China Bank Reform

Henry C K Liu

This article appeared in AToL on June 1, 2002

China adopted a new commercial-bank law on July 1, 1995, that aimed at commercializing the country's banks by the year 2000 by stipulating technical requirements such as capital-adequacy ratios in line with international banking practice under finance capitalism. The relaxation of banking controls in China created serious macro-economic problems in 1992-93 when many banks and their affiliated non-bank financial institutions poured resources into imprudent activities, such as speculation in real estate and stock markets, diverting funds earmarked for agriculture and other development projects in defiance of a largely ignored national Five-Year Plan.

The relaxation of administrative controls led to mounting risks of instability in the banking sector. When monetary control was reimposed in late 1993, these speculative investments suffered financial losses that caused instability in a banking system plagued by deregulation and lax supervision. The rising portion of non-performing loans (NPLs) in the commercial banks' total outstanding loans and the large household deposits in the commercial banks' total liabilities forced the banks to consider the quality of their assets and the liquidity risks involved.

As part of the 1994 monetary reform measures, commercial lending and policy lending in the state banking sector were separated. The four specialized banks were transformed into commercial banks to be operated for profit, while at the same time assuming full market and credit risks as stand-alone commercial institutions. Three policy lending banks - the Long-Term Development and Credit Bank, the Import-Export Bank and the Agricultural Development Bank - were set up. They will grant policy loans in accordance with state industrial policy and national plans. The capital sources of these policy banks will be mainly government budgetary funds, social insurance, postal and investment funds from a shrinking public sector.

Since 1987, many new local commercial banks located in and serving the provinces or special economic zones (SEZs) have been established. Examples include Guangdong Development Bank, Bank of China Merchants (Shekou), Shenzhen Development Bank and Pudong Development Bank. China Minsheng Banking Corp (CMBC), founded by the National Association of Industry and Commerce and other local interests, is the only officially recognized private commercial bank at present. The bank has successfully listed on the Shanghai Stock Exchange and attracted a strong customer base composed largely of small and medium enterprises (SMEs) and high-tech companies.

In November 2000, China announced that it was planning to set up a number of private banks prior to the country's entry into the World Trade Organization (WTO). The commercial banks already operating had been formed by private entrepreneurs pooling their funds and borrowing additional money to begin operations. A number of private banks (Siren Qianzhang) also operate in China. The private commercial banks typically pay higher interest rates on deposits than state institutions, and they charge higher loan rates than the state banks and concentrate on the SME market.

Before 1983, the central planning system in China operated financially mainly through collecting revenue from state enterprises and allocating investment through budgetary grants. The government budget was always balanced as expenditure was priced to match revenue. The banking system served to provide the credit needed by enterprises to implement national plans for economic output and provided and monitored cash used principally to cover wage costs above state-provided benefits, and credit for state purchases of agricultural products from collectives above state quotas. Investments in fixed assets in state-owned enterprises (SOEs) were all direct transfers or grants from government budget. Prices were not determined by market forces.

In 1983, as a key economic reform measure, direct grants were replaced with interest-bearing loans to agriculture, construction, and production enterprises in an attempt to solve the soft-budget problem of state enterprises. Consequently, the banking system gradually became the primary channel for financing investments and for exercising macro-economic control. At the same time, the importance of government budgetary expenditure in the economy declined rapidly. Resource allocation became more closely linked to the efficient performance of the banking sector, rather than the developmental needs of the national economy. Money went naturally to ventures of easy profit, causing recurring booms and busts, with widespread neglect in the public goods sector, such as education and basic health care, not to mention environmental protection. Frequent pockets of poverty and underdevelopment became the price for general prosperity.

Bank expansion
China's banking system expanded rapidly from 1985 to 1993, as the number of branches of state banks rose from 60,785 to 143,796 and the number of employees increased from 973,355 to 1,893,957. During the same period, total deposits increased from 427.3 billion yuan (US$51.6 billion) to 2.3 trillion yuan, while total loans increased from 590.5 billion yuan to 2.6 trillion yuan. In 1993, total loans from the banking system were 5.2 times the government budgetary expenditure, reflecting the rapidly increasing role of the banking system in the economy. Thus the NPL problem in China's new banking system cannot be traced primarily to state funding of pre-reform SOEs under a planned economy, as Western neo-liberals tirelessly claim. If anything, the NPL problem is the bastard child of haphazard liberal bank reform in a market economy, not a fixture of a planned economy.

China's state banking system had been criticized by neo-liberals for having functioned as a funding agency for national development programs, rather than as private for-profit institutions for the benefit of bank shareholders. Yet the banking regime of the New Deal functioned precisely as a massive funding machine from the United States government for a particular national policy - to save the US economy from the excesses of unregulated market capitalism. John Maynard Keynes' General Theory of Employment, Interest and Money (1936) showed that Adam Smith's classical model - founded on the virtues of balanced budgets, laissez faire capitalism and free trade - was a special case that only applied under conditions of full employment. Keynes' model portrayed the market as a car without a driver or a destination, allowing the slightest bumps in the road to push the economy off the road of prosperity at any time or it could be led by market forces to head toward a cliff. As Smith argued for an activist government against trade restraints, Keynes showed that the economy needed an activist government to steer it on the road of full employment toward maximum public good. Neo-liberals, in their eagerness to bash statism, tend to emphasize only government protection of private profit, but reject government responsibility for public good. Where is the logic of allowing private profit for a few shareholders to impede the development of a whole nation or the global economy?

In banking under finance capitalism, size translates into market power advantage. Yet, amid the current frenzied climate of global mergers and acquisition of private banks and non-bank financial institutions, China is following neo-liberal snake-oil advice to privatize and break up its state bank system into smaller private entities, presumably to be ripe targets of eventual acquisition by mammoth Western bank holding companies.

Taking the dubious advice of Western neo-liberals, China has tied itself up in a smoldering crisis trying to resolve the NPL problem in its banking system. In banking, commercial loans 90 days past due and consumer loans 180 days past due are generally classified as non-performing. Current international standards divide NPLs in commercial banks into four categories: special mention, substandard, doubtful and loss. Yet NPLs in China are a problem created by blind banking reform to fit into Bank of International Settlement (BIS) regulations designed for the benefit of advanced economies operating under finance capitalism. For any banking system, NPLs surface mainly as a regulatory issue, that is, adequacy of capital considered by regulators as appropriate for managing risk of loan default. The need for such regulation comes from the regime of factional reserves in the context of central banks, to prevent the danger of "moral hazard" - irresponsible lending by banks based on the knowledge that their irresponsibility will be bailed out by the central bank. Capital ratios are regulatory devices to make certain that banks hurt before help from the central bank is available to correct their lending misjudgments. Free banking without central-bank backing often operated historically on a much higher capital-to-loan ratio. State banks have no capital ratio needs, since the full credit of the state is behind them.

China's banking system is very different from the US system. NPL threats facing the US today are concentrated in institutional securitized debt, not corporate or individual consumer loans made by banks. With financial deregulation and loan securitization, bank loans can become serious problem NPLs, as the term is now generally used in a macroeconomic context, even when they are securitized and bought by institution investors, moving the risk off the banks' balance sheets. NPLs in advanced economies create problems for credit markets in ways different from problems they present to the banking system. It is through unregulated bank involvement in derivative trades that off-balance-sheet NPLs pose threats to the solvency of banks.

China has just begun commercializing and privatizing its state banks and there is hardly any credit market to speak of. NPLs by SOEs are merely accounting issues in government funds. Only a small number of Chinese banks need to be international players in the global market. There is no need for the entire national commercial banking system, the bulk of which deals only with domestic finance, to follow BIS international standards. Thus China's NPL problem is an exercise in regulatory self-flagellation in the name of modernization according to international standards.

In the US, the 1933 Glass-Steagall Act addressed the risks arising from universal banking, linking commercial banking with investment banking, triggered by massive bank failures in the Great Depression. During that period, securities underwritten by the investment banking arms of the commercial banks were difficult to sell, but the banks were able to tie loans to the purchase of securities underwritten by their investment bankers. The banks had a strong incentive to do so, since profit from underwriting was irresistibly high. Bank clients were forced to purchase these risky securities if they wanted bank loans. The risky securities bought with bank loans led to defaults in a downturn, causing the lending banks to fail. The Glass-Steagall Act was introduced in responding to such structural imprudence due to the linkage between commercial banking and investment banking. While Glass-Steagall has recently been repealed in the US in the brave new world of financial deregulation of the 1990s, the Chinese Commercial Bank Law stipulates that commercial banks in China are not allowed to engage in securities trading and underwriting, investment in non-bank financial enterprises and productive enterprises, and trust investment while China turns toward market economy. This restriction condemns Chinese commercial banks to a structural disadvantage in competition with deregulated Western banks. At the very least, foreign banks should be made to observe the same restriction when operating in financial markets in China.

Some have argued that as financial regulation has now moved toward favoring universal banking over the past two decades in advanced economies, why should China pursue the separation of commercial banking from investment banking? The question of universal banking is closely linked with the development of effective prudential and supervisory mechanisms. Universal banking relies to a large extent on functional and conduct regulation and implies a greater need for collecting and analyzing detailed and timely information and for taking prompt corrective action. Such institutional capabilities had been underdeveloped in China because under central planning, they were not needed. Yet the neo-liberal push for universal banking incorporates a large dose of wholesale deregulation and relaxed government supervision and control, in favor of industry self-regulation, a bias that has led to widespread abuse in the advanced markets.

Universal banking has also consistently produced negative results in developing economies by structural incentives for excessive borrowing. Universal banking, being more difficult to supervise effectively, exacerbates the dominant market position of large, complex banking organizations (LCBOs). The experience of the advanced economies shows that securities markets develop faster in countries where banks' activities are limited to short-term commercial finance and less rapidly in countries with universal banking. In countries allowing universal banking, a broad array of financial products in the form of derivatives appears likely to develop, sapping energy from traditional security markets. Therefore, China's decision to segregate commercial banking from investment banking activities at this stage is likely to be appropriate, but only if China slows its headlong rush in opening its financial market to foreign LCBOs.

Systemic crisis
China's banking crisis is mostly systemic, a direct result from its transition from a planned economy toward a partial market economy. China's successful battle against inflation in the mid-1990s contributed to the NPL problem in its new commercial banking system. The shift in policy toward price stability had dramatic negative effects on the country's commercial banking and real-estate sectors where profitability depended excessively on sharp asset-price appreciation. Most of these NPLs are actually government subsidies for loss-making SOEs, disbursed in the form of bank loans. These are in fact policy loans to enterprises not originally structured to operate profitably in a market economy. These SOEs, organized to operate in a planned economy, compensated for their structural unprofitability in a market economy with speculative investment in real estate and stock markets, and were caught short when the government took the punch bowl away just when the party was going strong by tightening the money supply to fight inflation. It was a momentous policy error by trying to solve a micro-economic problem with a macro-economic cure. Instead of stopping speculation, the government stopped the economy in its tracks. To save the situation, the government devalued the yuan from 5 to 8.3 to a US dollar in 1994 to boost exports, but in the process making the cost of servicing dollar loans prohibitive for yuan earners.

The SOE NPLs at the state-owned commercial banks can be classified into three categories: 1) loans to traditional old-line industrial enterprises; 2) loans to enterprises established during the mid-1980s in lieu of a founding equity; and 3) loans contracted during the overheated period in the early 1990s. On top of these three categories of loans, there were also the well-camouflaged rollovers of these NPLs since 1994. In terms of annual flows, the NPLs amount to between 2 and 3 percent of gross domestic product (GDP), comparable to the government budget deficits in many other countries. In terms of cumulative stocks, they amount to approximately $200 billion. With a GDP of $960 billion in 1998, this implies a NPL-to-GDP ratio of slightly over 20 percent, which is quite consistent with estimates by the People's Bank of China, and of 25 percent by international credit rating agencies. GDP in 2001 has crossed over the $1 trillion line.

Ultimately unrecoverable NPLs have been estimated to be between one-third (by Chinese bank officials) and one-half (by rating agencies) of all outstanding NPLs. These loans are really indirect loans by the state-owned banks to the state itself and thus should properly be included as part of the public debt. Official Chinese public debt outstanding was approximately 10 percent of GDP as of 1996. Adding in the estimated net new debts issued in 1997 and 1998 as well as the entire stock of outstanding NPLs, the public-debt-to-GDP ratio was between 35 and 40 percent, still considerably lower than those of many other countries. The US national debt is about 60 percent of GDP. US private-sector debt is about 250 percent of GDP. Moreover, it is also clear that the Chinese banks will never be allowed to fail in a way that hurts depositors. There is, in fact, universal implicit insurance for bank deposits. Thus it is purely technical that Chinese state banks have a capital/loan ratio problem.

As it does in Russia and Latin America, Washington uses the International Monetary Fund (IMF) as a foreign-policy slush fund (a term coined by The Economist) to promote neo-liberal or market fundamentalist policies in Asia, including China, known generally as the Washington Consensus (WC), a term coined in 1990 by John Williamson of the Institute for International Economics. The 10 propositions of the WC are:
  • Fiscal discipline;
  • Redirection of public expenditure priorities toward fields offering both high economic returns and the potential to improve income distribution, such as primary health care, primary education, and infrastructure;
  • Tax reform (to lower marginal rates and broaden the tax base);
  • Interest-rate liberalization;
  • A competitive exchange rate;
  • Trade liberalization;
  • Liberalization of foreign direct investment (FDI) inflows;
  • Privatization;
  • Deregulation (in the sense of abolishing barriers to entry and exit);
  • <>Secure property rights.

    Events have since proved the WC as a formula for disaster.

    At US/IMF urging, China has followed the example of other Asian countries in its approach to NPLs, notably South Korea, which had been reduced to a walking-dead economy after 1997 by IMF conditionalities. South Korea received an IMF rescue package of $58 billion in 1997. Kamco (Korean Asset Management Co), the bad-debt resolution vehicle, spent $31 billion to buy NPLs with a face value of $81 billion. The South Korean government poured $120 billion into the banking system, taking over eight failing banks and forcing mergers. South Korean NPLs dropped from 16.4 percent to 3.4 percent (US, 1.5 percent at big banks, Japan 15 percent). Looking desperately for profit, South Korean banks have since shifted to consumer lending, pushing consumer loans over $300 billion, heading straight for a consumer-loan bubble crisis down the road.

    Asset management
    The Chinese government has created asset management companies (AMCs) on the South Korean model to resolve NPLs in the banking system, specifically in the portfolios of the four state-owned commercial banks expected to be privatized in the near future. Asset resolution activities by AMCs are expected to be coordinated with SOE reform to safeguard social stability - the most critical issues affecting which are unemployment and pension obligation shortfalls. This is like coordinating between fire and gasoline.

    The debt restructuring efforts led by the AMCs aim at maximizing both the transactional and long-term economic value of the underlying assets while minimizing cost to the AMCs themselves and to the economy at large, through loan workouts as a priority and asset liquidation as a last resort. Debt restructuring is supposed to assist distressed enterprises in turning into viable enterprises, with an aim to reducing associated social costs of sudden and massive increases in unemployment and forfeiture of employee benefits. Bad-debt workouts are intended to be achieved through win-win negotiations with debtors, creditors, investors, government regulators and policy-makers and other parties with vested interests. Whether market forces can accomplish these self-contradicting intentions is highly controversial. The fundamental flaw lies in the reliance on market theories that are valid only under full employment, while the measures taken directly increase unemployment, making the market theories inoperative.

    The AMC operations, the bank restructuring process and the SOE reform program need a coordinated mechanism that formally supports loan workouts to enhance bank asset values and to optimize economic benefits. It is not clear that adequate coordination exists between the AMCs which have been assigned the task of debt restructuring and the State Economic and Trade Commission (SETC), which oversees the SOE reform program, and the central bank, which sets interest rates and money-supply targets. The government issued in August 1998 270 billion yuan, 3 percent of GDP, in sovereign bonds to bolster capital adequacy ratio in the four state commercial banks from 2 percent to 8 percent, as required by the BIS. The government is also the implicit guarantor of 1.4 trillion yuan in bonds issued by the four AMCs in 1999 and 2000. In addition, the big four state-owned commercial banks still have almost 2 trillion yuan in NPLs on their balance sheets. Applying international standards, that figure could be as high as 5 trillion yuan. In total, this amounts to 40-75 percent of 2000 GDP, about on par with US public debt to GDP.

    By the end of 2000, AMCs had disposed of 90 billion yuan in bad loans - about 6 percent of the NPLs taken over from the banks. The cash recovery on these sales was only 8.3 billion yuan. That is far below the interest due on the bonds issued by the AMCs to banks, which is in excess of 30 billion yuan a year. The AMCs are financing interest payments and other obligations with funds from the central bank, a status the People's Bank of China (PBoC) was formally granted in 1995 by the Central Bank Law. But the hidden economic cost of the restructuring is the resultant layoffs and economic contraction and associate social instability.

    China's official budget deficit and government debt outstanding are low by international standards: 3 percent and 15 percent of GDP respectively in 2000. Yet the real deficit may be closer to 7 percent if borrowing cost of AMCs is included. Government debt outstanding may well be understated because it excludes bonds issued by AMCs, as well as bonds of the state-owned policy banks created in 1994. These bonds amount to an additional 25 percent of GDP. There is a question whether the move toward NPL resolution, which is mainly driven by the pending privatization needs of the four state-owned commercial banks, is more damaging to the economy than the NPLs themselves. Some estimates have placed the capital-infusion requirement to be as high as $500 billion to resolve the NPL problem through the entire banking system. US bankruptcy laws have provision for debtor-in-possession (DIP) financing for a debtor under court protection in Chapter 11 reorganization. DIP financing, profitable to the lender, allows the bankrupt debtor to operate in an orderly fashion to maximize the value of its assets to repay creditors. Thus far, China's bankruptcy laws do not incorporate DIP financing, making economically viable reorganization difficult.

    Japan, which exerts substantial influence on its Asian neighbors, has an institutional and economic history that has been front and center mercantilist. The American economist Hyman Minsky, a respected opponent of deregulation because of its structural trend toward systemic instability, asserted that an understanding of a country's institutional and economic history is essential for a clear understanding of its financial processes. Institutional and historical realities dictate that a country cannot easily escape its relatively rigid past to join a global system without serious and sometime fatal penalties. The US, whose influence on financial globalization is paramount, enjoys the least upheaval to its national system because financial globalization is merely an extension of US economic culture. Thus, US insistence on other nations to adopt global standards sound like calls to Americanize other nations who must then relearn new social behavior and adopt new institutional relationships. There is clear evidence that much of Japan's banking crisis originates partly from its voluntary compliance with Basel Accord capital standard designed to buttress US values. The same is true for all of Asia.

    Bank restructure
    A good question is why China must restructure its banking system with such haste and thoroughness. Some of the state-owned commercial banks' NPLs have been transferred to four state-owned AMCs to improve the banks' balance sheets. According to public statements by Dai Xianglong, the central bank governor, the scheme reduced the banks' combined NPLs from 35 percent of the total loan portfolio at the end of 1999 to 25 percent by the end of 2000. One US study showing comparison with the actual value of NPLs transferred to the AMCs claims that an additional 400 billion yuan emerged in new bad loans during 2000, equivalent to 4 percent of GDP. Given such a substantial increase, it is unrealistic that the absorption of bad loans by the AMCs can be a one-off exercise. At any rate, even with AMC NPL disposal, 25 percent of the banks' total loan portfolios will still be non-performing.

    Paid Western consultants eager to earn lucrative commissions have been unduly optimistic about the prospect of solving China's NPL problem through the sale of NPL portfolios to foreign investment denominated in dollars. It is a puzzle why these yuan-denominated NPLs need to be sold for dollars when most of the debtors and the underlying assets are not likely to have dollar revenue or be willing to use precious dollar revenue to repay loans denominated in yuan. Further, in the current global market for distressed debts, most investors are looking for annual internal rate of return (IRR) approaching 50 percent. And it is unclear if the State Administration for Foreign Exchange (SAFE) is prepared to fund this substantial dollar cost of disposing yuan NPLs on an aggregated basis. For example, China HuaRong AMC's first tranche NPL portfolio sale of $2 billion may cost the nation $100 million annually, based on a 50 percent IRR for foreign capital on a sale price of 10 cents on a dollar of face value of NPL. Assuming the average term of NPLs to be 10 years, the sale of China HuaRong AMC's first tranche NPL portfolio of $2 billion will cost the nation $1 billion to dispose. Yuan receivables are currently not freely convertible into foreign exchange and remittable overseas to pay foreign investors without SAFE approval.

    With a registered capital of 10 billion yuan, China HuaRong AMC acquired by August 2000 NPLs of 407.7 billion yuan at book value. By the end of 2000, it acquired NPLs of 506 billion yuan, disposed NPLs of 7.858 billion yuan and recovered assets of 3.28 billion yuan, with cash recovery of 2.06 billion yuan. It has also conducted feasibility evaluations of debt to equity swap (DES) schemes of 496 SOEs recommended by the SETC, involving value of 110.7 billion yuan, of which DES conversion for 292 companies totaling 80 billion yuan has been expedited. While this is an impression record, it is still a long way from solving the NPL problem.

    The government issued 270 billion yuan (3 percent of GDP) in sovereign bonds to bolster capital adequacy ratio in the four state commercial banks in August 1998 from 2 percent to 8 percent, as required by the BIS. It is also the implicit guarantor of 1.4 trillion yuan in agency bonds issued by the four AMCs in 1999 and 2000. In addition, the big four state-owned commercial banks still have almost 2 trillion yuan in NPLs on their balance sheets. Applying international standards, that figure could be as high as 5 trillion yuan. In total, this amounts to 40-75 percent of 2000 GDP.

    The official debt figures make no allowance for implicit government debt, which includes not only the need for a substantial additional injection of capital funds into the banks, but also China's huge implicit pension debt, not to mention future obligation. China's budgetary revenues are below par by world averages - less than 15 percent of output, partly because of generous tax exemptions granted to the fast-growing new private sector which generates 20 percent of total output. As a result, in 1999 and 2000, the central government financed more than half its expenditure by net bond issuance. The tax exemptions granted to the AMCs and their foreign investors will add to this problem. The tax policies are one reason why the private sector grew faster than the state sector which is till saddled with punitively high tax rates and comprehensive social benefit costs. The private sector appears dynamic merely because it has not been required to pay its own freight, and not because God favors market fundamentalism. Chinese reformers have merely been playing with a stacked deck, taking the anti-state gospel of the Washington Consensus as universal truth.

    Foreign competition
    China's state-owned commercial banks appear seriously ill-prepared to meet competition from foreign LCBOs after China's entry into the WTO. China needs both to accelerate the restructuring of its loss-making SOEs by discouraging speculative manipulation of the market - the chief underlying cause of most of the non-performing loans in the banking system - and to develop a commercial credit culture in its state-owned commercial banks to reduce waste and corruption. But this cannot be done by merely selling distressed yuan debts at deep discount for dollars. It can only be done by a monetary policy that stimulates consumption in the domestic economy to turn distressed SOEs into profitable operations, thus turning their NPLs into performing loans.

    According to the State Theory of Money, which holds that the value of a currency is fundamentally supported by government's authority to tax, China can afford to greatly expand its domestic money supply to stimulate domestic consumption to remove a critical bottleneck of production overcapacity in the economy without fear of inflation. Most SOEs have been suffering losses because of structural weakness in aggregate demand, causing a downward spiral of increasing unemployment and stagnant or falling wages. If rising wages and full employment are sustained by a policy to boost the domestic money supply, the bulk of the banks' NPLs will turn into performing loans within a short time. This will greatly reduce the scale of the NPL resolution program. The economy will then expand, increasing tax revenue, thus reducing the budget deficit, notwithstanding that the larger policy question still remains as to whether a run-away market economy serves China's long-term national interest.

    The NPL resolution program must include provisions of assistance to workers laid off from enterprises undergoing restructuring; of establishing a social safety net in urban areas to help those hurt or neglected by market failure; reforming current state welfare schemes (pensions, health insurance and unemployment insurance) with a view to expand coverage to be financed by the productive privatized sector; improving equity between labor and capital and ensuring long term growth sustainability; narrowing regional disparities in income and marketable skills; and managing rural-urban-interregional migration so that the rural poor can benefit from local growth brought about by balanced development policies, rather than only from forced labor mobility that places undue strains on the social and economic infrastructure in the more developed coastal urban areas. There is little evidence that current AMCs are incorporating these objectives in their operation strategies. In fact, it appears that the AMCs are prioritizing the more marketable assets in the more developed coastal regions in their early sales, thus making each subsequent sales more challenging and leaving the less developed regions in escalating distress.

    As in South Korea, the Chinese government's SOE restructuring plan also calls for China's commercial banks to play leading roles in deciding which enterprises survive, which will be forced into involuntary liquidation and which of their affiliates and subsidiaries will be closed. Banks will conveniently target the weaker enterprises in the poorer regions for liquidation and closure, thus exacerbating the maldistribution of income and wealth between people and regions and the associated social problems such as unemployment.

    The other key problem is the pricing of asset sales. For foreign investors to put money into Chinese assets, valuations will be based on discounted cash flows, yields and a healthy dose of distressed asset discounts. Chinese SOE management investment criteria have for decades been driven largely by national planning targets. Even the post-reform new enterprises are often driven by the pursuit of technology development and new markets rather than return on assets, cash flow and profit. Thus Chinese NPL disposals are inevitably fire sales in a market that places no value on public good or national interests.

    From the experience of Japan, South Korea and the European Union, it should be noted that NPL resolution is not an end objective in itself. A good library is not one with all its books neatly stacked on the shelves, but one that has all its books in circulation, even though the return delinquency rate may be high. The opposite of bad loans being made in good times is that good loans are made in bad times. Disposal of bank NPLs within short periods when economic conditions are not optimum will lead to higher unemployment in general and further economic contraction and deflation. China will not be exempt from this rule. Instead of disposal, a preferred option would be to create economic conditions that can turn NPLs into performing loans. An accommodating monetary policy can go a long way down this path.

    There are various arguments on relationships between NPLs in the banking sector and deflation or long-term economic stagnation, as has occurred in Japan. Neo-liberals argue that Japan's long-term stagnation since the 1990s has been caused by the delay in the disposition of NPLs and, therefore, solving the NPL problem will lead quickly to Japan's economic recovery. Yet there is increasing evidence that Japan's NPL problem is a symptom, not a cause, of its economic malaise, which traces back to its over-emphasis on export for dollars. Indeed, creation of new NPLs due to deflation is the main cause for the delay in the disposition of Japanese NPLs. The NPL problem cannot be solved without stopping systemic deflation. NPLs, defined as firms' excess debts relative to their cash flows, cause deflation and recession, which in turn cause more NPLs. A firm's debt, however large though it might be, and however small its collateral might be, is not an NPL so long as there is enough profit for the firm to pay off the debt within a reasonable period of time.

    With regard to the relation between excess debts and economic growth, the effect of a reduction in NPLs on real GDP is statistically insignificant or may even be temporarily negative. On the other hand, a 1 percent increase in real GDP would lead to a 2.8 percent decrease in the excess debt balance, as has been shown by a study in Japan. The effect of excess debts on deflation is negligible compared to the effect of deflation on increases in excess debts. There is no evidence found for any negative effect of excess debts on the real economy, whereas there is clear evidence that a recession increases excess debts. However, to reduce the excess debt balance, the effect of a real economic recovery is smaller than the effect of elimination of deflation. That means that stopping deflation is the most effective in reducing excess debts.

    It is important to adopt an appropriate monetary policy in accordance with the basics of macroeconomics, where inflation and deflation are monetary phenomena from the long-run perspective. The advanced economies all adopted significant monetary easing policies by increasing money supply in order to avoid the formation of deflationary expectations when faced with decreases in the rate of consumer price increase below 1 or 2 percent in the 1990s. Stopping deflation cannot possibly lead to hyperinflation. It is extremely urgent that quantitative easing of money be adopted to stop deflation without hesitation. Stopping deflation is a necessary first step to the solution of the excess debt problem. What China needs is to shift from an over-reliance on export and to a policy to stimulate domestic demand, which means that the central bank must adopt a monetary easing policy as long as there is excess production capacity in the economy.

    June 1, 2002