Besides the possibility of provoking a deep depression, the accumulation of bad loans has several other adverse economic effects. Unresolved NPLs are an indicator of an inefficient allocation of capital within the system. They discourage new loans to healthier segments of the economy. Bad loans need to be cleaned out by the plumbing of market economies, an efficient bankruptcy system. If they are allowed to stagnate on the banks’ books, the rot could spread to the rest of the economy, as it has in Japan.

Systemic Stagnation

Unfortunately, China does not have an efficient bankruptcy system. Its 1987 Bankruptcy Law is out of date, limited to SOEs, and not enforced. According to a senior Chinese official, legislating a new law could take another five years. The reluctance is understandable. Bankruptcy is unpalatable to everyone (except creditors, who at least get something). In China, this means that managers—often Communist Party members—are out of work. Investors, usually the Chinese government, have lost their money, and workers without jobs can foment social instability.

Rather than risk bankruptcy, the Chinese have tried to imitate a US solution to their banking crisis. During the savings-and-loan banking crisis of the late 1980s, the US federal government created the Resolution Trust Corporation (RTC). Usually the RTC would guarantee depositors’ accounts in exchange for the NPLs of an insolvent bank. Once the RTC had title to the loans, it would foreclose on any collateral and sell it as quickly as possible. The bank would be closed, the depositors would be paid off, and the difference between the value of the collateral and the liability to the depositors was borne by the taxpayer.

The Asian version of the RTC has one major difference: in China, Asset Management Companies (AMCs) were established, and in Japan, the government created the Resolution and Collection Corporation (RCC). However, neither the AMCs nor the RCC have the power to close an insolvent bank. Instead, they only purchase the bank’s bad loans, while the bank and its management, who are responsible for making the bad loans, remain. The incompetent bankers are left to continue their profligate ways.

The main difference between the AMCs and the RCC is price. The RCC is supposed to buy dud loans at “market price,” a fraction of the original amount of the loan. In contrast, the AMCs purchase bad loans from one of the corresponding big four banks at face value in exchange for 10-year bonds. The bonds pay 2.25 percent per year, which is often better than the yield on the underlying loan. So, in theory, the banks’ balance sheets have been wiped clean. Instead of holding bad loans as assets, they hold the AMC interest-bearing bonds.

The reality is quite different. The bonds are not guaranteed by the government. In order to repay the bonds and pay the coupons, AMCs must collect 100 percent of the value of the bad loan and interest. “Nobody knows where [the AMCs] will get the money to pay the IOU at maturity—that depends on whether the AMC can create something out of nothing,” laments John Langlois of the Asian Wall Street Journal. The only party that benefits from this transaction is the government, as the interest paid by the AMCs to their corresponding bank is taxed.

Whatever their deficiencies, the AMCs were set up, and in 2000, 1.4 trillion renminbi (RMB) (US$170 billion) worth of bad bank loans were transferred. This was supposed to solve the problem, but it did not. Rather than restraining their lavish lending, the banks just kept making bad loans after the transfer. In 2002, a further RMB 400 billion (US$50 billion) worth of new loans were made, which accounts for more than four percent of GDP. The People’s Bank of China (PBOC), China’s central bank, has claimed that the NPL ratio fell 4.6 percent in 2002. However, it did not state the amount of the bad loans, which may have remained constant. The reduction may be the result of a larger number of loans. Besides, the main originator of bad loans, the SOEs, increased their debt by 3.1 percent.

The AMCs proved no better at collecting the NPLs than the banks. The deficient legal infrastructure, which encouraged the banks to make the loans, makes it impossible to get rid of them. Creditors have four alternatives for disposing of a bad loan: they can try to collect the loan (or at least the collateral) from the debtor, force the debtor into bankruptcy, exchange the debt for equity in the debtor’s enterprise, or, least likely, sell the loan.

An Unworkable Solution

Collecting a debt is almost impossible in China. Since state banks lend to state companies, there are often no records, collateral, mortgages or security interest. Even good collateral with a legally enforceable security interests is hard to find. Managers of SOEs often strip assets and transfer them to their own private companies.

Local courts protect local companies because they usually report to the same local cadres. According to a Chinese legal commentator, Cao Siyuan, there is less than a 0.1 percent chance of winning a case against the company, whatever the merits of the case. In one instance, cited by Richard McGregor in the Financial Times, when a local loan shark used local judges as well as muscle to enforce a debt, the “judges told him not to worry about repaying his official loans, ‘as [the banks] can write off debt.’” But the man had to pay back the loan shark at the risk of the courts destroying his family.

Since China does not have a functioning bankruptcy system, AMCs and banks occasionally have tried to solve the problem by exchanging the debt of an SOE for equity. Although in theory this gives the bank or AMC the power to restructure the SOE, in reality, nothing changes. Before the transaction, the SOE is entirely state owned, and remains so after the transaction. The bank or AMC may not have the power to change management, fire workers, or shut the company down. Even if the company had the potential to realize a profit, there is very little that the lender can do to bring about the transformation.