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Bad debts axe one of the most dramatic problems which emerged in the early 1980s when the People's Bank of China started to provide loans for fixed investment for state-owned enterprises (SOEs), which used to he directly financed by the government's fiscal plans. The bank was directed by the government to provide loans to the SOEs, which frequently did not have enough registered assets to back up the loans. Such loans served to maintain these SOEs' survival rather than make a profit and bad debts followed as an inevitable result.
When China separated the commercial banking function from the central bank (the People's Bank of China) in 1984, the task of providing loans for the SOEs. Hence the burden of bad debts, was transferred to the state commercial banks.
According to a statistical survey and several reports, the bad debts amounted to US$ 6.396 billion. 17-25% of GDP by the end of 1993. In 1995, the total of bad debts of the Industrial and Commercial Bank of China was more than 20% of its loan total, and about 57% of the loans were "dead." Among all four state commercial banks, the average bad debt ratio (bad debt over total outstanding total) is around 25%.
A well-functioning commercial banking system is crucial to financial reform. But the massive amount of bad debts has not only seriously damaged the banks' assets quality: but also hurt their credit rating in international financial markets. In 1995, some international financial institutes decided to downgrade China's commercial banks, prompting the Chinese government to think again about how to solve the bad debt problem.
Causes
There are three institutional sources of bad debts: the government, the SOEs and the banking system itself.
The central and local governments often decide to invest in a project based on social policies rather than economic criteria. The state commercial banks may then be asked to finance and refinance a questionable project or a bankrupt firm because the government wants to avoid increased unemployment.
SOEs abuse the banking system. Expecting that the government will cancel or restructure the debt, the managers of an SOE may shift the fund they get from the banks to some outside projects controlled by their relatives and friends. The practice creates a leakage of assets to the non-state sector, resulting in asset dissipation and increased loan risk.
The state commercial banks, which lack commercial incentive and expertise while enjoying tremendous financial resources, arc not experienced enough in analyzing projects, especially long term ones.
The Role of State Commercial Banks
Several institutional characteristics contribute to the bad debt problem:
1) The allocation of financial resources is still determined by the government authorities at central, regional, and local levels within a framework of overall economic planning. Loans from the state commercial banking system, both for investment and for working capital, are allocate, d. to a large extent, by the instructions and guidelines issued by the government. The state commercial banks have only limited freedom to choose the projects which they consider less risky or more profitable. As a result, credit risks of the state commercial banks have become higher.
2) The commercial banks can neither decide independently the interest rates nor allocate the loans according to the market. Rates are set by the People's Bank of China and any big change must be approved by the State Council. These restrictions have limited the state commercial banks from "acting like banks", influenced their performance and increased bad debts.
3) The state commercial banks are rigidly restricted within each province or each local region, and there are also many inter-industrial barriers that restrict market competition. As a result, the local branches of the state commercial banks may not be able to diversify their loan portfolios which also increases credit risks.
4) There are no well-developed prudential regulations for the commercial banks. Many state commercial banks are learning the concepts of liquidity, asset and liability, asset quality, capital adequacy, earnings, etc. The lack of informed management aggravated the bad debt problem, in 1992-1993, many local branches of the state commercial banks illegally transferred short-term (one day or one week) inter-bank loans into long-term loans for SOEs' investment projects, which reduced the credit quality dramatically and generated a serious financial crisis in the summer of 1993.
Proposals for the Solution
Are there any solutions for the bad debt problem? Poland, Hungary, and the Czech Republic have made three proposals: I) Debt Cancellation -- writing off the inherited debt; 2) Debt Transfer -- transferring the debt from the commercial banks to a special "bad debt" bank, and 3) Self Reliance -- leaving the debt on the banks' balance sheets and requiring that the banks work out or restructure the debt on their own. Some Chinese top officials and economists have also suggested the ideas.
Debt Cancellation is based on the following argument: since both the firms and banks are state-owned, any action that removes liabilities from the firms' balance sheets and equal amounts of assets from the banks will result in no change in the net writing of the government's balance. This argument looks compelling, but debt cancellation has not been adopted in Eastern European countries. In 1991-1992 Vice Premier Zhu Rongji cancelled more than RMB 100 billion (US$ 12 billion) in bad debts. This reduced the bad debt size from RMB 400 billion (US$ 48 billion) in the middle of 1991 to around RMB 150 billion (US$18 billion) at the beginning of 1992. Unfortunately, this action created a big credibility problem: since the government canceled their bad debt once, many SOE managers believed that it would again. Without any changes in policy and administration, bad debt will reaccumulate; the size of bad debt now is larger than that in the pre-cancellation year (1991). It was decided that debt cancellation was not the answer and Zhu said that they should look for a new solution.
Wu Xiaolin, one of the top officials of the State Administration for Exchange Control, suggested a Reconstruction Plan: the government and banks should distinguish between different kinds of bad debts: those caused by an insufficient input of government assets and those caused by the firms' performance. For the former, the government fiscal department should write a special check to the firm, .so that the firm can pay the banks; for the latter, the banks are allowed to accept the firms' equity in exchange for the bad debts. This proposal would appear to be a mixture of Debt Cancellation and Self-Reliance. The problems are: if the bad debt can be paid by the government special checks, then the credibility problem still exists; if the firms haves a serious loss-making problem, then they would welcome exchanging equity for bad debt, and the banks still lose money.
Another proposal by two economists in the United States, Lawrence Lau and Yingyi Qian, consists of three elements: I) creating an Enterprise and Bank Reconstruction Fund (EBRF) to provide explicit fiscal subsidies for a fixed period for some loss-making enterprises; 2) reorganization of banks by issuance of preferred stock to the public: and 3) revaluation of firms' assets and liabilities under the supervision of the banks. In this way, the reaccumulation of bad debt could be avoided. The goals of this proposal are to tighten the budget constraints on enterprises, forcing a real exchange between banks and firms, which is different from cancellation. This proposal looks like the Self-Reliance solution of the CzechRepublic since 1990. But, from the experience of the CzechRepublic, the fund (like EBRF) should be financed by the government. Otherwise, it is too difficult to build up. If the fund depends on government support, however, it is impossible to avoid the problem of incentive distortion.
The process of solving the bad debt will be long, depending on the whole process of market transition in China. Hopefully, the ultimate solution lies in the development of non-state sector. If the commercial banks can freely allocate their assets to the high growth non-state industries, the bad debt problem would be significantly reduced. |
