The current turmoil in global financial markets, which began with the U.S. subprime mortgage crisis in 2007, has shed a bad light on market liberalism. But it was the socialization of risk, not private free markets, that precipitated the crisis. Government sponsored enterprises (GSEs), not private enterprises, politicized investment decisions and overextended credit by buying up and guaranteeing subprime and other risky mortgages.

Risks and opportunities

The U.S. subprime mortgage crisis has become a global credit crisis that China cannot escape. Fortunately, 30 years of economic liberalization and opening up to the outside world have made China stronger and more resilient to outside shocks. China's leaders are to be congratulated for allowing greater economic freedom, which has helped millions of people escape poverty. Trade has expanded individual choices and given people new opportunities to improve their lives. It has also increased personal freedom.

While central planning has largely disappeared, it is still present to some degree in the financial sector. Macroeconomic prices-interest rates and the exchange rate-are heavily influenced by government policy, and the yuan is not fully convertible. Capital controls allow the central bank to peg the exchange rate and at the same time sterilize capital inflows to prevent inflation. Nearly all banks and non-bank financial institutions are state owned and controlled, though large banks have been turned into shareholding firms in which private investors can take minority positions.

China's "financial repression" means that the financial system is characterized primarily by market socialism, not market liberalism, which poses a risk for future development. Just as the socialization of risk and the privatization of profit in America's GSEs helped precipitate the credit crisis, the same could happen in China. Although large state-owned banks have been recapitalized and marketized to a degree, they remain creatures of the state. If they become insolvent, taxpayers will be the victims.

China will only be able to have an independent monetary policy aimed at long-run price stability, which fosters financial stability, if it floats the yuan and eventually allows full convertibility. Under the present regime, in which the yuan is undervalued, the People's Bank of China (PBOC) must buy dollars by increasing the supply of domestic currency. Firms are limited in the amount of foreign exchange they can hold, so the opportunity to increase domestic consumption through imports is restricted while expansion of the PBOC's balance sheet crowds out private investment. To prevent inflation, which would occur under a fixed exchange rate regime, the PBOC must withdraw liquidity by selling central bank bills or increasing reserve requirements. Sterilization, however, distorts interest rates and delays the appreciation of the real exchange rate by suppressing inflation, which is the only route adjustment can take if the nominal rate is pegged. In addition, sterilization prevents banks from lending to the private sector since they must accumulate reserves and hold central bank bills.

A final distortion is that financial repression has led China to hold massive amounts of U.S. treasury and agency debt, which has kept U.S. interest rates lower than they would have been, thus helping to bring about the housing boom.

In a recent article in the Cato Journal, John Greenwood, chief economist at INVESCO, considers each of these distortions and warns that suppressed inflation, the bottling up of liquidity by the central bank, eventually will surface. When it does, capital could flee China and the boom could turn into a crisis. The 1997-98 Asian financial crisis was preceded by excessive growth of money and credit, which led to overheating. China can buy time with capital and exchange controls, and by using credit quotas and price controls, but only by distorting the real economy. According to Greenwood, "In China's case, the controls on capital flows may for a time prevent such a sudden reversal of capital flows and drastic adjustment as occurred in the Asian financial crisis of 1997-98, but the key point remains. Allowing an extended period of overinvestment in one or two sectors that ultimately produces unacceptably low returns can shift a currency from being perceived as undervalued (as with the RMB today) or appropriately valued (as in the case of Asian currencies in 1996-97) to being suddenly overvalued."

Although consumer price inflation has slowed and China's asset bubble in the stock market has most likely been deflated, housing prices in major cities have skyrocketed over the last several years, and the growth of money and credit continues to be strong. With pressure to lower interest rates and reserve requirements to "stimulate" the economy, the PBOC will face some difficult choices.