China and India are now pursuing growth strategies based on relatively free markets, yet neither has the financial system it needs to sustain rapid and efficient growth in the years ahead. China's problem is that capital costs zero. India's problem is zero capital.
While the financial systems of China and India have grown from quite dissimilar roots, today they face many similar problems. Both countries are now pursuing growth strategies based on relatively free markets, yet neither has the financial system it needs to sustain rapid and efficient growth in the years ahead.
The most striking similarity between the two financial systems is their inefficient allocation of capital. In both countries, the government is distorting the financial system to achieve social ends—in India, to fund the government's persistently large budget deficit and its rural investment priorities; in China, to ensure a continued flow of funding to its many inefficient but massive state–owned enterprises in order to preserve jobs.
While these goals are understandable, the policies have similar unfortunate consequences in both countries: wasteful investments; restricted funding options for the private companies that are driving growth; high levels of state ownership of financial institutions, which limit competition and lower efficiency; minimal growth in the countries' underdeveloped corporate bond markets; and few choices of financial products for consumers.
To move to the next stage of development, both China and India must develop modern financial sectors that efficiently allocate capital and meet the needs of savers. Financial reform is much more likely to achieve the social objectives that are currently used to justify the diversion of capital from the financial system by the government in both countries. Faster and more far–reaching reforms in the financial system should therefore be among the highest priorities for the leaders of China and India.