Financial Repression and Interest Rate Liberalization in China

China has been experiencing financial repression for a long time. The main feature of this repression is a regulated interest rate system. This results in private firms’ low likelihood of getting money from the official banking system, and at the same time seeded the emergence of the shadow banks, which introduces uncontrollable risks into the Chinese economy. Also, other policy goals, such as monetary policy efficiency, cross-border capital mobility and a free-floating exchange rate, have to be sacrificed to maintain the dictated interest rates. We use an overlapping generations model to study the macroeconomic consequences of financial repression in an economy, as well as the effects of a potential interest rate liberalization reform of the Chinese financial system. We find that if the state-owned firm continues to have priority getting credit from the official banks, an interest rate liberalization may not deliver a convergence of the two interest rate systems and a shrinkage of the shadow banking industry. ∗Department of Economics, Indiana University Bloomington. 105 South Woodlawn Avenue, Bloomington, IN 47408. Email: [email protected]. †Third year paper committee: Todd Walker(Chair), Grey Gordon, Juan Carlos Hatchondo.