* World Bank China chief urges interest rate deregulation
* End of export-led manufacturing model, fed on cheap loans?
* Finance reform, more competition, needed to spur services
By Alan Wheatley, China Economics Editor
BEIJING, July 2 (Reuters) - Financial reforms including interest rate deregulation are vital if China is to spur consumption and services to make up for the demise of export-led growth, David Dollar, the World Bank's country director for China, said on Thursday.
By capping the rates banks may pay depositors, China has in effect taxed savers and funneled subsidised loans to export-orientated manufacturing firms that were a rich source of job creation, Dollar told Reuters.
"I would argue that, with the drop-off in export demand, that model is not going to work as well. It's not in China's interest," said Dollar, who leaves the bank this week to become the U.S. Treasury's economic and financial emissary to China.
It might not be practicable or desirable for China to free up interest rates overnight. But steps in that direction are possible, and the challenges posed by the global crisis are a good reason for Beijing to take them a bit more quickly, he said.
"As the economy picks up, I would liberalise that ceiling and eventually get rid of it," Dollar said. Because of the cap, banks may pay no more than 2.25 percent for one-year deposits.
By some estimates, letting interest rates rise would add three to five percentage points of gross domestic product to household income, Dollar said.
Because incomes have lagged GDP growth, household consumption in China fell to just 35.3 percent of GDP in 2008 -- a record low for a major economy in peacetime -- from 51.1 percent in 1988.
That has left the economy over-dependent on investment and, in the past five years or so on exports, but China can no longer count on the latter remaining a big source of final demand.
"That means the Chinese consumer really has to step up to the plate and become a more important part of this economy," he said.
Scrapping a system that guarantees banks a fat net interest margin and lets state-owned firms accumulate vast savings on the back of cheap credit would be a major political task. But Dollar expressed confidence that Beijing could rise to the challenge.
"The leadership is pragmatic. When they see where their interest lies, where the interest of the Chinese people lie, there's a good chance we'll get movement," he said.
OPEN UP SERVICES
Financial reform was also critical to give households more investment outlets and to provide smaller firms, especially service providers, better access to credit.
"China's model in the future will be based more on services than manufacturing. The banking system is very good at lending to manufacturing firms with collateral. It's not so good at funding small start-ups in software or other types of service industries," Dollar said.
Studies show China's service sector is far too small given its stage of development and resources, Dollar said.
To put that right, he said China also needed to open up key sectors now that often dominated by two or three big companies.
Greater competition in areas such as telecoms, airlines, logistics, media and finance could be one the wellsprings of growth to replace China's sputtering export engine.
"That's where a lot of the job creation and dynamism is going to come from in the future," he said.
Looking back on his five years as World Bank country head, Dollar said one area where he had been most impressed was China's success in improving health, education and other social services, especially in the vast countryside.
Poverty in China, essentially a rural phenomenon, has halved in the past five years or so.
"I would give pretty high marks for the social progress over the past five years. It's unfortunate that some of that did not start five years earlier, but now the issue is to keep up the positive trend," he said. (Editing by Ken Wills)