Interest-Rate Liberalization and Capital Misallocations

Abstract. We study the consequences of interest-rate liberalization in a two-sector general
equilibrium model of China. The model captures a key feature of China’s distorted financial
system: state-owned enterprises (SOEs) have greater incentive to expand production and
easier access to credit than private firms. In this second-best environment, interest-rate
liberalization can improve capital allocations within each sector, but can also exacerbate
misallocations across sectors. Under calibrated parameters, the liberalization policy can
reduce aggregate productivity and welfare unless other policy reforms are also implemented
to alleviate SOEs’ distorted incentives or improve private firms’ credit access.