The global economy faces an uncertain future. China also faces challenges to ensure steady economic development. Wei Jianing, Deputy Director of the Department of Macroeconomic Research of the Development Research Center of the State Council, shared his views with Financial News on how China will prevent financial risks and reform its financial system in 2012. Edited excerpts follow:

The Chinese economy faces three major risks: burst of real estate bubbles, risks of local government financing platforms and split of capital chains for private lending.

As for the burst of real estate bubbles, in 2009 the central bank revealed real estate loans accounted for 21 percent of the country's newly increased loans, a relatively high portion. The question is whether the economy can achieve a soft landing after the bubbles burst. During the Great Depression in the United States, the real estate bubbles popped before stock market bubbles. Recently, during the sub-prime crisis, stock market bubbles were first to go, followed by those of the real estate market.

If the government does not make proper adjustments before a bubble bursts but just props up the bubble with monetary policies, a new bubble will form and then further adjustments will be needed. If the real estate bubbles burst, will the economy see a hard landing? If this happens, it will definitely influence the banks.

At the local level, since a large amount of loans local governments received from banks in 2008 and 2009 will be due, local governments need large money bags to repay the loans. The Central Government recently tightened its control of the real estate market, reducing local governments' revenues from transferring land use right, which is a major source of income. In the meantime, commercial banks also lack incentives to grant new loans to local governments, because the interest rate for loans granted to local governments is 10 percent lower than the benchmark interest rate, while that for loans granted to enterprises now is 30-50 percent higher than the benchmark interest rate. As a result, it is hard for local governments to get new loans from banks or issue local bonds for financing, thus increasing the risks of the local government financing platform.

As for the problems of private lending, such as those I found in Wenzhou, Zhejiang Province last September, I have the following judgments.

First, interest rates of private lending are too high, leading to split capital chains. The risks surrounding private lending are growing rapidly.

Second, since there is no insurance mechanism for private lending, once the capital chains split, it will cause chain reactions, spreading to other regions and probably affecting legitimate financial institutions, because some private lending capital is borrowed from banks and then finds its way to private lenders. Through investigations we have found that the present situation is similar to the situation in 1993, when the financial market was in disorder. The difference is in 1993 the disorder was seen in legitimate financial institutions, while at present, the disorder is in illegal financial institutions. I think we need a better understanding of the problem.

Positively there is demand and supply for private lending and it has made contributions to economic growth, but negatively we should see the risks and prevent anyone from using the risks to force the central bank to loosen the monetary policy.

Reform tasks

To get things in order and advance financial reform, we need to complete three tasks.

First, the interest rate should be market-oriented to improve the efficiency of market resource allocation. A market-oriented interest rate is conducive to compressing the space for private lending and playing the role of the financial market in allocating economic resources and reflecting the diversity and difference of financial products and financial services. Market-oriented interest rates can also reflect the demand of macro-control and help improve the functions of the monetary policy.

Second, capital involved in private lending should be guided to legitimate financial institutions to diversify the functions and scales of financial institutions.

Third, construction of sound financial security networks should be accelerated. There are three core issues concerning financial security networks: prudent regulators, lender of last resort and the final investor protection mechanism.

The relationship between central and local governments in financial supervision should be straightened out, and the Central Government shall authorize the financial work offices of local governments to supervise micro and small local financial institutions, with the aim of enhancing effective supervision.

The lender of last resort should strengthen the independence of the central bank and regulate the decision-making mechanism of the monetary policy. This will be beneficial to China. Why? After the Plaza Accord in 1985, an agreement between the governments of France, West Germany, Japan, the United States and the United Kingdom to depreciate the U.S. dollar in relation to the Japanese yen and Deutsche mark by intervening in currency markets, both the Japanese yen and Deutsche mark appreciated. However, there was bubble economy only in Japan, because Japan did not raise the interest rate with pressure from the United States, leading to the bubble economy. On the contrary, despite the pressure from the United States, Germany still raised the interest rate and avoided a bubble economy. Therefore independence of the central bank is quite conducive to protecting national interest.

As for the investor protection mechanism, we have established an insurance protection fund and still lack a deposit insurance mechanism, hence we should set up a deposit insurance mechanism to prevent possible risks.

Why is the deposit insurance mechanism conducive to solving the financing difficulty of small and medium-sized enterprises (SMEs)? Because small and medium-sized banks should be vigorously developed to solve the financing difficulty of SMEs, but without a deposit insurance mechanism, depositors are more willing to save their money into large banks, leaving small and medium-sized banks in an unfavorable position. Moreover, if the interest rate is market-oriented, there will be losers in the competition, and an exit mechanism is needed for those losers. However, without a deposit insurance mechanism, the losers have no way of getting out. Therefore the deposit insurance helps to prevent both impacts of the financial crisis and public panics.