Reforms at a 'critical juncture'(2)

The premier had to overcome strong, entrenched interests to launch the Shanghai Free Trade Zone, which has paved the way for comparable FTZs in other Chinese cities and provinces in the coming years. But to deepen reform-and follow market rules-State-owned enterprises should be opened to private investment.

At the press conference, Li's remarks on government debt which he said was in control, were the most anticipated. To minimize the risk, however, government debt and shadow banking will be more closely scrutinized. Some recent shadow banking-related incidents, including the failure of a trust product and the subsequent murky bailout, have left international markets jittery.

The problems can be traced to the global financial crisis, which China overcame with the support of a 4 trillion yuan stimulus package. Although the government achieved many of its objectives, money from the stimulus package was also poured into local government funds and State-owned enterprises.

That led to overcapacity in several sectors, particularly shipbuilding, metals and mining, building materials, and solar equipment. The list also includes weaker borrowers in the property sectors, especially those with high exposure to trust funding.

According to the National Audit Office, local government debt by mid-2013 had increased to $2.9 trillion, which accounts for 31 percent of GDP. However, as the leading international ratings agency Standard &Poor's said recently, it does not see a credit crisis within China as a baseline scenario. "We are not in the panic camp," as S&P put it.

In accordance with international (Basel III) requirements, Chinese authorities now expect the minimum capital adequacy ratio of banks to increase to 10.5 percent, while larger banks must meet the 11.5 percent requirement. The authorities are aware of the challenges they face. They know that the longer the misaligned incentives in the shadow banking sector remain unaddressed, the larger the distortions will become.

Nonetheless, investor concerns have been fueled by the inability of projects to generate adequate cash flow to repay debts, which has led to defaults involving financial products-from wealth management and trust products to bonds.

"It is indeed difficult to avoid a few default cases," Li said. "We must tighten monitoring to prevent regional and systemic financial risks." Since the government is now willing to compel borrowers to abide by market rules, the financial reforms can foster a mature credit risk culture.

In the short term, it will mean some pain and associated volatility. In the medium term, it is vital to lay a foundation for a more sustainable and well-developed capital market in China. Delays are not an option. A thriving but robust financial system is critical to the nascent social model, which, in turn, is vital to shift growth toward consumption.

The author, Dan Steinbock, is research director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Centre (Singapore).