Microsoft Word EcRefChina Oct06. doc

de facto
bond issue 
controls.
In contrast to the thin securities market, the volume of bank assets is quite large in China, 
mainly because of the huge household saving in the form of bank deposits. While in other 
East-Asian countries banks tend to intermediate 30-40 percent of the total financial capital 
in the national economy, the corresponding figure in China seems to be above 70 percent 
(McKinsey Global Institute, 2006). Since large firms in China, in fact, get their main 
financing from banks rather than from the poorly developed securities markets, small and 
21
Indeed, the UNDP (2000, p. 58) makes already now the judgment that the “explosive increase in 
unemployment has become the most challenging issue in China’s economic and social development”. 
22
The Harris and Todaro (1970) model of urban unemployment seems less relevant for China since the 
unemployment rate for migrants to cities is lower than the unemployment rate for permanent residents; 
see Giles et. al.(2005)
23
The International Finance Corporation (IFC, 2000) reports that among 976 listed companies only 11 
were non-state firms in 2000.

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20
medium sized firms (SMEs) have been squeezed out from the formal loan market, and 
they have been forced to turn to the informal financial markets with much higher interest 
rates.
24
The efficiency and flexibility of the market for bank loans are also limited by the 
domination of public-sector banks, which have systematically favored state enterprises at 
the expense of private firms.
25
In the late 1990s and early 2000s, two-thirds of all bank 
credit seems to have been granted to the state sector. Thus, even though private firms 
produce most of GDP today, China’s character as a market economy is still constrained 
by the domination of government institutions in financial markets. 
Another well known weakness of financial markets in China is that bank lending often 
has been “soft” in the sense that a large fraction of the loans have turned out to be non-
performing (paying neither interest rates nor amortization). Indeed, according to many 
observers, 30-40 percent of the stock of loans by public-sector banks was non-performing 
around year 2000.
26
It is often also asserted that many bank managers expected 
government authorities to bail them out in the event of severe financial difficulties in the 
future – if so, a pronounced example of moral hazard in the financial system.
The share of non-performing loans is believed to subsequently have fallen to less than 10 
percent due to the transfer of a large volume of such loans to special asset management 
companies, as well as due to the recapitalization of some of the banks by government 
funds.
27
The large flow of deposits of household saving into state banks at low 
(occasionally negative) real interest rates has also helped avoid an acute financial crisis in 
the bank system.
For these reasons, the risk of an immanent financial crisis in China is remote. Indeed, the 
Chinese government has sufficient financial resources to avoid financial instability in the 
near future, even with a “new round” of non-performing loans, and only modest recovery 
24
McKinsey Global Institute (2006, pp. 65-66) estimates the informal loan market at US 
$
100 billion 
(about 5 percent of GDP), with interests often in the interval 15-20 percent. 
25
According to the OECD (2005a, Figure 3.2), more than 90 percent of total bank assets are owned by 
the public-sector banks.
26
See, for instance, Lardy (2000); Chow (2002, pp. 229-30); Aziz and Duenwald (2002); Asian 
Development Bank (2004); and OECD (2005a, Table 3.4). 
27
See, for instance,
 
(2006, March 25) and Dobson (2006). The latter study calculates that the Chinese 
taxpayers have injected US $ 231 billion since 1999 to fix up the balance sheets of three of China’s Big 
Four Banks. McKinsey Global Institute (2006, p. 32) estimates that more than US $ 300 billion worth of 
nonperforming loans has been transferred from the large state commercial banks to asset-management 
companies since their creation in 1998. 

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21
of the loans that have been shifted over to the asset management corporations.
28
However, 
in a long-term perspective, financial stability, and indeed macroeconomic stability, clearly 
requires that the quality of lending by financial institutions in China improves 
considerably. It is therefore disturbing that the large expansion of bank loans in China in 
recent years (a rate of expansion of about 20 percent per year) has continued to favor state 
firms; according to McKinsey Global Institute (2006, Exhibit 2) they have received about 
two thirds of the loans. Indeed, several observers have expressed concern about the 
quality of this lending; see, for instance, Goldstein and Lardy (2004).
Moreover, while future deregulation and increased competition in financial markets are 
important for improving the efficiency of these markets, such policies could during a 
transition period also contribute to financial instability through reduced profit margins. 
These observations underline the importance of improving the quality of lending in China 
sooner rather than later. (I will return to the consequences of deficiencies in Chinese 
financial markets for the efficiency of the allocation of resources in the country – a 
serious problem even if it turns out to be possible to avoid financial crises in the future.)
Another characteristic feature of the economic system in China is the heavy reliance on 
informal networks, partly as substitutes for “the rule of law” (i.e. the enforcement of 
contracts through the legal system). Observers of the Chinese business culture often refer 
to the so-called 
guanxi
– the Chinese variety of “social capital”.
29
More specifically, 
economic relationships among economic agents are largely founded on social norms of 
cooperation, with roots in traditional kinship and community institutions. Indeed, such 
norms may function as de facto property rights, thereby stabilizing expectations regarding 
the behavior of other economic agents (Wank, 1999). These norms are then based on a 
distinction between business insiders (