Lenders all over the world have the same problem: how to get debtors to pay them back. Basic game theory dictates that in interactions between a lender and a debtor, the debtor’s best strategy is to default. Of course, lenders know this, so often their best strategy is not to make the loan at all. Despite this obstacle, loans are made. Lenders use various means to ensure repayment. In emerging markets, social norms with second and third party enforcement are popular.

This explains the prevalent practice of lending to friends, cronies, and guanxi (connections) without formal credit analysis. Physical force or intimidation can be effective, but it requires a personal touch. Besides, these methods are useful only on a small scale.

Far more economically efficient—according to the Coase theorem—is a functioning legal system with low transaction costs. Such a legal infrastructure must include laws, a functioning and unbiased court system, lawyers, enforcement, and a central registry where title and security interests can be determined. All of these elements must be free of government interference. Officials must have sufficient incentives and disincentives to perform their functions in a reasonably honest manner. Although the legal infrastructure is the cheapest component of a state’s overall infrastructure, it is the most neglected.

This neglect is not an oversight. On the contrary, it is often part of policy. Laws, procedures, and property rights, while essential to a market economy, often restrict government power, specifically the power to allocate capital as the government sees fit. The misuse of this power has been an economic disaster throughout the world, especially in Asia. Financial and banking systems have been crippled and will require massive bailouts at taxpayer expense—assuming there are taxes to expend. China barely collects 14 percent of gross domestic product (GDP) in taxes, which is meager compared to the 2001 takings of Japan (27 percent), the United States (29 percent), and the United Kingdom (37 percent).

Non-Performing Loans

The pillaging of the financial system has created mountains of bad or non-performing loans (NPLs) that will probably never be paid back. The Chinese cannot pay back their debts; the Japanese, on the other hand, do not want to. While most bank regulators try to keep banks from making imprudent loans, Japan’s Financial Service Agency “has been pressuring the bank[s] to do just the reverse—or keep the funds flowing to borrowers the bank[s’] own credit department regards as dodgy,” as Akio Mikuni and R. Taggart Murphy comment in Japan’s Policy Trap: Dollars, Deflation and the Crisis of Japanese Finance. Malaysia, Thailand, and Indonesia cannot repay their loans because they are hobbled by ineffectual legal systems.

The numbers of NPLs inspire awe. In China, the official estimate of bad loans is US$406 billion, although a more realistic estimate would be US$518 billion. Most of these bad loans are concentrated in the four main state banks: Bank of China, Industrial and Commercial Bank of China, China Construction Bank, and Agricultural Bank of China. The worst offenders are the Construction Bank and the Agricultural Bank, where the NPLs are estimated to be approximately 40 and 80 percent respectively of total assets. Conservative estimates list Japanese debts at US$358 billion. The actual amount of questionable loans may be much higher. The criteria used in both China and Japan are less stringent than in the United States, even assuming that the amount of the loans has been accurately reported.

These bad loans are the result of three things: people, policy, and practice. In 1997, a new concept, crony capitalism, emerged. A less pejorative and more descriptive term for this particular problem would be “relationship lending.” In parts of Southeast Asia, certain loans were made to favored cronies of government officials. More often, these cronies loaned money to themselves through banks that they owned.

In Japan, loans usually went to companies with which the bank maintained a relationship, often within the bank’s keiretsu group, which is a uniquely Japanese grouping of affiliated companies that work together in close alliance. In China, the relationships, or guanxi, were determined by the local Communist Party. Most of the salaries, wages, and often government revenues come from a local state owned enterprise (SOE). The fact that these enterprises are often insolvent makes little difference. They were, and to a great extent still are, the principle recipients of loans from the four main state banks.

The second origin of bad loans has been policy lending. Regardless of the credit risk, governments throughout the world have encouraged banks to lend to industries favored under government policies. In China, the worst example is Angang, the steel giant based in Liaoning province. A showcase of the modernization for steel production in China, the company is a favored destination for loans even though it is not profitable. The same is true for Japan, where the Ministry of Finance, with its dirigiste tendencies, guides loans to favored companies without reference to credit risk.

In environments where loan recipients are not chosen by financial risk, it is unsurprising that good banking practices are noticeably absent. With very few exceptions, China’s lending institutions are owned by the government. Good corporate governance, prudent operations, transparency, and even profit are not high priorities. Their main purpose is to channel funds to favored people and enterprises, usually local ones. As a result, it is not surprising that some of the money goes astray. In one case, US$483 million was embezzled in a Bank of China loan scandal. This theft reached the highest levels of power, with culprits including Wang Xuebing, a former chief of the Bank of China.

Even without theft, some of the most basic banking practices are ignored. Loans are not always documented. Collateral is not requested, and even when it exists, the procedures for the bank to gain a legal interest in it are not properly followed. The absence of a legal environment that prohibits government interference and discourages prudent practice can have a devastating effect on both the financial system and investments. Governments can support their programs in two ways. They can spend taxpayer money or depositor money through loans from banks. Taxpayer money is preferable, since it does not have to be paid back. If depositors are not repaid, they have a history of creating financial panics, while taxpayers just complain.