The Center for American Progress (CAP) has published the second in a series of issue briefs on China’s economic reform agenda under the leadership of President Xi Jinping and Premier Li Keqiang.  While the first brief discusses the challenges and contradictions of the reform plan announced shortly after the Third Plenum in 2013, the second, China’s Path to Financial Reform, focuses more narrowly on major obstacles in the development China’s domestic financial markets and the country’s long path towards capital account liberalization.

According to CAP’s report, written by economist Adam Hersh, one of the primary issues that China needs to resolve is the overbearing role of the state in China’s financial markets: “Unfortunately, China’s financial institutions are falling short [in effectively allocating capital and in guaranteeing adequate corporate governance], and the pervasive role of the state in these core functions creates considerable structural inertia that is likely to keep things this way for China’s foreseeable future.”

With state-owned banks controlling the majority of China’s banking assets and state-owned enterprises accounting for more than 90 percent of the capital raised in China’s financial markets, “the fundamental problems of intertwined policymaking, regulatory oversight, and profit-maximization goals reflected in the predominance of state-owned financial institutions” prevent the development of effective and transparent regulatory institutions, which are necessary to manage emerging risks such as capital flight and shadow banking.

State dominance in the financial sector further prevents the market from playing a “decisive role” in financial transactions by interfering with fundamental pricing mechanisms such as interest rates and exchange rates.  With regard to interest rates, Hersh explains that, because “the majority of financing for investment . . . remains in the hands of state-owned and state-inflected parties . . . financial decisions are not necessarily based on the price of capital, and the price of capital is not necessarily set by supply and demand in a competitive market.”  Prospects for exchange rate liberalization, a perennial source of tension in the U.S.-China trade relationship, do not appear much stronger.

Despite ambitious goals to “internationalize” the RMB and transform it into a global currency to challenge the dollar in international trade and finance, Hersh concludes that, given Chinese leaders’ ginger approach to capital account convertibility and “the substantial means at policymakers’ disposal for managing the exchange rate, the current system will be in force for some time.”