China’s Credit Boom: New Risks Require New Reforms

October 10, 2013 6:59 PM

The Chinese financial system has undergone almost continuous reform since the dismantling in the 1980s of the Soviet-style system where only one state-controlled bank existed. Government efforts to create a financial system that adheres to international best practices of commercial lending accelerated in the 1990s. Reforms progressed quickly during this period, but they were accompanied by excessive credit growth and a massive increase in nonperforming loans, threatening the solvency of some banks and the financial stability of the entire economy. The risk of these weaknesses was dramatized by the 1997 Asian financial crisis, in which several nearby countries were crippled by plunging currency values, rising interest rates and difficulties servicing their foreign-held debts.

Seeking to avoid a similar fate, the Chinese government bailed out and restructured the banking system. The government removed nonperforming loans from the balance sheet of banks and transferred them to asset management companies. It also brought in foreign expertise and capital to improve corporate governance and lending practices. Large banks received major capital infusions by listing themselves on the stock exchange. These efforts continued for more than a decade, culminating in the listing of the last large state-owned commercial bank in 2010, the Agricultural Bank of China.

The banking cleanup achieved considerable success. The bad debts and shoddy lending practices in the 1990s have been replaced a decade later with record profits, healthy levels of capital, and low levels of bad assets. Mixed with this progress, however, has been a policy of allowing large-scale interest rate distortions. Low rates for borrowing and lending artificially stimulated economic growth and made the economy more dependent on a bank-dominated financial system. Despite these distortions, throughout much of the 2000s, bank lending was of better quality than before the bailout, a testament to the tough structural reforms imposed upon the banks.

The global financial crisis of 2008–09, however, aggravated the difficulties of the financial system, reversing recent progress and reform while creating new problems in risk management and credit allocation. For example, the government’s stimulus in response to the crisis was largely through bank loans rather than through direct government spending. To stop the decline in growth, the government loosened credit controls, removed home purchase restrictions, and approved a large infrastructure program. The result was a massive increase in the stock of loans. Bank loan growth moderated in subsequent years, but non-loan-financing channels, such as entrusted loans, corporate bonds, bankers’ acceptance bills, and trust loans, have continued to grow rapidly. The banks are still deeply involved in many of these non-loan-financing methods, and regulators have struggled to control them without generating financial distress. Post–global financial crisis, China’s financial sector once again appears vulnerable to large-scale credit misallocation and spiraling bad debts. The Chinese financial system will require a new round of restructuring and reform to reduce the risks that have accumulated over the past several years.

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