L1-China&39;s Economic Conditions(13)

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State-owned enterprises (SOEs), which account for about one-third ofChinese industrial production, put a heavy strain on China’s economy. Overhalf are believed to lose money and must be supported by subsidies, mainlythrough state banks. Government support of unprofitable SOEs divertsresources away from potentially more efficient and profitable enterprises.In addition, the poor financial condition of many SOEs makes it difficult forthe government to reduce trade barriers out of fear that doing so would leadto widespread bankruptcies among many SOEs.

The banking system faces several major difficulties due to its financialsupport of SOEs and its failure to operate solely on market-based principles.China’s banking system is regulated and controlled by the centralgovernment, which sets interest rates and attempts to allocate credit tocertain Chinese firms. The central government has used the banking systemto keep afloat money-losing SOEs by pressuring state banks to provide low-interest loans, without which a large number of the SOEs would likely gobankrupt. Currently, over 50% of state-owned bank loans now go to theSOEs, even though a large share of loans are not likely to be repaid. Ernst& Young estimates that the level of nonperforming loans by Chinese banksin 2002 was $480 billion (equal to about 43% of China’s GDP).5 The highvolume of bad loans now held by Chinese banks poses a serious threat toChina’s banking system. Three out of the four state commercial banks arebelieved to be insolvent. The precarious financial state of the Chinesebanking system has made Chinese reformers reluctant to open the bankingsector to foreign competition. Corruption poses another problem forChina’s banking system because loans are often made on the basis ofpolitical connections. This system promotes widespread inefficiency in theeconomy because savings are generally not allocated on the basis ofobtaining the highest possible returns.

Public unrest over pollution, government corruption, and growingincome inequality poses threats to social stability. The Chinesegovernment reported that there were over 74,000 protests (many of whichbecame violent) involving 3.8 million people in 2004 (up from 53,000protests in 2003) over such issues as pollution, government corruption, andland seizures. Pollution in China continues to worsen, posing series healthrisks to the population. The Chinese government often disregards its ownenvironmental laws in order to promote rapid economic growth. Accordingto the World Bank, 16 out of 20 of the world’s most polluted cities are inChina, and the direct costs to the economy (such as health problems, cropfailures and water shortages) is estimated to be hundreds of billions ofdollars yearly. The Chinese government estimates that there are over 300million people living in rural areas that drink unsafe water (caused bychemicals and other contaminants). Toxic spills in China in recent monthshave threatened the water supply of millions of people. Rising incomeinequality, particularly between people living in the urban coastal and those

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Ernst & Young Asia Pacific Financial Solutions, Nonperforming Loan Report, Asia, 2002.