Journal of International Development J. Int. Dev. 13, 211225 (2001) DOI: 10.1002/jid.

727

STATE BANKS AND ECONOMIC DEVELOPMENT IN CHINA

JAMES LAURENCESON* AND J. C. H. CHAI Department of Economics, University of Queensland, Australia

Abstract: State-owned banks remain dominant in China's nancial sector despite over two decades of gradual nancial liberalization. Their performance is typically evaluated using commercial banking criteria. The standard view is that because state banks have experienced declining protability and capital adequacy, they have been a drain on past economic development and endanger future growth prospects. However, we argue that state banks have strong development bank characteristics and hence warrant different performance criteria. The analysis in this paper suggests that while thier commercial performance may have been poor, the overall impact of state banks on China's economic development appears to have been both positive and sustainable. Copyright # 2001 John Wiley & Sons, Ltd.

INTRODUCTION

Even after two decades of economic transition, state-owned banks (SBs) remain dominant in China's domestic nancial sector. At year-end 1997 they accounted for 79.18 per cent of loans and 72.83 per cent of deposits in all nancial institutions in China (PBC, 1998, pp. 91, 92). By far the four largest SBs are the Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), Bank of China (BOC) and China Construction Bank (CCB). Since 1995, these banks have been labelled state-owned commercial banks in ofcial statistical publications and Chinese law. At year-end 1997, a survey of the world's 1000 largest commercial banks showed that they ranked 22nd, 79th, 27th and 56th respectively according to asset size (The Banker, July, 1998, pp. 131134). Given the importance of these SBs, and the ability of the nancial sector to impact on economic development (Levine, 1997), evaluating their performance is of considerable policy signicance. The behaviour of a commercial bank is dictated by its fundamental optimization objective, that being, to maximize expected prots subject to a risk constraint (Santeromo, 1984, p. 580). This objective function means that loans, for example, will be allocated to those projects that offer the highest expected rate of nancial return. Commercial banks
Correspondence to: James Laurenceson, Department of Economics, University of Queensland, St. Lucia, 4072, Australia.

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Table 1. Commercial performance measures in China's state banks Year
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Protability
1.4 1.3 1.4 1.1 1.1 0.9 0.9 0.7 0.4 0.3 0.3 0.3 0.3

Capital Adequacy
12.1 11.7 9.5 9.4 8.8 7.8 7.2 7.5 4.7 2.6 2.5 2.2 2.3

Notes: 1. Protability is calculated as pre-tax prots/total assets (%). 2. Capital adequacy is calculated as paid in capital/total assets (not adjusted for risk) (%). Sources: 1. Data for 198596 is from Lardy (1998, pp. 93, 100). 2. Protability data for 1997 is from The Banker, July 1998, p. 178. Capital adequacy data for 1997 is from ACFB, EE (1998, pp. 194, 195, 196, 198).

will also diversify their loan portfolios and maintain a strong capital base to more effectively manage risk. The performance of a commercial bank can therefore be ascertained from its balance sheet by calculating measures of nancial return such as protability, and measures of risk management such as capital adequacy. This has become the standard approach to evaluating the performance of China's SBs in both academic circles and the mainstream press (see Lardy, 1998a, pp. 76127). As shown in Table 1, the protability of SBs has declined markedly since the mid-1980s when they were amongst the most protable in the world (Girardin, 1997, p. 32). When compared with the world's 1000 largest commercial banks at year-end 1997, ICBC, ABC, BOC and CCB achieved a rate of return on assets that ranked 986th, 899th, 658th and 629th respectively. Their comparative level of capital adequacy was even more dismal, falling well below the internationally accepted safety benchmark of 8 per cent and ranking 962nd, 944th, 688th and 973rd respectively (The Banker, July 1998, pp. 131134). Therefore, even after taking into account the recent Asian nancial crisis, these gures have led some commentators to the conclusion that China possesses the `The worst banking system in Asia' (The Economist, 2 May, 1998). SBs are viewed as a drain on an otherwise successful programme of economic reform, and it has been suggested that the Chinese government has exchanged long-term economic development for short-term political benets. In this paper we offer an alternative view for understanding the behaviour, objectives and performance of China's SBs. While they may be labelled commercial in name, it would be wrong to automatically assume that their objectives conform to those of a typical commercial bank found in most Western countries. It is important to remember the historical context from which these SBs have evolved. Prior to economic transition, their primary objective was to facilitate the implementation of the government's physical plan
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(Chai, 1998, p. 119). In this context, their performance was simply dependent upon how well they undertook this task. Protability and risk management were not major concerns. Before any meaningful analysis of their performance during the reform period can be conducted, it is rst necessary to consider if their behaviour and objectives have changed. 2 THE BEHAVIOUR AND OBJECTIVES OF STATE BANKS

If SBs had begun to take on increasingly commercial objectives during the reform period, we would expect to see evidence of this through changes in their behaviour. This is particularly so given that China has experienced gradual nancial liberalization during the reform period (Laurenceson and Chai, 1998, pp. 396404). The experience of other transitional economies can serve as a useful guide to detecting the emergence of commercial banking behaviour. Borish et al. (1997, p. 340), for example, notes that the share of SB credit allocated towards non-state-owned rms has risen in the case of several central European transitional economies. However, there is little evidence of such a trend in the case of China. In 1995, Pei (1998, p. 327) estimated that SB lending to the non-state sector accounted for only 5.1 per cent of total SB loans. Even if all SB lending to the agricultural sector was regarded as non-state sector loans, the non-state share still only accounted for 10.0 per cent of total SB loans. By 1997, these gures had remained practically constant at 5.7 and 8.3 per cent respectively (PBC, 1998, p. 91). If SBs had begun to act in a more commercial manner, we would also expect their lending to have become increasingly sensitive to changes in the nancial rate of return in a particular sector of the economy. The experience of industry, the largest sector in the Chinese economy, suggests this has not been the case. Pre-tax prots of state-owned industrial enterprises, expressed as a percentage of their average net xed capital stock, fell from 37.3 per cent in 1978 to 11.9 per cent in 1997. Meanwhile, their share in total SB working capital loans actually increased from 19.0 to 26.0 per cent (SSB, EE, 1998, pp. 449, 451; PBC, 1998, p. 91). Unfortunately, lending for xed capital purposes is not disaggregated by sector in the ofcial statistics. Finally, if China's SBs had been transformed into independent, commercially motivated banks, their use of credit extended by the central bank, the People's Bank of China (PBC), should have fallen for several reasons. Firstly, SBs have historically had a privileged relationship with the central bank and relied heavily on cheap PBC loans to fund their own lending programmes. However, as commercial banks, they would be expected to collect their own deposits and compete with other nancial institutions on a level playing eld. Secondly, in the past the government has frequently instructed the PBC to provide credit to SBs in order to fund policy orientated loans. As commercial banks, they would be freed of this responsibility. The balance sheets of the individual SBs show that their reliance on PBC loans was extremely high until 1993, after which it declined substantially. In 1993, PBC loans amounted to 37.2 per cent of the value of total SB loans. By 1997, this had declined to 12.8 per cent (Lardy, 1998a, p. 88; ACFB, EE, 1998, pp. 194198). Similarly, in 1993, SBs received 97 per cent of the loans extended by the PBC to nancial institutions in China (PBC, 1994, p. 88). By 1997, their share had fallen to 39.8 per cent (ACFB, EE, 1998, p. 21). Thus, in this respect, there is some evidence that SBs have begun their transformation into commercial banks, but only in the most recent years. In summary, the behaviour of SBs during the reform period indicates that their objectives have remained considerably different to the typical commercial banking rm.
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An examination of the laws that have governed the activities of SBs during the reform period is instructive in understanding the nature of this difference. It appears that the major reason the behaviour of SBs has diverged from the commercial banking rm model is that their objectives are more akin to a development bank. Diamond and Raghavan (1982, p. 33) describe the purposes of a development bank in the following way. `The acceptance of responsibility for furthering the nation's development policies is the special factor that makes a bank a development bank. Whatever its name, that responsibility makes a conventional nancial institution a development nance institution'. The objective of a development bank is to maximize the development impact of lending, subject to the necessary condition that its operation remains solvent (Bhatt, 1983, p. 61). This objective is considerably different to a commercial bank because it has long been recognized that projects which may be of great development importance often only yield a marginal nancial return, if at all (Kane, 1983, p. 16). The intended objectives of China's SBs during the reform period have been outlined in two pieces of legislation: the 1986 Interim Banking Control Regulations of the People's Republic of China (IBCR), and more recently, the 1995 Commercial Banking Law of the People's Republic of China (CBL). Article 3 of the IBCR states that the activities of all nancial institutions, `Shall be aimed at economic development, stabilization of currency, and promotion of benecial social and economic results' (ACFB, EE, 1990, p. 177). Point 2 of Article 14 states that one of the fundamental functions of SBs is, `To grant loans to enterprises in line with state policies and plans' (ibid, p. 179). Protability in lending is not even mentioned as a specic objective. In more recent CBL, SBs are required to assume greater responsibility for their own prots and losses, and thus take into account the likelihood of repayment before extending loans (ACFB, EE, 1996, pp. 183, 189). The General Lending Rules, an order of the PBC in 1995, explicitly states that protability is now to be used as a basic principle to guide lending (ibid, p. 245). However, the CBL makes it clear that protability is not to be the sole criterion SB's are to consider. Article 34 of the CBL states, `A commercial bank shall conduct its loan business in accordance with the need for the development of the national economy and social progress and under the guidance of the state industrial policy' (ibid, p. 189). Article 41 continues that, `A commercial bank owned solely by the state should provide loans for special projects approved by the state council' (ibid, p. 190). Therefore, the objectives of SBs now appear to be a combination of development and commercial goals. The intended development objective they are to strive toward is that their lending should be supportive of state industrial policies. Available data with respect to their behaviour suggests they have been highly supportive of this development objective, even in the recent years. PBC (1998, p. 19), for example, states that in 1997, more than 70 per cent of total outstanding loans were directed towards key state construction projects and enterprises. 3 THE PERFORMANCE OF STATE BANKS

The previous section showed that China's SBs were originally instituted as development banks, and continue to hold strong development related objectives. This implies that the exclusive use of commercial criteria to evaluate their performance is inappropriate. For one, prot maximization would be an inappropriate economic goal for China's SBs. All
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development banks, and in particular those that are state owned, will naturally attach more importance to the development impact of their lending rather than nancial returns (Diamond and Raghavan, 1982, p. 61; Kane, 1983, p. 24). Thus, directly testing whether SBs have promoted economic growth is the more appropriate criteria by which their performance should be assessed. Secondly, the particular criteria that a development bank uses to evaluate potential borrowers will have a direct relationship to the development objectives of the country in which it operates (Bhatt, 1982, p. 61). As a socialist market economy, it would be wrong to presume that all of China's development objectives are nancial or economic in nature. Social goals are also considered important, and hence the extent to which SBs have helped to facilitate these goals should be included in their performance evaluation. Finally, it is a necessary condition even for development banks that their operations remain solvent. However, the solvency of state owned nancial institutions cannot simply be assessed on the basis of listed capital and loan-loss provisions specied in their balance sheet. As essentially administrative agencies, the ability of China's SBs to bear losses is not dependent on their balance sheet, but rather on the willingness and ability of the government to support them (Girardin, 1997, p. 30). It is therefore necessary to use broader measures of solvency when assessing the performance of SBs in this respect. 3.1 State Banks and Economic Development Very little empirical work has been conducted to directly examine the relationship between SBs and economic development. Li (1994) and Li and Liu (1999) are the rst to our knowledge to attempt such an analysis. In Chinese statistical publications, national xed investment data is disaggregated by sources of funding. Four sources are identied: state budget appropriations, domestic loans, foreign investment and self-raised funds. The basic methodology used in the above papers is to regress these four funding sources against a level of output, such as GDP or industrial output, in order to arrive at some indication of their productivities. The results in general showed that state budget appropriations and domestic loans had a negative coefcient, while self-raised funds and foreign investment had positive coefcients (Li, 1994, p. 131; Li and Liu, 1999, p. 15). Therefore, given that SBs account for the majority of domestic loans, the conclusion was reached that SBs, and government interventions in the nancial sector more generally, have hindered China's economic development. These conclusions, however, are not without concern. Firstly, Li (1994) estimates a regression over the period 198289. Given the short time frame and the fact that most ofcial data is annual in frequency, he is forced to construct much of the quarterly data used in the regressions. The reliability of such data is questionable. Secondly, both papers regress the various funding sources, which together sum to total investment, on the level of output. This is an inappropriate specication according to economic theory. Investment proxies for the change in a country's aggregate capital stock and hence the appropriate dependent variable is the change, or growth rate of output. Finally, the results themselves are cause for concern. The statistically signicant negative coefcients for xed investment funded through state budget appropriations and domestic loans imply that, all other funding sources held constant, if the government budget and SBs cut funding for investment, China's output would increase. The mechanism through which this outcome would take place is not clear.
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To consider the relationship between SB loans and output in China, we based our econometric analysis around regression equation (1), which is a standard aggregate production function, augmented for exports and human capital. Our data set is presented in Appendix 1 and consists of annual observations over the period 198198. Fixed investment data is not broken up according to funding sources prior to 1981. The data in Appendix 1 shows that self-raised funds have been the most important source of funds for xed investment in China, followed by domestic loans, foreign investment and lastly, state budgetary appropriations. Y 1 SBA 2 DL 3 FI 4 SRF 5 L 6 X 7 HC 1

where Y is the growth rate of real output. We use two measures of real output. Y1 is the growth rate of real GDP and Y2 is the growth rate of real industrial output; SBA, DL, FI and SRF are investment funded through state budget appropriations, domestic loans, foreign investment and self-raised funds respectively, all expressed as a percentage of GDP. Therefore, taken together, these equal the rate of investment; L is the growth rate of labour; X is the change in exports as a percentage of GDP; HC is the change in the human capital stock, as proxied by the number of higher institution learning graduates per 10,000 of population. In our initial estimation, we used the growth rate of real GDP as the dependent variable to measure changes in real output in China and included all of the above-listed independent variables. As can be veried by the interested reader using the data contained in Appendix 1, the results showed that SBA, DL and FI all possessed the expected positive coefcients. While the coefcient to SRF was negative, it was far from being statistically signicant. The coefcient to L was positive but not statistically signicant, while X and HC displayed the incorrect theoretical signs and were not statistically signicant. Therefore, for this paper we dropped these additional variables from the model and concentrated on the rate of investment (SBA, DL, FI, SRF). The results of this more concise specication are presented below.
Regression Output 1: dependent variable is the growth rate of real GDP Regressor
INPT SBA DL FI SRF

Coefcient
6.65 1.85 1.92 0.93 0.11

Standard error
6.43 0.68 0.85 1.68 0.60

T-ratio (prob.)
1.03 (0.320) 2.73 (0.017) 2.34 (0.043) 0.55 (0.589) 0.19 (0.854)

R2 0.53. F(4,12) 3.61 (0.034). Diagnostic test for autocorrelation F(1,12) 1.30. Notes: INPT is the intercept term.

The explanatory power of this simplied model is equal to that of the more complex formulation, with the overall regression being statistically signicant at the 5 per cent level. This is particularly pleasing given that the diagnostic test does not reveal any autocorrelation, a common statistical pathology in econometric models using time series
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data. The output shows that the only two investment funding sources to display a positive, statistically signicant relationship with economic growth at the 5 per cent level are state budget appropriations and domestic loans. It is interesting to note that investment funded through foreign sources displayed a large standard error. This could reect the fact that while foreign capital has overall been advantageous to China's economic development, it has on occasion fuelled speculative bubbles, such as that which occurred in real estate during the mid-1990s (Yang, 1996, p. 163; Jiang et al., 1998, p. 2108). We also regress the various investment funding sources against an alternative measure of real output, the growth rate of real industrial output. This is done because it could be argued that since most domestic loans are directed towards the industrial sector, the growth rate of real GDP is too broad a measure of output. The results when using this new development variable are given below.
Regression Output 2: Dependent variable is the growth rate of real industrial output Regressor
INPT SBA DL FI SRF

Coefcient
9.50 1.42 3.87 0.37 0.15

Standard error
10.44 1.11 1.39 2.73 0.98

T-ratio (prob.)
0.91 (0.380) 1.28 (0.221) 2.78 (0.015) 0.13 (0.896) 0.16 (0.878)

R2 0.69. F(4,12) 7.14 (0.003). Diagnostic test for autocorrelationF(1,12) 0.77. Notes: INPT is the intercept term.

When using this new dependent variable the statistical signicance of domestic loans increases to close to the 1 per cent level. Investment funded through state budgetary appropriations exhibits the next largest positive coefcient, although it is not statistically signicant. The fact that investment funded through state budgetary appropriations displays a stronger correlation with real GDP growth than does real industrial output growth, could reect that such investment may be more focused on infrastructure development rather than directly productive activities. The coefcients to other investment funding sources meanwhile remain small and statistically insignicant. Several other regressions were conducted and can be veried by the interested reader using the data presented in Appendix 1. For example, we also regressed the various investment funding sources against the growth rate of real industrial output produced by state owned rms only (SSB, EE, 1998, p. 433). Again, investment funded through domestic loans was the only variable to display a positive, statistically signicant relationship. In summary, given that SBs have accounted for the bulk of domestic loans, the results of our empirical analysis suggest that the inuence of China's SBs on economic growth has been a positive one. While the above analysis identied an overall positive relationship between SB lending and real output growth, it does not identify the specic channels through which this occurred on the rm/bank level. A discussion of the micro-foundations of this positive relationship is important, particularly given that the stylized facts of SBs lending almost exclusively to state-owned enterprises (SOEs) at low interest rates is generally regarded as clear evidence of allocative inefciency.
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One channel through which SBs may have positively inuenced economic development is that they have selected relatively productive SOEs in their lending programmes. Several recent empirical studies support this conclusion. Using rm-level sample survey data over the period 198089, Lee (1997, p. 155) found that the marginal revenue product of capital of SOEs which had borrowed funds was greater than those which had not. Cull and Xu (2000, p. 22) extended the data set until 1994 and again found a positive relationship between bank credit and rm productivity. There are several factors that have contributed to SBs lending to relatively productive SOEs. For one, banks were given more discretionary power in their lending decisions. By the mid-1980s many of the details contained in the traditional credit plan had become largely indicative in nature (Chai, 1998, p. 130). Secondly, loan ofcers at state banks were given an incentive to lend to productive SOEs by partially linking their remuneration to the nancial performance of their loan portfolio (Cull and Xu, 2000, p. 9). Thirdly, there have been improvements in areas such as accounting and disclosure standards that have made it easier to identify productive SOEs and good credit risks. In addition to selection factors, the positive correlation between SB lending and productive SOEs could also be the result of SBs positively inuencing the productivity of SOEs. In market economies banks can inuence rm performance through effective corporate governance measures such as linking future credit to the economic performance of the rm. However, Cull and Xu's analysis suggests this has not been the case in China. A more plausible way that SBs have been able to positively inuence the productivity of SOEs is through their interest rate policy (Zou and Sun, 1996). It is frequently assumed that the only purpose of the low interest rate policy used by SBs is to ease the nancial burden on inefcient and unprotable SOEs. Meanwhile, the costs in terms of allocative inefciency are held to be extremely high (Li, 1994, pp. 136145; Lardy, 1998a, p. 90). This view is rooted in the familiar McKinnonShaw approach to the role of nance in economic development, which contends that low interest rates creates an excess demand for credit and brings about the need for an inefcient administrative rationing process. The preferred approach is nancial liberalization, allowing the market to price and allocate credit. However, until SOEs and SBs face a hard budget constraint, the benets of higher interest rates are questionable. As long as an SOE cannot go bankrupt, it will be more concerned about the availability of credit rather than its cost (Mehran et al., 1996, p. 62). The demand for credit by SOEs with lower protability or risk-loving managers will be the least affected of all by higher interest rates. These rms are already unable to repay loans and will simply continue to borrow to nance losses, which invariably increase as the interest rate rises (Fry, 1997, p. 758). Moreover, SBs need not concern themselves with risk when lending to SOEs because the government is the effective guarantor of these loans. In this context, Zou and Sun (1996, pp. 312, 315) argues with the aid of a theoretical model that lower real interest rates can actually act as an incentive to more productive SOE investment by moderating risk and promoting greater effort on the part of management and staff. A second channel through which SBs, and government intervention in the nancial sector more generally, may have positively impacted upon economic development is by correcting for market failure. Financial liberalization appears sound policy advice because the state does not have sufcient information to make detailed investment decisions. However, nancial deregulation in a transitional environment where prices are still distorted and enterprise budget constraints remain soft does not necessarily improve investment efciency. In fact, it may worsen it (Chai, 1998, p. 136). The effects of nancial liberalization in the context of partial price reform have already been observed in China.
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During the nancial liberalization that characterized the early stages of economic reform, SBs began to channel credit towards areas of the economy where state control over prices was weak (World Bank, 1990, p. 33). This was a rational response given that higher output prices increased the relative protability of these sectors. However, as a result, the rate of investment in several key sectors of the economy plummeted and they became bottlenecks to development (Chai, 1990, p. 152). To correct this lop-sided investment structure, the government was forced to step up its own investments in the neglected sectors through budgetary allocations, and tighten its grip on SB lending (Chai, 1998, p. 136). There are many reasons to think that a liberalized nancial system would allocate too little credit to SOEs. For one, they have become disproportionately located in areas of industry where output prices have been xed at below equilibrium levels by the government (Laurenceson and Chai, 2000, p. 33). This articially reduces their protability and so their ability to attract credit in a liberalized environment. The protability of SOEs has also been articially reduced by the fact that they have continued to act as China's primary social safety net, providing costly services to workers such as retirement pensions, subsidized housing, medical care, education and child minding facilities (Hu, 1996, pp. 126129). Chai and Docwra (1997, p. 165) also point out that for much of the reform period SOEs have borne an unequal tax burden. A third way SBs may have supported economic development in China is that by lending predominantly to SOEs, they have reduced inationary pressures and the scope for moral hazard to occur in lending (McKinnon, 1991, p. 117). Transitional economies typically face a deteriorating scal situation as their traditional tax revenue base, the remitted prots of SOEs, is erobed. This forces the government to borrow from the state banking system to meet current expenditures. China is no exception to this phenomenon (McKinnon, 1994, p. 445). If the government is already heavily borrowing from the state banking system, this implies that there exists little room for non-inationary bank lending to the non-state sector. Also, because SBs continue to possess a soft budget constraint, this implies that they may not lend responsibly to non-state-owned enterprises anyway. It is curious that those who claim that SB lending is currently devoid of economic considerations apparently hold that this situation would be different if they were dealing with nonstate-owned enterprises. The experience of China's non-bank nancial institutions (NBFIs) is enlightening in this respect. The bulk of lending from NBFIs is directed towards non-state-owned enterprises, yet recent research puts the share of non-performing loans (NPLs) in NBFIs at an equal or greater level than in SBs (Pei, 1998, p. 333). Similarly, the protability of many of China's major NBFIs has also declined along with the SBs during the 1990s (Laurenceson and Chai, 1999). A nal channel through which SBs may positively inuence economic development is that through their continued support of the SOEs, many positive externalities have been conferred on the non-state sector (see Zhang and Yi, 1997, pp. 32, 33). The importance of externalities is extremely difcult to quantify, although the effects are obvious. Perhaps the most signicant of these externalities is that the continued operation of SOEs has provided a stable environment in which the non-state sector can ourish. The growth of the nonstate sector in China has been spectacular. In 1978, non-state rms only accounted for 22.4 per cent of gross industrial output value. By 1998, their share had risen to 71.8 per cent (SSB, EE, 1999). Given that SOEs serve both economic and social functions, their closure potentially invokes considerable economic and political instability. Such instability is rampant in economies which have adopted a `big bang' approach to economic transition, and has seriously affected their development drives (Rana, 1995).
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3.2 State Banks and Social Objectives In a socialist market economy such as China, social goals also feature highly in national development objectives. Given that SBs have strong development bank characteristics, the extent to which they have promoted social goals should also be included in their performance evaluation. This paper endeavours to focus mainly on economic issues and hence we simply make several brief comments. Firstly, as was mentioned earlier, China's SOEs still form the primary social safety net in China. Therefore, by supporting SOEs, even those that may be performing poorly by economic criteria, China's SBs have met a social goal. Secondly, another social goal of the Chinese authorities is to promote the common prosperity of people living in China's lagging western and central regions. Provincial level loan and xed investment data indicates that SBs have been supportive of this policy. SB loans for xed assets, expressed as a percentage of actual xed investment conducted, have been consistently higher in the central and western provinces of China than in the east (Laurenceson and Chai, 1999). 3.3 State Banks and Solvency Much has been said recently about the supposed growing fragility of China's SBs and the implications this has for the sustainability of China's economic development. The basis for this claim is that during the 1990s, NPLs in SBs have been rising relative to their listed capital (Lardy, 1998a, p. 119). The earliest authoritative estimate of NPLs in SBs was at year-end 1994, when they were put at 20.4 per cent of total loans (Pei, 1998, p. 336). Moreover, when Dai Xianglong became Governor of the PBC in mid-1995, he stated that NPLs had been rising by about 2 per cent annually in the few years prior (Lardy, 1998a, p. 121). Therefore, we can suppose that the share of NPLs at year-end 1993 was approximately 18.4 per cent or 476 billion yuan. This value was three times greater than their listed capital at the time of 154 billion yuan. By year-end 1997, the share of NPLs had risen to 25 per cent (Lardy, 1998b, p. 83), or 1322 billion yuan. This value was now six times greater than their listed capital of 220 billion yuan (Laurenceson and Chai, 1999). When NPLs in a privately owned commercial bank exceed the invested capital of its owners, its performance with respect to solvency is deemed failed and monetary authorities will swiftly suspend its operations. This is because owners have lost their money and third party depositors are now at risk of losing theirs. However, to use this logic to evaluate the solvency performance of SBs is inappropriate. Firstly, since SBs shoulder part of the responsibility of development banks, a rise in NPLs does not necessary reect a decline in their performance. A rise in NPLs may be tolerable if the development impact of lending was considered sufciently great to compensate for the negative nancial effects. Secondly, the government could use its taxation powers to pay off the bad debts of SOEs, or alternatively, it could cancel the debts of SOEs and recapitalize SBs. Indeed, this is the approach currently being taken by the Chinese authorities. In February 1998 the Ministry of Finance announced a 270 billion yuan special bond issue `to raise additional capital for solely state owned commercial banks' (Far Eastern Economic Review, 12 March, 1998). As SBs, NPLs are essentially a scal responsibility of the central government. Therefore, in determining changes in the solvency of SBs in recent years, we must consider whether NPLs have remained at scally sustainable levels. Governments in most countries
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meet scal shortfalls through a debt issue of long-term maturity. As long as the value of outstanding debt does not rise relative to the size of the economy, such a practice is considered sustainable. This is because as the economy grows, so too does the government's taxation revenue and their ability to repay debt. In 1993, the value of NPLs in SBs was approximately equal to 13.8 per cent of GNP. By year-end 1997, this had risen only marginally to 18.0 per cent of GNP. In 1993, if the government had decided to write off NPLs an replenish bank capital through a bond issue of an equivalent amount, China's total outstanding long term (maturity > 1 year) public and publicly guaranteed debt would have been approximately equal to 30.1 per cent of GNP. If they had undertaken the same course of action in 1997, this gure would have remained practically constant at 30.7 per cent of GNP. Such a debt level would be comparable with other low-income Asian developing countries. For example, at year-end 1997, the gure was 26.6 per cent in Indonesia, 30.3 per cent in the Philippines and 77.9 per cent in Vietnam (World Bank, 1999). These calculations indicate that the solvency performance of SBs has not deteriorated in recent years. In addition, it was mentioned earlier that their reliance on other subsidies such as cheap central bank loans has clearly declined. 4 CONCLUSION In this paper we have argued that the commercial banking criteria by which the performance of China's SBs are typically evaluated is inappropriate, and can even be misleading in terms of designing effective economic development policy. If SBs were solely attempting to maximize prots they would be failing in their part role of development banking institutions. In an environment of considerable market failure, there can be no presumption on the basis of economic theory that prot maximizing behaviour by SBs in a liberalized nancial system would best serve China's development goals. Our empirical analysis, which directly considers the impact of SB lending on economic growth, suggests that they have played a positive role. In addition, they have facilitated some of the social goals of the Chinese government. Finally, reports warning that SBs could soon `implode with alarming force' were found to be overstated (The Economist, 8 March, 1997). Therefore, the sustainability of China's economic development would seem to be greater than in conventionally asserted. By way of conclusion, we make several qualifying statements to the preceding discussion. Firstly, the results of this paper do not imply that the economic performance of China's SBs and SOEs, or that the level of government intervention in the nancial sector more generally, has been optimal. SBs and SOEs continue to lag well behind international best practices and the experience of other Asian countries clearly shows that while government intervention may be justied in the initial stages of economic development, the benets diminish over time. However, we do argue that the performance of SBs and SOEs should be evaluated directly using appropriate criteria, and that nancial liberalization must be looked upon as a means to an end rather than an end in itself. Secondly, the empirical results presented in this paper do not directly address the question of whether China's development would have been better served by alternative nancial sector policies, such as the early commercialization and privatization of SBs. It is difcult to contemplate, however, that China's rate of economic development could have been even more rapid than that which has actually occurred during the reform period. Thirdly, we are mindful that the ability of China's central government to repay future debt is challenged by
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the fact that taxation revenue as a percentage of GDP has declined during the reform period. This is a real and serious problem potentially affecting the future solvency of the SBs. However, the root cause is a lack of scal reform, which should not be confused with the solvency performance of SBs. Finally, while our analysis suggests that SBs have quite successfully pursued a development role in the past, the future appropriateness of this policy in light of China's imminent accession to the World Trade Organization (WTO) is questionable. Under the USChina agreement signed in 1999, two years after China's accession to the WTO foreign banks will be able to directly compete with SBs in servicing domestic enterprises and all current geographical restrictions over their operations will be removed. Five years after accession foreign banks will also be able to compete for the business of domestic individuals (The Economist, 8 April, 2000). As long as SBs are required to lend some proportion of their portfolio on the basis of non-commercial criteria and/or hold a stock of NPLs which is the result of past lending, direct competition with foreign banks will be counter-productive. Therefore, it is important that any future policy lending is channelled through the three policy banks established in 1994 for that purpose and the commercial burden of the existing stock of NPLs is addressed. China's entry into the WTO also needs to be accompanied by commensurate upgrades in the prudential framework. Otherwise, as was the case with many other Asian developing economies, nancial liberalization may lead to economic instability rather than promote economic development. ACKNOWLEDGEMENTS The authors would like to thank Ryan McAllister and Darrian Collins for their valuable input during the writing of this paper, and two external referees who reviewed the paper and made several helpful suggestions for its improvement. REFERENCES
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Appendix 1: Data, notes and sources for regressions (1) and (2) Year
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

225

Y11
5.2 9.1 10.9 15.2 13.5 8.8 11.6 11.3 4.1 3.8 9.2 14.2 13.5 12.6 10.5 9.6 8.8 7.8

Y22
4.3 7.8 11.2 16.3 21.4 11.7 17.7 20.8 8.5 7.8 14.8 24.7 27.3 24.2 20.3 16.6 13.1 10.8

SBA3
5.55 5.27 5.72 5.87 4.55 4.47 4.15 2.89 2.16 2.12 1.76 1.30 1.40 1.13 1.06 0.92 0.93 1.51

DL4
2.51 3.33 2.96 3.60 5.69 6.45 7.29 6.55 4.51 4.77 6.08 8.31 8.87 8.55 7.18 6.72 6.40 6.98

FL5
0.75 1.14 1.12 0.99 1.02 1.35 1.52 1.84 1.72 1.53 1.48 1.76 2.76 3.78 3.93 4.05 3.59 3.30

SRF6
10.96 13.49 14.29 15.10 17.11 18.32 18.73 19.89 17.68 15.93 16.56 18.96 24.72 24.66 22.93 22.70 22.86 24.38

L7
3.2 3.5 2.5 3.8 3.5 2.8 2.9 2.9 1.8 2.6 1.4 1.2 1.2 1.2 1.1 1.3 1.1 0.5

X8
2.0 0.9 0.4 2.0 2.5 2.7 3.2 2.0 1.1 5.6 3.9 3.2 1.8 11.0 3.5 0.2 3.4 0.1

HC9
1.4 4.5 3.3 2.8 3.0 3.7 4.9 5.0 5.1 5.4 5.3 5.2 4.8 5.3 6.6 6.9 6.7 6.7

Notes/Sources: 1 Y1 is the growth rate of real GDP (%). The data is from SSB, EE, 1999, p. 57. 2 Y2 is the growth rate of real industrial output (%). The data is from SSB, EE, 1999, p. 424. 3 SBA is xed investment funded through state budget appropriations as a percentage of GDP. The data is from SSB, EE (1999, pp. 55, 185). 4 DL is xed investment funded through domestic bank loans as a percentage of GDP. The source is the same as2. 5 FI is xed investment funded through foreign investment as a percentage of GDP. The source is the same as 2. 6 SRF is xed investment funded throough self-raised funds as a percentage of GDP. The source is the same as2. 7 L is the growth rate in the labour force (%). There is some discrepancy in the published level data since 1990. We have therefore calculated the growth rate until 1990 using the level data from SSB, CE (1990, p. 113): SSB, EE (1996, p. 88). The growth rate since 1990 has been calculated using the level data from SSB, EE (1999, p. 134). 8 X is the change in the value of exports as a percentage of GDP. The data is from SSB, CE (1990, p. 64); SSB, EE (1999, pp. 55, 578). 9 HC is the change in human capital. We use the number of higher learning institution graduates per ten thousand of population to proxy for this change. This choice is made for several reasons. Firstly, compared with other developing countries, China has a strong record of providing its population with basic literacy skills and education. These variables have not changed markedly during the reform period. The number of higher learning institution graduates, however, has greatly increased (SSB, EE, 1996, p. 632). Secondly, a complete time series of commonly used proxies such as government education expenditure as a percentage of GDP is not available. The data is from SSB, CE (1990, p. 709). SSB, EE (1993, p. 65); (1999, pp. 111, 643).

Copyright # 2001 John Wiley & Sons, Ltd.

J. Int. Dev. 13, 211225 (2001)