(Yicai Global) Aug. 6 -- An ideal monetary and financial environment would channel private investment into China's real economy to better underpin a structural improvement, according to a key scholar from the nation's central bank.

"In the past, funds were idling, interest rates were high and all the risks were left to enterprises," Sheng Songcheng, counselor to the People's Bank of China and former director-general of the authority's financial survey and statistics departments, told Yicai Global in an exclusive interview. "That's unhealthy."

"Banks' appetite for risk has diminished sharply as a result of the recent credit crunch, but PBOC supported funding and market-oriented debt-to-equity swaps at micro and small enterprises by cutting the reserve requirement ratio," he added. "This is probably why the financial stress plaguing the real economy cannot be alleviated despite the recent loosened liquidity in the monetary market.

"Credit events are pretty much inevitable if the real economy is to be deleveraged," Sheng continued. "We should treat it in a calm and rational manner."

He believes the frequent occurrence of credit events is attributed to internal factors, changes in the financing environment and some external matters. Defaults as a result of poor operations are just a natural process in market clearing, Sheng said.

Shadow Banking Should Stay

Shadow banks are a true reflection of the market economy, he added, saying China should guide them toward sound development rather than eradicate them as bank loans are unable to meet the financing requirements of all companies.

They play an important role in satisfying investment and financing needs of the real economy in China's financial market, Sheng said. Though problems are surfacing which exacerbate vulnerabilities, such as regulatory arbitrage, non-standard operations, lack of investor suitability checks and insufficient information disclosure, he added.

"Should not just understand their practical use, but be aware of their risks so that we can guide the shadow banking system toward positive development."

Sheng believes China should prioritize understanding of the relationship between off-sheet and on-sheet financing, retain off-sheet financing properly and expand financing channels for business -- small and micro ones in particular.

"At the moment, undiscounted bankers' acceptances are shrinking significantly. However, their acceptances are a guarantee provided by banks for businesses to finance, which reflects their normal financing needs."

China should build an organically unified and dynamically balanced relationship to prevent financial risk and serve the real economy, Sheng added. "To deleverage necessitates not only control of debt increments, but also the growth of business and fiscal revenues as well as resident income. If finance cannot serve the real economy well, its own risk will be inevitable. The subprime mortgage crisis in the United States is an unforgettable lesson."

Editor: James Boynton