We study non-performing loan (NPL) transactions in China using proprietary data from a leading market participant. We find these transactions – driven by tighter financial regulation – are consistent with banks concealing non-performing assets from regulators as (i) transaction prices do not compensate for credit risks; (ii) banks fund the NPL transactions and remain responsible for debt collection; and (iii) 70% of NPL packages are re-sold at inflated prices to bank clients. These results imply NPL transactions do not truly resolve NPLs. Recognizing the hidden NPLs implies the total NPLs in China is two to four times the reported amount.

Great credit risk is a big headache which blocks the development of the banking sector of China. Based on the panel data of the Chinese banking sector from 2002 to 2006, this paper empirically examines the effects of foreign strategic investors’ participation on the risk behavior of Chinese banks. The results show that foreign strategic investors (FSI) had a positive, but limited impact on the credit risk of Chinese banks. Further analysis reveals that the risk management abilities of Chinese banks have improved apparently when the proportion of shareholding of the leading foreign strategic investors exceeds 15 percent, which results in a significant drop of the credit risk. However, due to the ‘minority ownership’ restriction on foreign investors' stock shares, the positive effect of the participation of foreign strategic investors is limited. The visible decline in both non-performing loans (NPLs) and the NPL ratio of Chinese banks mainly reflects the rapid growth of China's economy and benefits a lot from the massive financial restructuring of state-owned banks.

China’s non-performing loans were as high as 35 percent of state banks’ total loans, or about RMB 3,549 billion (about 40 percent of its GDP) in 2000. The adequacy ratios of the four state banks were only between 1.4 percent to 4.6 percent in September 2000. Moreover, non-bank financial institutions as a group as early as 1996 had non-performing assets equal to 50 percent of their total assets. By Western accounting standards, China’s most financial institutions are insolvent. Be conventional standards for measuring financial sector robustness, China is past the point at which a systemic banking crisis might be expected. China faces enormous risks delaying the state bank reforms due to increasing capital account leaks, increasing large proportion of household deposits in banks’ total liabilities, and gradual structural shift of Chinese saving behavior. China needs to resolutely address the financial reforms soon to avoid a financial crisis, which will lead to a broad anti-regime coalition against the Chinese government. Nevertheless, China faces enormous difficulties. First, the 2000 Chinese official estimate puts the financial cost of restructuring the state banks at RMB 2,260 billion ($273 billion), or close to 30 percent of GDP. Second, the current AMC scheme is fraught with difficulties. Finally, the required financial sector reforms are closely interlinked with many other reforms such that a sequential or partial approach will not be effective.