THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 218

186 PA R T I I I APP LI CAT IO N Financial Institutions Is China a Counter Example to the Importance of Financial Development? Although China appears to be on its way to becoming an economic powerhouse, its financial development is still in its early stages The country s legal system is weak so that financial contracts are difficult to enforce, while accounting standards are lax so that high-quality information about creditors is hard to find Regulation of the banking system is still in its formative stages, and the banking sector is dominated by large state-owned banks Yet China has had one of the highest growth rates in the world over the last twenty years How has China been able to grow so rapidly given its low level of financial development? As noted above, China is in an early state of development with a per capita income that is still less than US$5000, one-eighth that in the United States With an extremely high savings rate averaging around 40% over the last two decades, it has been able to rapidly build up its capital stock and shift a massive pool of underutilized labour from the subsistence agriculture sector into higherproductivity activities that use capital Even though available savings have not been allocated to their most productive uses, the huge increase in capital, when combined with the gains in productivity from moving labour out of lowproductivity subsistence agriculture, has been enough to produce high growth As China gets richer, however, this strategy is unlikely to work The Soviet Union provides a graphic example In the 1950s and 60s, the Soviet Union had many similarities to China It had high growth fuelled by a high savings rate, a massive buildup of capital, and shifts of a large pool of underutilized labour from subsistence agriculture to manufacturing During this high-growth phase, the Soviet Union was unable to develop the institutions to allocate capital efficiently As a result, once the pool of subsistence labourers was used up, the Soviet Union s growth slowed dramatically and it was unable to keep up with the West Today no one considers the Soviet Union to have been an economic success story, and its inability to develop the institutions necessary to sustain financial development and growth was an important reason for the demise of this once superpower To get to the next stage of development, China will need to allocate its capital more efficiently, and to this it has to improve its financial system The Chinese leadership is well aware of this challenge: The government has announced that state-owned banks are being put on the path to privatization In addition, the government is engaged in legal reform to make financial contracts more enforceable New bankruptcy law is being developed so that lenders have the ability to take over the assets of firms that default on their loan contracts Whether the Chinese government will be successful in developing a first-rate financial system, thereby enabling China to join the ranks of developed countries, is a big question mark CON FL IC TS O F IN T ERE ST Earlier in the chapter, we saw how financial institutions play an important role in the financial system Specifically, their expertise in interpreting signals and collecting information from their customers gives them a cost advantage in the production of information Furthermore, because they are collecting, producing, and