China's Banking Reforms: Background and Issues for Congress

The Peoples Republic of China's entry into the World Trade Organization (WTO) will require that it open its financial services sector to foreign investment and international competition. In preparation for a more market-based banking system, China has announced reforms intended to strengthen its banks and American investors have been buying portfolios of Chinese non-performing loans. The international community has a stake in Chinese financial reform primarily for three reasons. The first is to prevent contagion -- to keep a failure of Chinese banks from touching off global financial turmoil. The second surrounds the likely political unrest in China that could ensue should the Chinese economy fail, and the third is to ensure that foreign firms gain access to Chinese financial markets. This report concludes that despite serious problems in China's banking system, the risk seems small that, in the near future, a financial crisis will occur that will pose severe problems for the international financial system. An internal financial crisis, however, could occur. Without government support, the economic viability of many of China's banks is questionable. The government and central bank authorities acknowledge the situation and have taken some steps toward reform. The most serious threat to the banking system lies in the accumulation of non- performing loans (NPLs) -- many of them policy-based loans extended by state-owned banks to money-losing state-owned companies with little expectation that they would be completely repaid. Between 28 and 40 percent of all bank loans in China are estimated to be nonperforming. China has been taking measures to keep the problem from worsening and has created four asset management companies to dispose of NPLs that still have value. Since the Chinese economic reforms began in 1978, Chinese authorities have made significant progress in modernizing their banking system, although they still have a long way to go and are faced with competing interests. While attempting to introduce more market forces and efficiency into their economy, for political and other reasons, the government continues to subsidize ailing state-owned enterprises. They would like to clear the banks of excess NPLs, but fear the resultant rise in unemployment and social distress that might occur. China escaped the worst effects of the 1997-99 Asian financial crisis because of factors that still keep its financial and foreign exchange system viable. China's continued high rate of growth and high savings rate have funneled deposits into the banking system, while a $20 to $30 billion annual trade surplus together with an inflow of foreign direct investment at about $40 billion per year have resulted in an accumulation of foreign exchange reserves exceeding $200 billion. China does not carry an unusually heavy debt burden, either domestic or international, although its short-term borrowing in foreign currencies has been increasing. China, therefore, does not currently face a serious risk of either a domestic or international liquidity crisis -- unless, of course, a severe and prolonged world recession occurs that adversely affects Chinese exports as well as the inflow of foreign direct investment.