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By Root 526 0

’s financial deepening also has exceeded that of the newly industrializing countries (NICs).50 On the other hand, China’s financial sector, dominated by the state-controlled banking system, is the weakest among the world’s major economies, with a very high level of NPLs, pervasive corruption, and low efficiency. Judging by standard accounting criteria, all the major state banks became technically insolvent in the mid-1990s.51 The main function of the Chinese banking system is to funnel credit to value-destroying SOEs, not to the thriving private sector. In this section, I will review the history of gradualist reforms in the banking sector, assess the results of such reforms, and analyze the factors that have contributed to their failure.

Banking Reform since 1979

During the prereform era, China had a mono-bank system. The People’s Bank of China (PBOC) combined the functions of both central and commercial banking under state planning. The reform of the banking sector began gradually and tentatively in 1979, as China began its economic transition. That year, the government set up three specialized state-owned banks, the Agricultural Bank of China (ABC), the Bank of China (BOC), and the China Construction Bank (CCB). In 1984, it establishcd the Industrial and Commercial Bank of China (ICBC). These specialized state-owned banks then became the primary institutions of financial intermediation, with the PBOC assuming its role as the central bank. In the 1980s and early 1990s, the government took additional steps in diversifying the banking system. State-affiliated joint-holding banks (the Bank of Communications, Guangdong Development Bank, Shenzhen Development Bank, Shanghai Pudong Development Bank, China Merchants Bank, and Fujian Industrial Bank) entered the sector. The ownership of these banks was spread among local governments, government ministries, and SOEs. In addition, the government allowed the establishment of a large number of nonbank financial institutions, such as rural credit cooperatives (RCCs), urban credit cooperatives, and investment and trust companies. Foreign banks were permitted into the Chinese market to conduct limited banking operations as wcll.52 These measures had a negligible impact on the liberalization and development of the banking system, however. According to top Chinese economists who were drawing up plans for financial reform in the early 1990s, China’s central bank was considered dysfunctional and failing in its management of monetary policy. Specialized state banks were similarly unable to perform their assigned tasks of financial intermediation efficiently. China’s financial markets were judged to be chaotic.53

By all accounts, serious banking reform did not begin until 1994 and was probably precipitated by the overheating of the economy and credit explosion in 1992-1993 that alerted the Chinese leadership of the dangers of an unreformed banking sector. The reform package included most of the recommendations provided by liberal economists.54 On the whole, the reforms introduced in 1994 and 1995 created a legal framework for the financial sector through the promulgation of the People’s Bank Law and the Commercial Banking Law, strengthened the PBOC’s role as the central bank, established three policy banks, and transformed the four specialized state banks into state commercial banks (SCBs). Additional reform steps included the strengthening of banking regulations, the consolidation of poorly regulated investment and trust companies, the establishment of one private bank (China Minsheng Bank in 1996), and the transformation of urban credit cooperatives into city commercial banks.55 The East Asian financial crisis in 7997-1998 jolted the government into taking additional steps to strengthen its banks, as weak financial institutions were blamed for causing the crisis. It imposed tighter prudential supervision and pushed Chinese banks to adopt more stringent standards for classifying loans. The PBOC abolished loan quota control over the four SCBs in January 1998. The Ministry of Finance