Why do we care that China's inflation has been relatively low and that the banking sector is squandering vast sums of money? In important ways, the inflationary and efficiency outcomes of the Chinese financial system represent two disparate future paths for the Chinese economy. On the one hand, sustained financial deepening, coupled with relatively low inflation, can propel China to become a global economic powerhouse. On the other hand, inefficient financial intermediation, which generates a high nonperforming loan ratio, augurs a financial crisis that spells the end of the “China Miracle” and ushers in a period of economic and possibly political instability. China's financial system produces the seeds of both future trajectories.

This chapter first discusses why inflation and efficient allocation of capital are important outcomes for China's growth trajectories. Second, it empirically compares China's inflationary and efficiency performance relative to other developing and transition countries. Compared with these countries, China's low rate of inflation has been impressive, if not stellar. This is puzzling, given the lack of institutional guarantees against political intervention in the financial system. At the same time, the banking system's efficiency, measured by the nonperforming loan ratio, is among the worst in the world.