Shadow Banking: China's Dual-Track Interest Rate Liberalization

Abstract

Shadow banking in China constitutes a dual-track interest rate reform that adds a new market track beside the controlled formal banking track. Shadow banking leads to Kaldor-Hicks improvement if the gains from financing the underfunded private enterprise (PE) and reducing bank capital idleness caused by ultrahigh reserve requirements outweigh the losses from shadow banking risk. Pareto improvement is feasible as the state-owned enterprise (SOE), a potential reform loser, participates in shadow banking to transfer credit to the more productive PE. Full interest rate liberalization, which removes formal banking controls after the dual-track reform, does not warrant additional profit gain if bank credit misallocation favoring the SOE and SOE's low productivity persist.

Keywords: Shadow banking, interest rate liberalization, dual-track reform, Kaldor-Hicks improvement, Pareto improvement

JEL Classification: G21, G23, G28, P21, P31, P34