WASHINGTON — In January, Chinese Deputy Prime Minister Wu Bangguo said that whether or not China gets into the World Trade Organization, China’s policy would be “to reform and build a market economy.” Now that China is assured of entering the WTO, the hard work of transforming China’s socialist market economy into a free-market system must begin.

China’s path to a full-fledged market economy will be unique. But, at the end of the day, if it is to develop real — rather than pseudo — capital markets, privatization is essential, which means a legal structure that protects private property and freedom of contract. As Zhao Zhijun, a member of the Economic Research Institute of the Chinese Academy of Social Sciences, said, what China needs is to “create laws that protect the rights, interests and property of the private sector.”

China has made significant progress since 1978 when it initiated its long march toward a market economy. Per capita income has increased more than fourfold, and millions of people have moved from the dying state sector to the vibrant private sector. But serious problems remain, especially in the financial services industry, where foreign competition has been narrowly limited.

The four large state banks continue to monopolize the allocation of scarce capital and restrict the flow of funds going to the nonstate sector. Political factors, not profitability, largely determine who gets the available funds. Indeed, state-owned enterprises receive more than two-thirds of the funds but account for less than one-third of industrial output value. The inefficiency of SOEs has created a nightmare for state-owned banks, which now hold nonperforming loans that total as much as 25 percent or more of all loans outstanding.

Recapitalizing the banks is not a panacea. Without institutional change and a hard budget constraint, the politicization of investment decision-making will continue. Cheap credit will flow to favored SOEs that will waste scarce capital on low quality “pet” projects that have little net value to consumers.

Breaking up the large state banks might help to increase efficiency but not unless private owners, who can specialize in risk taking and be held accountable for use of resources, take the place of politically motivated state managers whose first loyalty is to the Chinese Communist Party. Making asset values fully dependent on market forces and letting interest rates be freely determined would remove the last vestige of central planning and depoliticize economic life. Those measures would help end the rampant corruption that now is ubiquitous throughout China and lay a sound basis for future economic growth.

In their heart of hearts, the party elders must know that privatization is the only logical way to change the incentives and the behavior of inefficient SOEs. But they also recognize that privatization would mean the end of the CCP as they know it. Thus, many party members are reluctant to sever their ties to the old economy and jump into the sea of private enterprise. Yet, the new economy and global competition may force them do just that.

It is not difficult to forecast that, with China’s entry to the WTO, foreign competition will spur domestic competition and foster growth of the nonstate sector; freedom of choice will expand; alternatives to state provision will give people greater independence; and, as China becomes more open to the outside world and more liberal, the chances for peaceful interaction will increase and conflicts diminish.

A modern economy requires the free flow of goods, services and ideas. China will have to allow greater freedom of expression and tolerate differences of opinion if it wants to be on the leading edge of the global economy. Pretending to create capital markets by debt-for-equity swaps, in which most of the shares are owned by the state, will not fool international investors.

If China wants to join the new global economy, it must be more open to information flows, allow thoroughgoing privatization, make the renminbi fully convertible and allow greater foreign competition. Those reforms cannot be accomplished overnight, to be sure, but they must begin if China is to take the next step toward freedom and prosperity.

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