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China's Road to Greater Financial Stability

Chapter 15. This Time Is Different: The Domestic Financial Impact of Global Rebalancing

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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Information about Asia and the Pacific Asia y el Pacífico
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In 1998, the Chinese financial system faced a severe challenge. The region was in financial turmoil, and the wave of bankruptcies of state-owned enterprises (SOEs) in the 1990s had produced official nonperforming loan (NPL) ratios of over 25 percent. Yet, the Chinese leadership brought China through the difficulties with sweeping financial reform that revolved around the centralization of the “Big Four” state banks and the disposal of NPLs in asset management companies (AMCs). The result was stunning success that ended with the successful listing of all of China’s major state banks.

Today, China faces a much more benign but nonetheless challenging environment. External demand has remained stagnant and official NPL ratios remain at historically low levels, although the pool of illiquid assets on the banks’ balance sheets may well be large. Yet, China now has a smaller cushion with which to buffer a significant worsening of the financial balance sheets. The main reason is that trade surplus and foreign exchange flows no longer infuse the banking system with large new deposits, which in the past allowed the banks to comfortably roll over illiquid assets while still financing new economic activities. Also, off-balance-sheet financial activities make up a much larger share of total credit than was the case in 1998. Going forward, the central bank will need to be much more aggressive in releasing sufficient liquidity into the economy, especially if significant financial reforms are carried out simultaneously. Over time, Chinese firms must learn to reduce their demand for capital inputs.

Financial Restructuring in the Late 1990s

The administration of Zhu Rongji devised a set of sweeping changes to reduce NPLs in the late 1990s because existing policy on write-offs only resolved a tiny fraction of the estimated RMB 3.3 trillion in NPLs (37 percent of 2000 GDP). In October 1997, the Central Committee and the State Council jointly issued the Notice Concerning Deepening Financial Reform, Rectifying Financial Order, and Preventing Financial Risk (Guanyu Shenhua Jinrong Gaige, Zhengdun Jinrong Zhixu, Fangfan Jinrong Fengxian De Tongzhi). Local branches of the state banks and of the People’s Bank of China (PBC) were removed from the local party committees’ jurisdiction and placed under the newly formed Central Finance Work Committee. The central government also closed hundreds of locally controlled trust and investment companies and underground banks (Zhu, 1998). To ensure compliance with these stunning announcements, Zhu, who was slated to become premier in the spring of 1998, chaired an emergency Central Finance Conference in November 1997 with the main theme of “preventing financial risk” (fangfan jinrong fengxian).1

A crafty politician, Zhu offered provinces in western China, as well as large state-owned enterprises, additional financial support in exchange for their agreement with his plans to centralize the banking system and institute sweeping changes to the banks’ internal credit approval process. Zhu also set harsh targets to lower the ratio of NPLs and ordered state banks to implement systems of responsibility such that managers who authorized loans could be punished with wage reductions and employment termination (Zhu, 1998). PBC governor Dai Xianglong further specified this policy by ordering the Big Four banks to lower their NPL ratios by 2 to 4 percent annually depending on the quality of their portfolios (Editorial Committee of the Great Reference of Economics, 2001).

To resolve the enormous NPL problem at the time, the four AMCs—Xinda, Changcheng, Huarong, and Dongfang—assumed the NPLs from the China Construction Bank (CCB), Agricultural Bank of China (ABC), Industrial and Commercial Bank of China (ICBC), and Bank of China (BOC), respectively (the People’s Bank of China, Ministry of Finance, and China Securities Regulations Commission, 2000). In essence, the four AMCs issued RMB 1.4 trillion in financial bonds to the state banks and used the funds to purchase RMB 1.4 trillion in NPLs from the Big Four state banks at face value.2 A few years after the NPLs were offloaded from the major state banks, the central government transferred US$45 billion from China’s foreign exchange reserve to the CCB and the BOC in preparation for their listings, followed by an additional US$30 billion, half from the foreign exchange reserve and the other half from the Treasury, to recapitalize the ICBC. Finally, the ABC received a whopping US$40 billion for its recapitalization. Central Huijin, which was capitalized by resources from China’s foreign exchange reserve, injected an additional US$45 billion in the Everbright Bank and two policy banks. With a much-reduced NPL burden and a bolstered capital base, China’s major banks listed in Hong Kong SAR and Shanghai in succession throughout the 2000s.

The sweeping financial reform of the late 1990s has become the foundation of the world’s confidence in China’s ability to deal with potential banking crises. With a great deal of control over the banks and the largest foreign exchange reserves in the world, surely China can repeat its actions in the late 1990s to rescue the banks.

Challenges to China’s Banks Today

In many ways, conditions today are significantly more benign for China than in the late 1990s. For one, China’s economy is much bigger today, making it more resilient to external and internal economic shocks. Even in 2008, China had the third-largest economy in the world behind only the United States and Japan, but today China has become the second-largest economy in the world. With a current GDP of US$8.24 trillion, few external crises can have a catastrophic impact on China. Also, China now has the world’s largest foreign exchange reserves at US$3.2 trillion, making the country’s currency seemingly impregnable to speculative attacks. Finally, the banking reform of the late 1990s left its mark, as banks in China today generally are much more professional than they were in the mid-1990s. Since the late 1990s, reducing NPL ratios has become an obsession with Chinese banks, and as a result banks in China now have some of the lowest NPL ratios in the world (Figure 15.1).

Figure 15.1Commercial Bank Nonperforming Loan Ratio

(In percent)

Source: CEIC.

Despite these great advantages, some worrisome trends have also emerged for China’s banking sector. First and foremost, the banking recapitalization a decade ago was too successful, in a sense. When the world financial crisis descended on China in 2008, Chinese banks were so well capitalized and had so much liquidity that they could boost lending by over 30 percent in one year. After 2009, Chinese banks’ balance sheets continued to grow at a rapid clip such that bank assets, when one takes into account assets in the shadow banking sector, are now approaching 300 percent of GDP. Figure 15.2 shows that whereas China’s GDP in 2011 was RMB 47 trillion, assets in the formal banking sector totaled RMB 115 trillion, and bank assets continued to grow to RMB 125 trillion by end-July 2012. Meanwhile, Fitch Ratings (2012) estimates that wealth management products, which also provide credit, totaled RMB 10 trillion as of mid-2012. In 1998, repairing a hypothetical 50 percent NPL ratio meant finding resources equivalent to 50 percent of GDP. Today, if 50 percent of bank assets were to become nonperforming, the write-down would be close to 150 percent of GDP. Even a nonperforming asset ratio of 20 percent translates to a nearly 60 percent of GDP write-down.

Figure 15.2GDP, Central Bank Assets, and Bank Assets

(In billions of renminbi)

Source: CEIC.

Also, in a way, China was lucky in the late 1990s because it was on the verge of entering the most spectacular period of current account surplus the world had ever seen. When money flowed into China from the current account surplus, foreign direct investment (FDI), or hot money inflows, the recipients of dollars sold them to their banks in return for renminbi. When banks ran short on renminbi, they had to sell their dollar holdings to the PBC, which printed high-power money to purchase banks’ foreign exchange sales. Thus, indirectly, the creation of high-power money by the PBC allowed foreign exchange earners to increase their renminbi deposits while exchange rates remained at roughly the same level. At their height in early 2008, net foreign exchange inflows over a 12-month period increased deposits by 7 percent of bank assets (Figure 15.3). The trade surplus increased deposits by 3.5 percent of bank assets over a 12-month period in 2007–08. Even as late as mid-2011, net foreign exchange inflows still increased deposits equivalent to 3.5 percent of bank assets over a 12-month period. Into 2012, however, these inflows only brought in a tiny amount of new liquidity. By July 2012, net foreign exchange inflows only brought in deposits equivalent to 0.5 percent of bank assets over a 12-month period. In sum, easy money creation from net foreign exchange inflows has become a thing of the past.

Figure 15.3Trade Surplus and Net Foreign Exchange Inflows (12-month rolling) as a Share of Total Bank Assets

(In percent)

Source: CEIC.

The enormous size of China’s banking system and the end of easy liquidity from foreign exchange inflows have enormous implications for China’s monetary policy going forward. First and foremost, without active PBC intervention to increase money supply, the pace of lending will slow to a level that is detrimental to the targeted growth rate of 7.5 percent. To be sure, since the beginning of the year, the PBC has continued to redeem PBC sterilization bills and to lower reserve requirement ratios to release high-power money into the economy (Figure 15.4). However, in combination with weak external demand, industrial output and fixed-asset investment have both slowed substantially from previous years. Growth in 2012 will be more modest than in the previous years. Without the PBC’s short-term facilities in the form of reverse repos, growth likely would be even slower. This stands in sharp contrast to the situation in the 2003–08 period, when the PBC only had to guard against inflation because banks had plenty of liquidity with which to lend to firms. Today, the PBC needs to be ever more vigilant against liquidity shortages in the interbank markets and intervene in a timely matter to prevent spikes in interbank rates.

Figure 15.4The People’s Bank of China Bills Outstanding

(Billions of renminbi, LHS; reserve requirement ratio, RHS)

Source: CEIC.

For firms in China, the era of easy credit from the banks is over. As bank deposit growth slowed sharply after 2011, the real cost of capital for firms also rose, despite rate cuts by the PBC (Figure 15.5). Smaller firms have a hard time borrowing from the banks, forcing them to borrow from trust companies and underground banks at much higher rates. Even larger real estate firms have had to borrow from trust companies, which raise money by issuing trust products paying high yields. Figure 15.5 reveals that the gap between the rate of investment growth and the rate of deposit growth is diverging, which is not sustainable. If the rate of deposit growth continues to slow due to low foreign exchange inflows, firms in China will need to slow the pace of investment. In the long term, this will contribute to economic rebalancing in China. However, in the short and medium term, this may cause painful changes in industries that are used to easy liquidity from the banks.

Figure 15.5Percent Increases in Fixed-Asset Investment and Deposits

(Year over year)

Source: CEIC.

Fortunately for China, the PBC still has multiple weapons with which to ease this process of slowing investment by firms. First, as seen in Figure 15.4, China continues to have some of the highest reserve requirement ratios in the world and can lower those requirements to pump long-term liquidity into the banking system. Second, the PBC can redeem the RMB 1.8 trillion or so in sterilization bonds, which it has done at a relatively fast pace in recent months. Finally, the PBC can provide short-term liquidity via reverse repos. However, because reverse repos mainly provide 7-day or 14-day liquidity, banks are reluctant to provide long-term liquidity to firms, fearing that PBC inaction would force them to borrow at a high cost in the interbank market. With the end of easy liquidity, the PBC must find a way to provide banks with long-term expectations of sufficient liquidity that does not signal reckless easing. The PBC may be wary that aggressive reserve requirement ratio cuts may give rise to another investment mania. However, the slowdown in inflows itself should credibly signal to firms the limit of PBC easing.

In the medium term, the greater challenge for the PBC and the financial regulators, as well as China’s planning authorities, is to slowly adjust the economy away from capital-intensive investment toward a more consumption-driven growth model. As Yifu Lin and others have noted, distortions in the form of taxes and subsidies need to be removed over time to reduce incentives to engage in a capital-intensive pattern of investment (Lin and Li, 2009). Distressed assets in the banking system will increase, and the authorities need to anticipate this and deal with the rising pool of distressed assets in an orderly fashion. Perhaps the greatest challenge going forward is the political opposition from capital-intensive industries against any adjustment policies.


    Editorial Committee of the Great Reference of Economics2001“Guoyou Yinhang Shangshi Sannian Zhinei Meixi” (“There Will Not Be Much for State Banks IPO within Three Years)”Jingji Da Cankao (The Great Reference of Economics) No. 4.

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    FitchRatings2012Chinese Banks: Wealth Management Risks Climb as Small Banks Accelerate Issuance,July27.

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    LinYifu and FeiyueLi2009Development Strategy, Viability, and Economic Distortions in Developing Countries,World Bank Policy Research Working Paper No 4906 (Washington: World Bank).

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    The People’s Bank of China Ministry of Finance and China Securities Regulations Commission2000“Guanyu Zujian Zhongguo Xinda Zichan Guanli Gongsi De Yijian” (“Opinion Concerning the Formation of Xinda Asset Management Company”) in Lun Zhongguo Buliang Zhaiquan Zhaiwu De Huajie (On the Dissolution of Bad Debt and Bad Debt Obligations in China)ed. by Xiangyang Zhan (Beijing: China Financial Publisher).

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    ZhuRongji1998“Shenhua Jinrong Gaige; Fangfan Jinrong Fengxian; Kaichuang Jinrong Gongzuo Xin Jumian” (“Deepening Financial Reform Preventing Financial Risks and Creating a New Phase for Financial Work”) in Xin Shiqi Jingji Tizhi Gaige Zhongyao Wenxian Xuanbian (“A Selection of Important Documents for Economic Structural Reform in the New Period”)ed. by Document Research Center of the CCP Central Committee (Beijing: Central Document Publisher).

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The routine Central Financial Conference had already taken place in January 1997.


“At face value” means at the original amount of the loan plus accrued interest. In a market economy, private asset management companies by definition never purchase a NPL at face value because of its high risk profile.

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