China's entry into the World Trade Organization is providing additional motivation for that country to develop a modern banking system. Entry into the WTO exposes China's domestic industries to increased competition and, after 5 years, allows foreign banks to compete for Chinese borrowers and depositors. Unless China modernizes its banking system, domestic production and banking services could substantially diminish, reducing China's economic growth.

When the Communists came to power in 1949, one of the first steps taken was to dismantle the capitalist banking structure. A single bank, the Peoples Bank of China, was established. However, the bank operated on the basis of guanxi, a system where personal relationships mattered more than potential profitability in securing a loan. During the first years of the Communist reign, this Soviet-style system was probably adequate, but as the economy grew, especially during the 1980s when China shifted to a market-oriented economy, the banking sector started funneling funds to state-owned enterprises without considering the possibility of repayment. The legacy of that system is that bad loans, according to one government estimate, amount to $218 billion or 27 percent of total bank lending. Another estimate, by Ernst and Young, place total bad loans at $480 billion, or 44 percent of total bank lending and 44 percent of Gross Domestic Product. This would make the potential problem in China considerably worse than in Japan where stories of bad loans continually make headlines. Furthermore, China's banking sector is overstaffed, under-capitalized and dependent upon government support.

An insolvent banking system would reduce China's economic growth from its current rate of 7 percent. Failure to correct this problem would mean that the government would continue to support industries that are not competitive and not be able to provide capital to firms that are profitable. Because of the importance of the problem, China is resolved to correct this situation. Following the U.S.'s approach to the savings and loan debacle, China is shifting assets from unprofitable state-owned companies to private investors. Many Chinese criticize this approach and resent the fact that their assets are being sold at deeply discounted prices. Another consideration is that this restructuring could force thousands of firms to close and add millions of Chinese workers to the unemployed population.

(Updated February 13, 2002)