China’s banking sector has traditionally served as a party-controlled feeding ground for its inefficient and unprofitable state-owned enterprises (SOEs), most of which were technically insolvent. The process was simple: make a loan to an unqualified SOE applicant, then write off the loan as a bad debt when it wasn’t paid. This situation is beginning to change and Chinese banks are attracting the attention of foreign banks who are beginning to see them as investment opportunities rather than potential competitors. However, China’s banking industry is beset by various problems.

1. Loans to State-Owned Enterprises: It is hard to overstate the importance of the Chinese banking sector as a source of domestic capital. Mainland China’s stock markets are anemic compared to the giants Hong Kong, Tokyo and New York, and China’s bond market is virtually non-existent. That leaves banks as the only major source of domestic financing on the table for private companies. However, SOE lending continues to siphon off much of bank capital, despite the fact that China’s stock markets were largely designed to provide SOEs with an alternative source of funding. Many national companies have turned to clandestine institutional loan sharks with their high interest rates, or relying solely on retained earnings for financing. Even though SOE loan defaults have fallen sharply at some recent lending banks, the industry as a whole is still experiencing a hangover of reckless lending under older, more politicized lending policies.

2. Corruption: Strong measures are being taken, but corruption is rampant in many sectors of the Chinese economy, and the government is always cracking down on corruption in this or that industry. Meanwhile, the cycle continues. It is tempting to predict that just the threat of bankruptcy due to foreign competition will be enough to create the necessary political will for consistent application of the law.

3. Decentralization: China’s banking sector appears fairly centralized on paper, but the hidden problem is the de facto independence of remote branches from headquarters. Bank branches in China have been used to operate with much greater independence than is the norm in the West (thus contributing greatly to the problem of corruption), and any attempt to exercise control from headquarters will be met with vigorous local resistance. .

However, the moment of truth is fast approaching, as China’s WTO commitments require it to fully open its banking and insurance markets to foreign competition next year. The government is responding by introducing a series of new regulations to streamline credit practices and cracking down on internal corruption (whether bank branches will actually follow the new regulations is a question only time can answer). Banks are responding by listing on IPOs in foreign markets and with US-style “cutbacks,” closing branches and laying off staff.

Foreign banks are responding by investing billions of dollars in Chinese banks, surprising in light of past problems. In addition, they are acquiring minority stakes that are unlikely to ever give them operational control, in some cases primarily in order to secure access to distribution networks for insurance, credit card and investment products after 2007.

No one wants China’s banks to wither in the wake of foreign competition, not even their foreign “competitors,” because a Chinese banking crisis would have a significant negative effect on the entire world economy.