Dual-track interest rates and capital misallocation

The control-track interest rate and the market-track interest rate constitute China's dual-track interest rates. A theoretical model of dual-track interest rates and financial frictions is studied. In the model, bank loans are provided to state-owned enterprises with the control-track interest rate, private enterprises resort to shadow banking with the market-track interest rate. The interest rate wedge between these two interest rates distorts capital allocation, even driving a sector out of production. Full interest rate liberalization which eliminates the interest rate wedge alleviates cross-sector capital misallocation. However, the net effect on aggregate TFP is ambiguous due to the within-sector effect. Under calibrated parameters, full interest rate liberalization improves aggregate TFP moderately, unless the financial reform aimed to have SOEs and POEs face the same degree of financial frictions is also implemented.