This Time It’s Different: The Ecosystem of China’s Financial Sector Cleanup

On the face of it, China’s banks look remarkably robust. By international standards, China’s nonperforming loan (NPL) ratio is still incredibly low. After gradually rising since 2012, the NPL ratio peaked at 1.76% outstanding loans at the end of September 2016, before leveling off at 1.74% where it has remained ever since. At 1.74%, it is roughly in line with Germany’s 2016 level, a little higher than the US level that year, and far better than other major emerging markets like Brazil.

Healthy By International Standards…
China’s NPL ratio compared with other major economies
Source: World Development Indicators from the IMF.

However, there’s little to suggest that China’s official NPL figure is a fair representation of the actual level of distressed debt. In annual surveys of Chinese bankers conducted by China Orient Asset Management, respondents routinely say they believe NPL levels to be significantly higher than the officially reported level. Even the China Banking Regulatory Commission (CBRC) doubts the veracity of the 1.74% figure. In January, CBRC published a statement in which it outlined the various ways that banks disguised their bad loans (which MacroPolo wrote about here). According to the International Monetary Fund, Chinese banks sometimes choose to classify delinquent loans as normal if they feel the value of the loans is sufficiently insured by collateral or third-party guarantees.[1] Moreover, loan officers are given targets under which they’re required to keep bad loan levels, creating incentives to distort the figures.

…But the Data’s Unreliable
According to an annual survey by China Orient AMC, Chinese bankers consistently estimate that the NPL level in their area is well above the national level (percentage of respondents per NPL ratio range).
Source: China Orient Annual NPL report.

The actual level of bad loans is anyone’s guess, but by one commonly cited estimate, banks will have had to deal with 20 trillion yuan worth of NPLs by the time the problem is fully resolved.[2] That roughly equates to about 16% of outstanding bank loans at the end of 2017—albeit those NPLs will be recognized and dealt with gradually. That’s a far cry from the last time Beijing had to clean up the financial system, when in 1999, authorities estimated that 40% of all bank loans had gone bad.[3]

Given that China has had to deal with a large-scale clean-up of bad loans before, it’s easy to assume that Beijing will simply dust off the old playbook. After all, the previous clean-up laid the foundations for the prosperity China currently enjoys. However, China’s financial system and economy have changed so much that the tools used last time are no longer appropriate, sufficient, or feasible. A massive clean-up effort has already begun in earnest, taking place on multiple fronts, and in ways that have gone unnoticed.

MacroPolo’s ‘The Cleanup’ will produce regular reports like this one that monitors those efforts, tracks the changes, and strives to identify trends that are otherwise overlooked. Over time we will delve deeply into the various areas of the financial system where Beijing is trying to rein in risk, but in the months ahead, we will start by focusing on the fast-evolving ecosystem of institutions and investors that are helping banks deal with their asset quality problems.

This first report is an overview of that ecosystem, and highlights issues we intend to examine in the future. But to understand what China is doing today, it is important to first understand just how it differs from last time.

Stopping the Party…Like It’s 1999

In 1999, China launched a cleanup of its financial system that ultimately lasted more than a decade and involved three overlapping stages: first, bad loans were removed from the banks’ books; second, the banks were recapitalized; and finally, the banks were restored to profitability.

Following the example of other countries that had dealt with banking crises, the first stage involved setting up four asset management corporations—otherwise known as bad banks—with each initially responsible for acquiring bad loans from one of the four major banks. In 1999 and 2000, the four AMCs (Cinda, Huarong, China Orient, and Great Wall) acquired about 1.4 trillion yuan worth of bad loans from the big four banks,[4] which was equivalent to about 20% of the banks’ total outstanding loans. In stark contrast to typical practice among AMCs elsewhere in the world, they acquired the NPLs at face value, which meant the banks bore no cost for their having made the loans. Instead, the losses were borne by the AMCs which were unable to recover more than a fraction of what they paid for the loans. (A decade later, the government assumed a hands-on role in helping the AMCs pay off their debt.[5])

Timeline of Last Cleanup of China’s Banking System, 1999-2010
Sources: WSJ, RBA.

In that one-off transfer, banks were required to mainly spin-off loans issued prior to 1996, the rationale being that loans made prior to that time were policy loans. At the time, China was still emerging from a planned economy, and state firms had treated bank loans as a substitute for the government transfers that they no longer received—and so the burden of their delinquency should fall on the state, not the commercial banks.[6] However, a host of reforms had been launched throughout the 1990s aimed at making the banks more commercially oriented. So, the initial loan transfers signaled that the government regarded loans made from 1996 onward as being the result of commercial decisions, and that the banks would be held responsible for them.

According to the People’s Bank of China (PBOC), the central bank, in 2002 the NPL ratio of the major banks was officially 25%, but the market calculated it as being between 35% and 40%,[7] that is, broadly the same as immediately prior to the first round of disposals. So, in 2004 the AMCs embarked on a new round of bad loan purchases, although this time they were free to acquire post-1996 loans, and the loans were sold at a discount to their face value. (The Ministry of Finance and PBOC acquired some NPLs as well.)

Meanwhile, the banks were recapitalized. In 2003, Beijing used funds from its foreign exchange reserves to inject the Bank of China and China Construction Bank with $23 billion worth of capital.[8] Two years later the Industrial and Commercial Bank of China was injected with $17 billion. Soon after, the three banks raised additional funds in IPOs on the Hong Kong and Shanghai Stock Exchanges. (Agricultural Bank of China didn’t receive a capital injection until 2008, when it spun off a further $117 billion worth of NPLs, and then listed in 2010, thus bringing the decade-long clean-up process to an end.)[9]

The final component of the clean-up was the use of financial repression to return banks to profitability. Starting in 2004, the PBOC reduced the maximum interest rate banks could offer on deposits to below the pace of inflation.[10] While the rate would fluctuate from time to time, sub-inflation deposit rates became the norm for the rest of the decade. By keeping their money in the bank, Chinese citizens lost money on their savings, but there were few other places to invest. Neither the stock market nor the bond market could absorb more than a small fraction of national savings, and capital controls made it difficult, if not impossible, for households to move their savings overseas. With savings captive to the banking system, the central bank could do what it liked with the deposit rate.

By keeping deposit rates so low, banks could afford to make loans at comparably low interest rates, making it easier for heavily indebted state firms to make interest payments. The PBOC also set a minimum level on lending rates. The margin between the maximum deposit rate and minimum lending rate meant that banks made a healthy profit on every loan—profit that might otherwise have been eroded by competition to offer better rates. Explaining the model years later, the then-chief economist for the National Bureau of Statistics put it thusly:

“Banking in China has become like a highway toll system…With this kind of operational model, banks will continue making money even if all the bank presidents go home to sleep and you re-placed them by putting a small dog in their seats.”[11]

While that may be true, ensuring that the banks were profitable made it easier for them to list, and helped them bolster their capital beyond what they raised by listing publicly, and what the state injected. By 2010, China’s banks were among the largest—and most financially sound—in the world.

This Time It’s Different. No, Really.

In 2018, the Chinese economy looks very different than it did in the late 1990s and early 2000s, and subsequently the tools for dealing with bad loans have changed. Below we lay out the several key elements of how the financial system has changed and grown much more complex.

  1. First, this time the banks don’t need to be rescued. Whereas last time the sheer volume of NPLs had rendered the banks technically insolvent, in 2018 the banking system continues to function just fine. Instead, banks’ increasingly aggressive efforts to dispose of bad loans (which MacroPolo wrote about here) are best thought of as a preventative—not restorative—measure, aimed at ensuring that the financial system is robust enough to continue providing the credit that the economy needs to grow. Put another way, the clean-up is about shoring up the financial system now, at a time of the government’s own choosing, rather than being forced to do so under duress caused by some economic or financial shock.
  2. Second, financial repression is no longer possible to the extent it once was. As recently as ten years ago, banks were responsible for almost all credit in the economy and were home to almost all household savings. But starting in 2009, a shadow banking system emerged that was able to set interest rates free from the central bank’s control. It has since drawn tens of billions of yuan worth of savings into wealth management products, trusts, and online investment platforms. But while the expansion of shadow banking means that the government is unable to exercise control over the financial system like it once did, it has also created new opportunities for the disposal of bad loans.
  3. During the last clean up, there was really only one outlet for NPLs. Banks transferred them to the four AMCs that then set about recovering value from them, whether by renegotiating the terms of the loans with debtors, seeking repayment through the courts, or exchanging debt for equity in the delinquent companies. While AMCs were able to sell a small number of their NPL portfolios to foreign investors and to local governments looking to protect the interests of local companies, both were marginal channels at best. However, over the past decade China has developed a vibrant investment culture, a subset of which has embraced NPLs as an asset class. There’s a nascent market for bad loans repackaged into investment products, like asset-backed securities or various forms of wealth management products. And both the banks and AMCs now sell bad loans directly to investors, by auctioning them on provincial financial asset exchanges (a type of online auction house that has proliferated around the country) and Taobao, Alibaba’s online shopping platform.
  4. Supporting the development of a secondary market is that the quality of NPLs is far better than during the last clean up. That’s in part because the loans spun off in 1999 and 2000 had been borrowed by state firms that never intended to pay them back. In other words, those state firms considered loans as basically a massive free fiscal transfer. But more importantly, unlike back then, today most loans are backed some sort of security, be it collateral—which is typically real estate, but sometimes takes the form of inventory, car fleets, company equity, and mining rights—or a guarantee from a third party that it will make good on the loan in case of default. The upshot is that whoever acquires an NPL can go after the collateral, or the guarantor, or, in some cases, both. Making it easier to turn collateral into cash, both Taobao and the financial asset exchanges provide a platform for banks, AMCs, and NPL investors to auction assets they’ve seized from delinquent borrowers.
  5. Also making NPL investing easier is that the composition of borrowers has changed. This time far more delinquent debtors are private companies. Whereas during the last clean up, almost all bank loans were lent to state firms, currently only about 40% of loans go to state firms.[12] This time, there are plenty of private companies and individuals included among the delinquent borrowers. Resolving loans to state firms invariably involves a political element—whether it be dealing with government concerns about the loss of state assets or the interference of local authorities looking out for local interests. On the other hand, investors who’ve acquired loans to delinquent private borrowers are less likely to face political obstruction.
  6. However, the diversification of the financial system has also created new sources of bad loans, and many new financial institutions are less well equipped than the banks to absorb losses and shield their customers from default. Already, there have been a spate of collapses among credit guarantee companies and P2P platforms. And the legal system is clogged with cases involving private companies and entrepreneurs that have failed to repay money borrowed from family, friends, and other private companies. Moreover, banks are indirectly responsible for many loans extended through the shadow banking system, meaning the levels of delinquent loans they’re likely to ultimately be responsible for is far higher than what they acknowledge.
  7. Meanwhile, in the formal banking system, the source of bad loans has changed. Last time, most of the NPLs were concentrated in the big four banks. Joint stock banks accounted for less than 10% of total banking assets in 1999 and they also faced less severe bad loan problems.[13] Rural credit cooperatives were in far worse shape and eventually went through a shake-up that saw many close down, but collectively they were only a very small fraction of the financial system. This time, the big four banks have the best quality loans. Meanwhile, city commercial banks and rural commercial banks—which have poorer asset quality—play a far bigger role in the financial system. That has created a need for more specialist local organizations that can deal with bad loans at banks that operate only on a local or provincial basis. Subsequently, according to MacroPolo’s research, almost 50 provincial AMCs have been approved since 2014, which operate alongside the big four central AMCs that have been in operation since 1999.
  8. The bigger, better managed banks are likely to rely less upon AMCs and play a far greater role in cleaning up the mess themselves. Some have already set up their own centralized “special-assets management” departments in order to extract more value from their loans before writing them off or selling them. And the big four banks have set up subsidiaries to facilitate debt-for-equity swaps—whereby the bank accepts equity in a company in lieu of repayment on a delinquent loan—a concession that only the big four AMCs were entitled to last time.

A Whole New Ecosystem for Disposing of Bad Loans is Emerging
Note: Not all NPLs flow through to investors.
Source: MacroPolo.

All this is extremely promising in that it means the banks should be able to extract greater value from bad loans than otherwise would be the case. It also means that the process of improving the banks’ asset quality will fall primarily to the market and not the government. However, there are plenty of challenges that threaten to complicate, if not derail, the process.

Notably, as economic growth slows, the proportion of bad loans will likely rise. The rapid pace of NPL disposals is already putting bank profits under pressure. According to CBRC data, banks’ provisions against NPLs have fallen from 290% in 2013 to 180% at the end of 2017, and bank efforts to keep provisions even at that level have aggressively eaten into profits. Moreover, another potential concern is whether the secondary market for NPLs that is supporting much of this new ecosystem is sufficiently robust. China’s financial assets are prone to bubbles, and since most new investors don’t have much prior experience investing in NPLs, there are signs that prices are already too high.

But perhaps the biggest concern is whether the clean-up of the financial system will be accompanied by a sufficiently robust overhaul of the economy. Last time, in an effort to lift the efficiency of the economy, tens of thousands of state firms were closed, while others were merged, and some privatized. Meanwhile, the liberalization of home ownership, and China’s accession to the World Trade Organization, unleashed a new driver of growth—housing construction—and turbo-charged another—exports.

Beijing envisions a similarly grand economic transformation this time. On the one hand, it wants to reduce industrial overcapacity by shutting down factories, fill the empty apartments that plague some cities, and deal with zombie companies that can’t repay their debts. Meanwhile, it wants to create new sources of growth by embracing innovation and high-tech industries. However, while the reforms at the turn of the century resulted in a declining role for the state in the economy, this time Beijing wants to bolster the state’s involvement. Even though it is experimenting with the bankruptcy and liquidation of state-owned firms (see here for our piece on the liquidation of Guangxi Nonferrous Metal) that are beyond saving, Beijing’s preference is for struggling state companies to merge or to be somehow reinvented. That complicates things for banks. The extent to which the state industrial sector is forced to reform will influence just how readily the banks can dispose of certain loans—and potentially whether NPLs will continue to accumulate unabated.


Efforts to cleanup China’s financial system are still nascent. Those efforts really took off in 2017, resulting from a combination of factors that included the return of Guo Shuqing as CBRC chairman, greater support for managing financial risk from Xi Jinping, and long-time reform advocate, Liu He, assuming a greater role at the top of government. However, how reform proceeds will change over time as banks and regulators adapt to what works and to shifting political priorities.

Thus far, one of the more high-profile changes has been the decision to approve a batch of new bad banks to complement the four that have been operating since 1999. However, the new bad banks bear little resemblance to their forebears—or for that matter bad banks deployed by other countries to deal with nonperforming loans. In our first deep-dive into China’s cleanup efforts, we take a look at what the new bad banks are, and what contribution they’re making to China’s financial stability. You can read that report here.



[1] ‘People’s Republic of China Financial System Stability Assessment—Press Release and Statement By the Executive Director for People’s Republic of China,’ IMF Country Report No. 17/358, December 2017.[2] ‘张晓琳:不良资产行业进入第二个周期 机构预测存量逼近20万亿,’(‘Zhang Xiaolin: NPLs have entered a second cycle, institutions estimate there exists close to 20 trillion yuan worth’), Caijing, November 30, 2017,; ‘Andrew Brown: China Committed To Market-Based Solution To Excess Debt Challenge,’ Wu Yimian, China Money Network, November 10, 2017.

[3] ‘China’s asset management corporations,’ Guonan Ma and Ben SC Fung, BIS Working Papers No 115, August 2002.

[4] They are China Construction Bank, Industrial and Commercial Bank of China, Bank of China, and Agricultural Bank of China.

[5] When the AMCs first issued the bonds that funded their acquisition of NPLs, the Ministry of Finance said that it would provide support for the payment of interest and the repayment of the bonds’ principal, but didn’t say how it would provide that support. In 2010, however, it said it would use income taxes paid by China Construction Bank to repay Cinda’s bond (in 1999, Cinda was responsible for acquiring its NPLs from CCB). A similar technique has since been extended to the other AMCs. ‘At Cinda, a reshuffling of the deck chairs,’ Dinny McMahon, The Wall Street Journal–China Real Time, August 11, 2010.

[6] ‘China’s asset management corporations,’ Guonan Ma and Ben SC Fung, BIS Working Papers No 115, August 2002.

[7] “China Financial Stability Report 2013,” People’s Bank of China, May 24, 2013,

[8] ‘The Chinese Banking System Grant Turner,’ Nicholas Tan and Dena Sadeghia, Bulletin, Reserve Bank of Australia, September 2012,

[9] Ibid.

[10] ‘Financial Reform Policies for Rebalancing Economic Growth,’ Nicholas Lardy, China Finance 40 Forum, February 19, 2013. (Chinese Version on PIIE website:

[11] ‘A dog could run China’s banking system, says former statistics bureau spokesman’, Jeremy Blum, South China Morning Post, December 25, 2013,

[12] ‘The Role of State-Owned Enterprises in the Chinese Economy,’ Fan Gang and Nicholas Hope, in US-China Economic Relations in the Next 10 Years: Toward Deeper Engagement and Mutual Benefit, 2013,

[13] ‘China’s Banking Reform: An Assessment of its Evolution and Possible Impact,’ Alicia Garcıa-Herrero, Sergio Gavilay, and Daniel Santabarbara, CESifo Economic Studies, Vol. 52, 2/2006, 304–363.

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