When Will China's Financial System Meet China's Needs?

Over-investment in property development, excess production capacity and a massive inventory buildup are current symptoms of inefficient financial intermediation in China. Although a series of important financial reforms have been undertaken in recent years, the results are compromised by the lack of related institutional reforms and inadequate competition in the financial and capital markets. More importantly, the bank restructuring required to resolve the problems of non-performing loans poses a serious fiscal challenge. Optimistic assessments of the potential for debt-equity swaps fail to account adequately for the recent fiscal deterioration and the accumulation of contingent government liabilities. This paper constructs three scenarios that make different assumptions about the pace of revenue and expenditure growth, as well as the adoption of commercial discipline in bank operations. Comparing these scenarios suggests that revenue buoyancy and the creation of a credit culture are both indispensable for a successful recapitalization of China's huge state-owned banks.