On the surface, the financial systems of China and India appear to have little in common: China’s—by far the larger—is dominated by a massive banking sector, while India has a strong equity market. The two systems have vastly different roots as well. The Bombay Stock Exchange along with many of India’s venerable banks trace their ancestry to the era of British rule. China’s current financial institutions are products of an economic liberalization that began only in 1978.

Yet the two countries’ financial systems, different as they are, share a common handicap: excessive government intervention that distorts the allocation of capital and consequently holds back growth. In China, state-owned enterprises (SOEs), many with low productivity, receive most of the available funds for investment in order to maintain employment levels. In India, the government itself absorbs a good deal of the country’s capital to finance its rural investment priorities and large fiscal deficit. In both countries, the results are wasteful investments that yield negligible returns, limited financing options for the private companies that drive growth, and limited investment options for consumers. To reach the next stage of development, both China and India must create a modern financial sector that allocates capital efficiently...