Chinese citizens have few alternatives other than to entrust their hard-won earnings to state-owned banks. Official statistics indicate that at the end of 2001, household savings in China amounted to over US$894 billion. This represented a 14.7 percent increase over the year before and a 24 percent increase from 1999. Unfortunately, putting their trust in the state to protect their savings has proved to be a bad bargain.
This is because a crisis looms in China's state banking system due to the burden of faulty loans granted by the four largest state banks to wobbly state enterprises. As it is, loans to state enterprises account for around 85 percent of the total lending of the four largest banks. This arrangement represents a worse outcome than when these enterprises previously received direct grants from Beijing since it could lead to a collapse of the domestic financial system.
Up to the end of last year, non-performing loans (NPLs) amounted to US$213 billion, about 25 percent of total loans. This figure would be substantially higher, however, if Beijing applied standards applied by international banks.
Even accepting its official data, the value of NPLs is greater than Beijing's outstanding debts. Overall economic stability and the capacity to attain a sustained recovery depend upon the quality of the financial system.
As if this were not bad enough, Beijing siphons much of the remaining liquidity held by state-owned financial institutions that buy sovereign treasury bonds to cover about 30 percent of central government spending. Buying these low-interest bonds and other government paper reduces banks' liquidity, and if they do not have sufficient funds the central bank will provide them with bridging funds.
To understand the danger of this shaky racket, consider the fact that the banks are engaging in short borrowing from depositors while lending long to the government and other borrowers. China's banking system has become a big pyramid scheme whereby new depositors provide funds to repay old ones and to give away to SOEs.
Losses in the form of non-performing loans to SOEs combined with low returns on government paper make China's banks extremely vulnerable to external shocks that could disrupt the system and lead to widespread default. The instability of the system is evident by the reaction to rumors circulating on the Internet about embezzlement from a state-owned bank in April 1999. In but a few days, depositors withdrew US$108 million.
Keeping this pyramid going requires a continuous inflow of new savings to offset losses and low returns to avoid illiquidity and insolvency that will eventually cause it to implode. With the supply of savings drying up and Beijing's growing commitment to spending rising, it is only a matter of time before the juggler will start to find it hard to keep all the balls in the air.
One leakage will come from Chinese savers moving more of their money into stock markets and insurance. Another diversion of cash from state-owned banks will come within five years when foreign banks are allowed to take local currency deposits from domestic residents.
Inflows of savings into the system have also been affected by eight consecutive cuts in interest rates forced by China's central bank to support economic growth. The response to declining market interest rates has been for savers to turn to non-licensed deposit-takers that offer higher returns.
In order to fix the financial system, ailing banks must be recapitalized so they can increase the supply of credit, especially to real private-sector ventures. Only when there is sustainable growth can durable employment opportunities be provided.
A consensus has finally formed that recognizes that China's economic problems cannot be resolved without bank reform to sort out the mountain of bad debts. China's banks have tried to clear their books of bad loans by transferring billions of yen to asset-management companies. Nonetheless, Chinese banks still show new and growing bad loans.
Following experience elsewhere, it is possible that about half of this can be collected. That means that aggregate losses for the banking system will be at least US$100 billion. This would be about ten times the proportion of GDP required to clean up the US savings and loan problems of the 1980s.
It is not that nothing has been done to sort out China's banks. It is just that too little has been done and more progress must be made before it is too late.
So, steps must be taken quickly to resolve the nonperforming loans that hang like an albatross around the neck of China's economy. All the bad debts must be removed from the banks to be resolved outside the system, perhaps using debt-equity swaps to convert NPLs into shares of stock from debtors.
But the disposal of bad debts will sharply undermine the capital base of the banks. Unless insolvent institutions are recapitalized with sufficient real capital and banks end their ruinous lending practices, the stock of bad loans will continue to rise.
It turns out that there are limited options for recapitalization to offset the billions of yuan in risky loans waiting to rear their ugly heads. Perhaps the best solution would be to allow more involvement by foreign financial institutions. Not only would they make fresh capital available to the Chinese economy, but they would bring in new lending and risk-management practices. They would also transfer new technology and introduce best corporate governance practices.
As long as the bad investments remain on the books, they will continue crowding out potentially good investments that could create more jobs and wealth. Let's hope that policymakers in Beijing can focus their minds on what must and can be done, and that they will do it quickly.
Christopher Lingle is a professor of economics at Universidad Francisco Marroquin in Guatemala and Global Strategist for eConoLytics.com.
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