Moving from economic growth driven primarily by investment and exports to consumption-led growth is perhaps the greatest challenge facing China today.  A crucial but often overlooked element necessary for this transition is fundamental reform of the banking system.

The Chinese financial system has been highly effective in funding large enterprises and, in particular, large enterprises with significant levels of government ownership or control.  Channeling the famously high level of Chinese savings into large enterprises  has allowed the engines powering Chinese economic growth to run at such accelerated  speeds for the last three decades.

If domestic consumption is to be the new engine of growth, however, it too will require a source of fuel.  Consumer credit will have to become more readily available to support individual purchases and entrepreneurs.  This will require a fundamental transformation of the financial system, since consumer finance institutions hardly exist in China.  Simply relying upon borrowing from family members, as now happens in China, is not an efficient way to allocate funds and exposes families to much greater risk concentrations than would a diversified and well-functioning consumer credit system.  A lack of credit will constrain the ability of the rapidly expanding middle class in China to play the key role that the middle class has played in driving sustainable long-term growth in countries like the United States.

Private consumption accounts for nearly 70% of US GDP, whereas it is half that in China.  Access to mortgages, credit cards, consumer loans is critical to support this level of consumption in the US. “How the Middle Class Became the Money Class” – the subtitle of Joseph Nocera’s book on the financial empowerment of the US middle class through innovation in consumer finance following WWII – sums this up. Consistent record-keeping on individual repayment histories as inputs to credit-scoring models, for instance, provided the necessary information, at relatively low cost, to evaluate the creditworthiness of individual consumers.  Obviously, the recent financial crisis shows that excesses can occur and underscores the importance of ensuring the safety and soundness of the institutions in this sector, but consumer finance is undeniably necessary for the transition to consumption-led growth.

The Chinese banking and financial authorities should make rapid progress on structural reforms to bring down barriers to entry into “retail” banking. They should also encourage competition to provide sound credit to the hundreds of millions of middle-class Chinese, to stimulate and sustain their consumption.  Banking reform, thus, holds the key to a successful rebalancing of the Chinese macroeconomy.

Author: Randall S. Kroszner is the Norman R. Bobins Professor of Economics at the Booth School of Business, University of Chicago, and Vice-Chair of the World Economic Forum Global Agenda Council on the Global Financial System.

Image: A billboard of a Chinese family is seen in Shangai REUTERS/Carlos Barria.