near future. However, despite sweeping reforms of China’s state-owned dominated financial system significant policy distortions exist.
The author points out that government dominance in China’s banking and financial systems at large will remain. As a result, the basic weakness in the financial system will oppress economic growth through its adverse effect on the supply of savings and efficiency of resource allocation. This reduces China’s ability to handle various shocks and to achieve its growth potential.
The magnitude and implications of potential risks suggest that further financial market reform and development is a main priority for China to achieve its growth potential. Building a broader-based, well functioning financial market would also help to rebalance China’s economy by shifting domestic demand away from heavy reliance on investment toward consumption.
The current situation is grim and the outcome over the next three years is difficult to predict. But this situation also presents China with an opportunity to analyze its problems, reflect on its weaknesses, and concentrate on areas they should focus their efforts toward.
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