Asia's Next Casualty?

An alarmed Beijing is starting to get serious about financial reform

China's leaders would like to think that they are immune to the financial turmoil engulfing Asia. But a recent $36 million scandal involving 120 government officials is just the latest reminder that China is vulnerable. Shocked by one Asian country after another slipping into a financial morass, Beijing is using the crisis to hasten the pace of change in its troubled banking sector, crack down on financial corruption, and strengthen regulatory bodies. "We should speed up reform of the financial system," says China Construction Bank President Wang Qishan.

With a staggering official figure of $200 billion in bad bank loans--the true amount likely is much higher--China risks becoming Asia's next casualty. If Chinese banks start imploding under the weight of their loans to money-losing state industries, the economy is sure to take a massive hit. That may force Beijing to devalue China's currency to pump up exports. And that could deliver a huge shock to Hong Kong's fragile stock market and currency, as well as bourses in Shanghai and Shenzhen.

Indeed, many observers believe that unless China acts quickly to reform its ailing banks, the whole world will be affected. "If China starts a great export drive--and if they devalue--this would have a damaging effect on the global economy," says Mitsubishi Corp. President Minoru Makihara. Economic czar Zhu Rongji insists that Beijing, with $134 billion in foreign reserves, will not devalue. The reserves could give Zhu a financial cushion as he and his colleagues clean up China's banks.

Chinese officials have held three key meetings in just as many months focusing on financial liberalization and reform. The 15th Party Congress in September put the top leadership's seal of approval on reforming lenders and state-owned companies. Then, in November, came two closed-door banking conferences attended by China's financial elite. Emerging from the meetings is a move by Beijing to centralize control over the sprawling financial sector while focusing on accountability for managers. The government will have more control over the central bank, the People's Bank of China. Authorities have decided to close thousands of municipal and provincial PBOC branches and replace them with 10 regional ones more accountable to Beijing. More significantly, China plans to let state companies go bankrupt and has allocated a fund to write off around $12 billion in bad loans. There is even talk of a Resolution Trust Corp.-style entity to take over dud loans and clean up the mess.

BIG CUTS. With Zhu trying to strengthen China's threadbare regulatory structure and promote competition, modest signs of banks beginning to operate like real businesses are starting to appear. For example, Wang has set up an international investment bank with Morgan Stanley, Dean Witter, Discover & Co. to do both China and international deals. But at home, he is slashing costs. He plans to cut 100,000 out of a total 400,000 employees and shutter 25% of his bank's 6,000 branches as soon as he gains Beijing's go-ahead. It's an "almost Thatcherite program," says a Western financial analyst in Beijing.

For a year, regulators have also been cracking down on scams like the alleged one in Nanjing. There, government officials are charged with attracting depositors through illegal means, falsifying deposit slips, and making inappropriate loans. Authorities are also going after other types of lending institutions such as credit cooperatives and property companies. In January, for example, regulators pulled the plug on China Agribusiness Development & Trust Corp. after finding a balance sheet riddled with bad loans. In the past year, 200 of the 580 such institutions faced the same fate. Regulators have severely punished stock market-related fraud. In June, senior bankers and brokers were fired and their firms fined and suspended in an unprecedented crackdown on market abuses (BW--June 30).

The central bank will tighten control over the Big Four commercial banks--Bank of China, Industrial & Commercial Bank of China, China Construction Bank, and Agricultural Bank of China--that control over three-quarters of all lending. In a move the official China Daily termed as part of a "campaign against financial risks," the PBOC on Nov. 12 established a supervisory board composed of its own officials as well as those from the Finance Ministry and outside financial institutions. The board will "be significant to the improvement of the commercial banks' operation and asset quality," China Daily said.

But Beijing faces a possible backlash if its reforms are too heavy-handed. Thousands of agricultural and light industrial enterprises rely on unregulated financing sources, including over-the-counter stock exchanges, which Beijing wants to eliminate. The enterprises may lose their only source of financing just when they need it most. People involved in rural development "are up in arms that this will fundamentally affect rural enterprise reform," says a Beijing-based Western economic analyst.

For now, the Chinese say they're determined to avoid the errors that Korea and Japan made: making the financial system a servant of central planners' industrial-development policies for too long. "We will avoid the mistakes made by others," vows Di Weiping, executive vice-president of the PBOC's Shanghai branch. With $200 billion worth of mistakes already, China can ill afford more.

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