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«Incomplete financial reform in China is puzzling because Premier Zhu Rongji, a seemingly promarket technocrat, was largely insulated from explicitly ...»

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The heart of the centralization drive was the establishment of a vertical party committee system within the financial system that was insulated from the local party committees, which successfully removed local branches of state banks from the grasp of the local government (anonymous, personal communications, October 8, 2000; October 10, 2000; November 27, 2000;

December 25, 2000; May 21-23, 2001; June 8, 2001). In addition to centralizing their internal command structures, the Big Four state banks also lowered the lending authority of the local branches from billions of Reminbi (RMB) to hundreds of millions of RMB (anonymous, October 10, 2000, May 22-23, 2001). The net effect of these policies was a new autonomy for the financial sector from local influence and the concentration of enormous financial resources at the central level. If combined with other policies, this could have furthered financial reform significantly, but Zhu instead mobilized the centralized banking system to achieve short-term policy goals.

The most pressing policy goal for the Zhu Administration was another SOE rescue program, which promised to get SOEs “out of difficulties” in 3 years. This was indeed an ambitious goal. For the best part of the 1990s, 12 Comparative Political Studies the Communist regime had witnessed ailing SOEs fall deeper and deeper into the quagmire of low productivity, high inventory, and high debt.

Despite repeated efforts to improve SOE performance, more than 40% of SOEs were making losses (State Information Center, 1999a). By the late 1990s, the leadership had made rescuing SOEs a top priority for the regime, and financial centralization allowed Zhu to provide impressive but temporary solutions to the problem. In essence, Zhu channeled an enormous financial resources to politically connected large SOEs while denying smaller SOEs and private firms credit.

The State Council designed two major banking policies to help large SOEs—debt-for-equity swaps and interest subsidies for loans—even though these policies diminished bank autonomy. Debt-for-equity swap involved forgiving SOE debt in exchange for SOE equity. Zhu mobilized the powerful central bureaucracy, headed by the State Economic and Trade Commission (SETC), to determine which SOEs would receive this free-ride of debt forgiveness, greatly empowering the agency. Furthermore, the Zhu Administration bolstered the practice of providing subsidized loans to major SOEs. Again, central agencies, rather than the banks themselves, decided on the recipients. In 1998 alone, the state banks extended some 200 billion RMB in loans through this program, equivalent to 22% of the increase in state bank loans that year (State Information Center, 1999b). Although banks were not formally required to approve loans going toward SETC approved projects, bank managers in reality approved more than 90% of these loans because of implicit loan guarantees from powerful government agencies (anonymous, personal communications, April 15, 2000; November 27, 2000; December 25, 2000; April 21-22, 2001; June 7, 2001). Thus, rather than evaluating firms based on their commercial risk profiles, bankers continued to lend to firms based on their bureaucratic risk profile.

The net effects of these policy biases did not suggest bold reform.

As Figure 1 demonstrates, the share of state bank loans outstanding to the private sector remained largely stagnant through these policy changes.

Overall, the share of total loans outstanding to nonstate enterprises and to individuals increased from 11% during the first quarter of 1997 to 14% in the fourth quarter of 2003.2 Furthermore, although the state sector lost a quarter of its workforce during Zhu’s tenure, state bank loans outstanding to the state sector increased from 4.6 trillion RMB (67% of GDP) in the first quarter of 1997 to more than 9 trillion RMB at the end of 2003 (77% of GDP; China Statistical Information and Consultancy Service Center, 2004). Moreover, the Big Four state banks continued to dominate China’s financial market with both lending and deposit share well above 50%.

Shih / Reform Equilibrium 13

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Source: China Statistical Information and Consultancy Service Center, 2004; Division of Statistics of People’s Bank of China, 2000.

Digesting NPLs Years of soft-budget loans to SOEs had produced a major NPL problem in China by any standard. By 2001, independent estimates place China’s NPL ratio at between 40% and 45% of all loans outstanding, or some 44% to 55% of the GDP.3 After Zhu convinced the leadership that NPLs constituted a major risk confronting the regime, he quickly devised a two-pronged strategy to deal with the problem. First, he recapitalized banks and set up asset management companies (AMCs) to digest the existing pool of NPLs among state banks. Second, he centralized the banking system and implemented strict policies to prevent the formation of new NPLs. Rather than radically transforming the Chinese banking sector, his NPL strategy primarily deferred the explicit fiscal and inflationary risk of NPLs to the future.

To decrease the massive pool of NPLs in China’s financial system and increase capitalization in the banking system, Zhu first ordered the central government to issue 270 billion RMB of special financial bonds to recapitalize the banks. This process made explicit the government’s responsibility 14 Comparative Political Studies for the creation of NPLs. Instead of banks bearing the burden of NPLs because of government policies, the burden of NPLs was transferred to the government in the form of national debt. Had this process repeated itself in subsequent years and had banks been allowed to use government injections to write off NPLs, state banks would have been on their way to being free of the “historical burden” of state intervention.

Indeed, some government experts argued for large-scale issuance of special bond to pay off NPLs, thereby making explicit the government’s obligation from the outset. Proponents of this approach argued that making the government’s obligation explicit would render future government bailouts more costly, increasing the credibility of this “last supper” and decreasing the moral hazard for banks (Zhan, 2000). This proposal was ultimately shelved, because it would result in a sudden surge of central deficit, which would reflect badly on Zhu and highly constrain central government spending in other areas (Er, 1999).

To accomplish the goal of digesting an enormous store of NPLs without large-scale deficit financing, a group of technocrats suggested establishing financial companies to take over the NPLs. Within this rubric, one option was to set up state-owned AMCs, which gave either bonds or stocks to the banks in exchange for bad debts. This would clean up the banks’ balance sheets and separate bad debts from the banks. Finally, the government considered using private financial companies to purchase NPLs from banks at a highly discounted rate (Er, 1999). The last option was deemed undesirable because the government would still have to write off the discounted amount after the sale of the NPLs to private entities, thereby rapidly increasing the government’s deficit.

The decision to set up four state-owned AMCs came fairly quickly after Zhu had become premier in 1998. On the basis of a token 40 billion RMB in initial capital from the treasury, the four AMCs issued 1.4 trillion in financial bonds to the state banks and used the funds to purchase 1.4 trillion in NPLs from the Big Four banks at face value (see Figure 2).4 AMCs had a charter of 10 years and were tasked with recovering as much of the NPLs as possible through debt-to-equity swap and auctions. At the end of the 10-year charter, the treasury would issue bonds or inject government surplus to write off the remaining amount. Essentially, AMCs became the government’s warehouses for bad debt, enabling the government and banks to keep bad debt off of their balance sheets. In this manner, state banks replaced 1.4 trillion in NPLs with 1.4 trillion in Ministry of Finance (MOF)–backed AMC bonds, thereby getting rid of some two fifth of the estimated 3.3 trillion in NPLs. Meanwhile, the MOF did not have to list the Shih / Reform Equilibrium 15

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Note: AMC = asset management companies; NPL = nonperforming loans.

1.4 trillion in special bonds on the official budget, because the MOF merely guaranteed the bonds issued by the AMCs. The AMCs, on the other hand, were saddled with 1.4 trillion in NPLs and 1.4 trillion in debt to the state banks. Although AMC officials initially resisted purchasing NPLs at face value, the opposition soon dissolved as they realized that the MOF was ultimately responsible for the pool of NPLs (anonymous, personal communication, May 14, 2001).

In the short run, all the bureaucratic interests and the political interest of Zhu Rongji gained from the transfer of NPLs to AMCs. The state banks replaced NPLs with performing assets backed by the MOF. The MOF did not have to make explicit the treasury’s obligation to the public by massively issuing bonds. Although the MOF would have to deal with the remaining NPLs in 10 years, top MOF officials were mainly interested in short-term results, which served to promote their career prospects (anonymous, personal communications, May 19, 2001; June 23, 2001). The SETC gained enormous power to decide the fate of thousands of SOEs through debt-to-equity swaps. Although technocrats involved in setting up, AMCs all realized that the recovery ratio for NPLs was likely to be low (10% to 20% range) and that the treasury would have to write off an enormous amount of NPLs in the future, their main objective was to minimize the shortterm burden for themselves and for the Zhu Administration (anonymous, 16 Comparative Political Studies personal communications, May 14, 2001; June 23, 2001). In fact, finding it the ideal tool, the central government increased the amount of NPLs transferred to AMCs from the originally planned 400 billion to 1.3 trillion and finally to 1.4 trillion RMB (Chang, 2001, p. 5).

The outward effect of the AMC policy was impressive (see Figure 2).

Trillions of NPL disappeared from banks’ balance sheets while government deficit remained at about the same level. Nevertheless, the primary net effects of Zhu’s anti-NPL policies were transferring the fiscal pressure of the NPLs to the future and creating dependency on the AMCs as a convenient way of reducing NPLs. Although official announcements claimed that AMCs would recover 30% to 50% of the NPLs, Western analysts and government experts agreed that the actual cash recovery ratio is likely to be much lower (Gilley, 2000). AMCs have thus far dealt with more than 400 billion RMB in NPLs, but cash recovery as of the end of 2005 was only 154 billion RMB, or 11% of the transferred NPLs (Wang, 2005). Furthermore, as skeptics of the AMC policy had feared, instead of supplying banks a “last supper,” the government continued to use AMCs to bail out banks and other financial institutions. In the middle of 2004, for example, Cinda AMC purchased a further 300 billion plus RMB in NPLs from the Bank of China, the China Construction Bank, and the Bank of Communications in preparation for their listings (Hu, 2004).

Setting the Interest Rates

Although enthusiastically implementing policies that increased the authority of the central economic bureaucracy, Zhu was much more reluctant to liberalize interest rates, which would have decreased the central government’s ability to direct the flow of money. This reluctance created an enormous opportunity cost for China’s economy. The rationale for setting mandatory interest rates to which all financial institutions must abide is threefold. First, the central government feared that marketized interest rates would drive banks to lend to more profitable private enterprises, depriving SOEs access to cheap capital. Moreover, mandatory interest rates on deposits prevented banks from engaging in “ruinous competition” with each other to attract deposits, which would increase the state banks’ interest payments to depositors (Xie, Liu, Cheng, & Zeng, 2001). Furthermore, without an established national credit system, marketized interest rates would adversely select risky companies to apply for high-interest loans (anonymous, personal communication, May 14, 2001). Ultimately, control over deposit and lending Shih / Reform Equilibrium 17 rates constitutes a powerful monetary tool to boost short-term growth and relieve interest payments for SOEs and state investment projects (anonymous, personal communications, May 14, 2001; June 23, 2001).

Liberalizing interest rates, however, would greatly increase the efficiency of capital allocation. First, liberalized interest rates would provide banks, especially joint-stock banks, the incentive to lend to the vibrant private and joint-venture sector, creating jobs and increasing productivity. As one People’s Bank of China (PBOC) researcher put it, “(mandatory interest rates) weakens the role of interest rates to guide liquidity toward sectors with high efficiency....” (Xie et al., 2001, p. 29) More important perhaps for central bank technocrats, interest-rate liberalization would drastically reduce the transaction and monitoring costs for the PBOC. Under the existing system, the PBOC had to monitor more than 70 types of interest for commercial banks, 36 types for policy banks, and an additional 14 types of subsidized interests. Essentially, because interest rates were manipulated to allocate rent to regions, sectors, and policy areas, the PBOC had to ensure the proper interest rates applied to every major loan (Xie et al., 2001).

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