The Chinese financial system's evolution in recent years has been extraordinary. In 2002, all of China's major banks were awash in bad loans, which in some cases amounted to more than 10 percent of the total balance sheet. None of the major banks met international standards for capital adequacy. Few financiers in London or New York could have named any Chinese bank other than Bank of China, which was often wrongly thought to be the central bank. And to suggest that the United States Federal Reserve, or the United Kingdom's Financial Services Authority, might have anything to learn from China's financial authorities would have been thought absurd.
Less than a decade later, much has changed. The problem of nonperforming loans was resolved, primarily by establishing asset-management companies to take over doubtful assets and injecting new capital into the commercial banks. Now, reported NPLs amount to little more than 1 percent of assets. Foreign partners have been brought in to transfer skills, and minority shareholdings have been floated. Current valuations put four Chinese banks in the global top 10 by market capitalization. They are now expanding overseas, fortified by their strong capital backing.
Of course, challenges remain. Even in China, there is no magic potion that can revive a loan to a defunct exporter. And China's big banks have lent large sums, willingly or otherwise, to local governments for infrastructure projects—many of them of dubious economic value. There is an ever-present risk that the property market might one day collapse, though banks would emerge in better shape than have banks in the United States and the United Kingdom, because much speculative investment has been funded with cash, or with only modest leverage.
The authorities in Beijing, especially the China Banking Regulatory Commission (on whose international advisory council I serve) and the People's Bank of China (the real central bank), have a good record of managing incipient booms and busts, and I would not bet against their success this time. They have a range of policy tools, including variable capital and reserve requirements and direct controls on mortgage lending terms. They have already been tightening the screws on credit growth for several months with positive effects.
It would be flattering to think that this turnaround in China's financial system is attributable to the wise counsels of foreign advisers. But, while external influences have been helpful in some ways—the stimulus of Basel 1 and 2 strengthened the hands of those in Beijing determined to clean up the banking system—the Chinese now, not unreasonably, treat advice from the City of London and Wall Street with some skepticism.
For example, recent criticism of Asian regulators by Treasury Secretary Timothy Geithner is viewed across the region with scorn, not to mention incredulity. A little more humility is in order, given U.S. regulators' performance in the run-up to the crisis.
The most interesting development is that we can now see increasing convergence in regulatory philosophies in Beijing, London, and New York. Until the recent near-implosion of Western capitalism, the North Atlantic authorities thought that the end of financial history had been reached. Financial conditions could be controlled with one tool—the short-term interest rate—deployed exclusively in pursuit of a target, implicit or explicit, for consumer price inflation. Banks' capital-adequacy ratios were set globally, and, once set, remained fixed. Otherwise, the market knew best. Banks had their own incentives to lend wisely, and controls on lending would necessarily prove ineffective.
By contrast, in China, all aspects of a bank's business were directly overseen. Indeed, most banks were under the sway of the central bank.
Now, in Beijing, officials see the advantages of a more hands-off approach—and of institutions with a primarily commercial focus. But they have not eschewed the use of variable capital and reserve requirements, loan-to-deposit ratios, and thresholds for minimum deposits and maximum leverage as controls on property lending.
Meanwhile, in developed capital markets, we are busily reinventing these "macroprudential instruments," to use the term now in vogue in Basel. We can now see the utility of a more flexible toolkit to respond to excessive credit expansion, or asset-price bubbles, where the manipulation of short-term interest rates can be a blunt instrument or, worse, a double-edged sword. An interest-rate rise might take the heat out of the mortgage market, but it will also chill the rest of the economy.