To address problems facing the economy, the government must resist its instinct to interfere and let the market handle the recovery

With strong headwinds buffeting China’s economy, businesses have been warned to brace themselves for lean times. But there’s more bad news. A Caixin report recently sounded the alarm that bad debt in Chinese banks was rebounding after steadily falling for years.

Both the ratio and the amount of non-performing loans in the banking sector have increased since the last quarter of 2011, the China Banking Regulatory Commission says. This is backed by Caixin’s investigation into the health of Zhejiang’s banking sector, which has traditionally been a strong performer.

It’s true the numbers are not high – yet. Regulators and bankers say that even if the ratio of non-performing loans rose to 2 per cent, the risks would still be manageable. But given China’s economic contradictions, its flaws in bank management and the increasing pain felt by private enterprise, there’s reason to worry the problem could get worse. After all, the forces that drove the creation of bad debt are not unlike those that led to the global financial crisis. China is no exception to the rule; it isn’t immune to a financial crisis. While the rise in bad debt is a concern, the bigger worry is the complacent attitude of government officials, regulators and bankers.

We agree, too, with the analysis that in challenging times, it’s only natural that bad debts will rise. But, again, this should not lead to complacency and deter officials from preparing for worse to come.

The modern economic cycle is said to have been born in England with the stock market crash of 1825. Since then, economies have fluctuated between recession and boom, and a banking crisis all too often leads to financial crisis, then an economic crisis. The ebb and flow of economy is inescapable market logic – at least for the foreseeable future. Only the severity and length of each phase in the cycle differ. Having embraced the market after its experiment in centralized planning failed, China must prepare itself to face financial turbulence.

The seeds of China’s rising bad debt were planted in the credit binge after 2009. When policymakers began to turn off the taps last year, an economy awash in cash was suddenly faced with a crunch. At the same time, a plunge in demand for exports and stagnant domestic demand also hit businesses hard. The rise in bad debt was unavoidable.

In some cases, the availability of easy money also emboldened efforts to maximize profits. Some companies pulled out of the real economy altogether and invested instead in property. When the slew of property controls pushed prices down, asset values dropped and the result was a further drag on banks’ balance sheets.

The dynamics of China’s financial troubles are in fact similar to those in other economies, despite the vast differences in policy environment, financial tools and private-sector development.

Dealing with the existing bad debts isn’t difficult because the accumulated provision for impairment of banks can cover them easily. The real challenge is to face up to the medium-to-long-term risks of such debts.

The government has room to maneuver in two main areas: macroeconomic controls and financial supervision. The first must be fact-based and forward-looking. This means a measure of independence for monetary policymaking. As long as political priorities continue to dictate monetary policies, the problem of bad loans can’t be rooted out. Meanwhile, bank regulators must raise their game and improve their reach and efficiency.

After 10 years of banking reform, the industry is still tied to the state. Bad loans increase whenever the economy is shaky. Without clear rules governing property rights and a healthy credit culture, the reform of banks’ branches lag far behind their headquarters. The relationship between state-owned banks and private enterprise is also distorted and unnecessarily antagonistic, and bankers unfairly blame companies for their own lax risk management.

The problem is the unclear management of listed banks. The government disrupts the normal workings of a market by using banks as a stimulus tool, and whenever it interferes in their management. It is clear by now the state should not be a major shareholder of a bank. The government should make plans now to ease itself out of the industry.

Whether or not China’s banking sector can weather the current storm will depend largely on the government’s determination to respect and adhere to market principles. It has to stop its interfering and allow Chinese banks to become “real banks,” as Deng Xiaoping pledged.

The ills of government interference are made clear in its handling of bad loans. Since the Wenzhou credit scandal last year, the government has repeatedly stepped forward to “rescue” companies in trouble, including by leaning on banks not to call in their loans. The government temporarily averts a crisis by stepping in as a kind of ultimate guarantor. But the price of such “stability” is the creation of “zombie enterprises.” The Chinese model of solving problems does not really solve the problems; it makes them worse.

The market is far better at hedging and balancing risks than the state can be, and it gives an economy in crisis a much better chance of recovery. Improving its workings is the only way to minimize risks in China’s banking sector and pave the way for a sound regulatory culture.