Department of Economics Working Paper No.

0108
http://www.fas.nus.edu.sg/ecs/pub/wp/wp0108.pdf

The Link between Bank Behavior and Non-performing Loans in China

Ding Lu
National University of Singapore

Shandre M. Thangavelu
National University of Singapore

Qing Hu
National University of Singapore

May 2001
Abstract: This paper uses a panel data set of public listing companies in China to empirically explore the relationship between banks lending behavior and non-performing loans. Our results show that the stateowned enterprises (SOEs) borrow more than other firms, other things being equal. This suggests that the banks lending decisions are systematically biased in favor of SOEs. We also find that the investment sensitivity to cash flow of the moderate-risk firms is substantially higher than that of the other firms, while investment of the worst-risk firms is the least responsive to changes in cash flow. This pattern of investment-cash-flow sensitivities suggests that, although banks do ration credits to some extent, they tend to provide liquidity to keep afloat the borrowers in financial distress. Such liquidity provision has worked together with the banks SOE-biased lending to cause substantial loan losses and widespread moral hazard in credit market. JEL classification: P34, G21, G32 Keywords: credit rationing, bank behavior, non-performing loans, soft budget constraint

2001 Ding Lu, Shandre M. Thangavelu and Qing Hu. Correspondence: Ding Lu, Department of Economics, National University of Singapore, 1 Arts Link, Singapore 117570, Republic of Singapore. Email: ecslud@nus.edu.sg. This paper was presented in 35th Canadian Economic Association Annual Meeting held in Montreal, Canada, May 31-June 3, 2001. We are grateful to Eric Santor and Woodrow Johnson for their helpful comment. Qing Hu acknowledges financial support from National University of Singapore. Views expressed herein are those of the authors and do not necessarily reflect the views of the Department of Economics, National University of Singapore

1. INTRODUCTION Recent evidence suggests that the Chinese banking system is one of the most inefficient in the world. Studies by Xu (1998) and Lardy (1998) claimed that Chinas four major state banks, namely, the Bank of China (BOC), the Agricultural Bank of China (ABC), the China Construction Bank (CCB), and the Industrial & Commercial Bank of China (ICBC), were technically insolvent by the late 1990s. 2 It was estimated that, by 1997, 35 percent of state owned enterprises had debts greater than assets. Despite that government had since then set up asset management companies to take over about RMB 1.4 trillions (USD 169 billions) bad debts off the state banks accounts, Dai Xianlong, Chinas Central Bank Governor, disclosed in February 2001 that the Chinese banks non-performing loans (NPL) ratio was alarmingly high: a quarter of the state banks loans were still overdue.3 While Chinas NPL phenomenon is well recognized in the literature as a combined result of government policy and the banks management failure, there is no consensus over which one has been the main culprit. Those who blame it on government policy point the finger at various forms of state intervention into the banking sector (CASS, 1999; Zhang, 1999, Fan, 1998). Those who blame the NPL problem on poor banking management trace its source to the soft budget constraints under which the state bank managers pay little attention to credit risk of loans (Xu and Lu, 2001). So far little empirical study has been conducted to quantify the contributions of different sources to bank inefficiency in the Chinese economy. The lack of such analysis is partially due to the complexity of the issue itself. A rising NPL ratio in banking assets could indicate deterioration of bank management or escalation of government-imposed policy lending. Unfortunately, detailed data of the exact

2 3

China Daily, 4 October 1998, Beijing. The Straits Time , 2001 Feb 19, Singapore.

scale of policy lending in NPLs are usually unavailable. To make analysis more difficult, the institutional environment of Chinas banking sector has undergone a series of drastic reforms. Before the mid 1990s, the Chinese banking system had been a legacy of the centrally planned command economy that was dissembled and phased out in the economic reform over the past two decades. It was not until 1995 that a Peoples Bank of China Law and a Commercial Bank Law, which laid the basis of a modern central banking system, were promulgated. Since then the PBOC has developed institutions and techniques to substitute instruments of a fractional reserves system for the direct credit allotment. To prepare the major state banks for becoming full-fledged commercial banks, three policy-loan banks were set up in 1994 to shoulder the burdens of providing policy loans.4 A nation-wide interbank market started operation in 1996. To beef up its surveillance over the commercial banks, the PBC introduced an accounting standard by the end of 1998 to classify banking loans into five categories according to their financial risks, namely, passed, special mention, substandard, doubtful, and loss. Banks bad loan provisions were accordingly increased. More reliable accounting for NPLs has only become possible since then. Regulation on the Administrative Penalties on Personnel Responsible for Illegal Activities of Financial Institutions was enacted to improve bank governance. To ameliorate provincial governments interference in bank lending, the PBOC consolidated its 30 provincial branches into nine regional centers in 1999. The dynamics of these reforms has made it extremely difficult to seriously assess the link between bank behavior and nonperforming loans.

The three policy banks are: the National Development Bank, the Agriculture Development Bank of China, and the Export & Import Bank of China

Nevertheless the governments recent effort to clean up the four major state banks highlights the need for an accurate assessment of the lending behavior of the banks and its relationship with the NPL phenomenon. In 1998, in a bid to help these banks get rid of the NPLs accumulated over past years, the Chinese government established four state-sponsored asset management companies to take over bad debts from the banks balance sheets. On top of that, the government injected RMB 270 billions into the four major banks to strengthen their capital bases. These reforms drew immediate criticisms from some economists who feared a resurgence of an even more severe NPL problem thanks to the banks moral-hazard type of lending after such a wholesale bailout by the government (Lardy, 1998; Crockett, 1999; Xu and Lu, 2001). It remains to be assessed whether the 1998 reform has been successful to give a fresh start for these banks to reorient their management and lending behavior to meet market demands. This paper attempts to study empirically the Chinese banks lending behavior and its role in accumulating non-performing loans. With a new financial data set collected from the public listing companies in Chinas stock market, this study takes the research strategy to infer banks lending behavior from firms debt financing and investment behavior. This research strategy addresses the key difficulties in the assessment of lending behavior of the banks. First, the data covers the period 1994-1999, after the setting up of the three policy banks. This removes a major part of policy lending influence on bank behavior. Second, details of the data set enable us to identify degree of state ownership of these listed companies so that an analysis on differences in bank financing for SOEs and non-SOEs is possible. We can therefore observe whether bank financing was biased. Last but not the least, the study is exclusively focused on part of the banks lending that was least distorted

by government-orchestrated policy lending. To become a public listing company, a firm must meet minimum profitability qualifications and accounting standards set by the stock exchange regulators. Public listing companies are thus perceived as one of the best borrower groups and are the customers that the banks are wooing for. The initial lending to the public listing companies mostly represents banks commercial behavior. Consequent loans lent to these companies also reflect bank loan officers judgment. Thus, a consistent lending behavior can be observed throughout the sample period. This research strategy makes it possible to address two major questions: Do the Chinese banks favor state-owned enterprises (SOEs)? Do these banks impose a credit constraint on all borrowers by the same riskmanagement standard? Two models are developed to help answering these questions. Model A (the borrowing ratio model), which tests banks lending bias towards SOEs, captures the relationship between the borrowing ratios of the firms and the key variables that indicate default risk, collateral level, state-ownership, firm size, and industrial policy. Model B (the investment-cash-flow sensitivity model) measures the relationship between corporate investment and internal cash flow. It allows us to investigate whether sensitivity of firms investment to internal cash flow increases with their default risk, thus indicating the extent to which banks ration credit to firms according to the latters risk ranking. Our findings reveal that the banks lend more to SOEs than to non-SOEs given the same default risk and collateral provision. This suggests that the Chinese banks are systematically biased in their lending decisions. We also find that the investment-cash-flow sensitivities increase with the borrower risk among the best-risk borrowers and the moderate-risk borrowers. The investments of the worst-risk borrowers, however, are least

responsive to the internally generated cash flow among all firms. The low investment-cashflow sensitivities of the worst-risk borrowers indicate that the banks tend to bail out the financially troubled borrowers. This systematic lending bias is largely induced by the expectation of governments bailout of troubled SOEs, a moral hazard that dominates banking decisions. The remainder of this paper is organized as follows: Section 2 provides theoretical model to explain the bank behavior in China. Section 3 provides the description of the data. In Section 4, we produce empirical evidence regarding lending bias and credit rationing. Section 6 provides the conclusions.

2. THE MODEL: THEORY AND HYPOTHESES 2.1 Soft budget constraint as a cause of non-performing loan problem Soft budget constraint of state banks is widely cited as a major cause of Chinas non-performing loan problem (Yuan, 2000; CASS, 1999; Zhang, 1999; Li, 1999; Xu, 1998). Lack of hard budget constraint in banks themselves leads to the failure of the banks to impose hard financial constraint on the borrowers, causing the development and accumulation of non-performing loans. Soft budget constraint is a popular jargon first introduced by Kornai (1980), which refers to the case when the firm is not concerned with financial losses and always expects to be bailed out by the government or a third party. According to the existing literature, government intervention and insider control are the main reasons for soft budget constraint.

Government intervention Government intervention in Chinas banking sector and credit market arises for several reasons. Zhang (1999) pointed out that the central government forces banks to extend credit beyond the equilibrium level in order to achieve a targeted economic growth rate. In his view, the discrepancy between the realized credit supply and the equilibrium credit supply constitutes banks loan losses. Ding and Liu (1993) claimed that the local government from time to time coerces the banks to lend money to the lossmaking SOEs in order to avoid rising unemp loyment. Besides, government officials rent seeking also leads to government interference in bank lending. Government intervention in bank lending could take place either ex ante, i.e. before the lending decision is made; or ex post, i.e., after the transaction is completed. Both ex ante and ex post government intervention could soften budget constraints of the banks. Regarding ex ante intervention, it is widely known that, until 1994, the Chinese banks were obliged to make policy loans, which were granted out of policy or political considerations. Chinese Academy of Social Sciences (CASS) (1998) estimated that policy loans accounted for 35 percent of total loans made by the state banks in the first half of the 1990s. It is widely believed that policy loans are of lower quality than commercial loans (CASS, 1999; Xu and Lu, 2001). Ex ante government intervention makes it difficult to measure the banks performance. As a result, the Chinese state banks constantly use policy lending as an excuse for their poor lending decisions (Zhang, 1999; Xie, 1994).

The Chinese government has also intervened in credit market ex post by bailing out troubled SOEs or state banks. The government bailout can take various forms, such as the restructuring of ailing SOEs, the takeover of non-performing loans, and deliberate delays in closure of insolvent financial institutions. In fact, such bailout activities would reduce the banks incentive to improve lending efficiency, leading to moral-hazard type of riskier lending (Xu and Lu, 2001; Xie, 2001). Insider control Insider control refers to a situation where the managers obtain critical control right of the firm and extracts substantial benefit from it but do not have full claim rights to the cash flow of the firm. The term also describes the capture of substantial control rights by the managers or the workers of a formerly state-owned enterprise in the process of its corporatization (Aoki, 1995). Thus, the insider may have an incentive to pursue nonproductive projects to enhance h own benefit rather than shareholders. Li (1999) is explains why excessive insider (manager) control of a firm leads to soft budget constraints. When the manager is protected from downward risk of investment, it will be to the insiders advantage to obstruct liquidation of an existing asset or propose inefficient projects. Although the Chinese state-owned banks are yet to be corporatized, the insider control problem is still present. Since 1994, the Chinese state banks have been granted increasing autonomy in lending decision-making. In the meantime, the government as the de facto owner of the state banks exercised less control over bank management. Zhang (1999) claims that moral hazard problem will arise if the banks are granted the critical control right of bank fund and they are not required to take full responsibility for their

decisions. Xu and Lu (2001) showed theoretically that non-performing loans would build up over time if bank managers consumption is unrelated with loan quality. 2.2 Testable hypotheses for bank behavior under soft budget constraint Although the soft budget constraint is theoretically appealing, it is difficult to test the softness of budget constraint either for firms or for banks. Therefore there is little empirical evidence to support its application to Chinas banking sector. Cull and Xu (2000) study the effects of bank financing and government grant on SOEs productivities by using survey data of SOEs in pr-1994. They found that there was a positive relationship between SOEs productivity and the share of investment financed by the banks but no such relationship exists between SOEs productivity and the share of investment financed by the government. Thus they concluded that the banks impose harder budget constraints on SOEs than the government. Unfortunately, Cull and Xus finding does not suggest whether the banks are sufficiently hard by commercial standards. As opposed to their study, we propose the following testable hypotheses to assess whether the banks are operating under soft budget constraints. Not only will these hypotheses be testable for the existence of soft budget constraints but also will they be used to assess empirically the link between bank behavior and non-performing loans. H1: Bank lending is biased towards SOEs, other things being equal. Soft budget constraint leads to inefficient lending and credit misallocation that favors the SOEs. According to an estimate by CASS (1998), SOEs attribute to only one third of GDP but account for two third of the total dom estic loans. Government intervention, either ex ante or ex post, tends to protect SOEs. Ex ante intervention of the

government forces banks to lend more money to SOEs than to non-SOEs. Ex post intervention provides an implicit guarantee for SOEs borrowing. As a result, the banks would extend more loans to SOEs either out of government policy priority or due to implicit government guarantees. It should be noted that soft budget constraint is not the sole cause of lending bias toward SOEs. At least two additional explanations can be provided for the lending bias. The banks have limited legal recourse in the event of loan default. Without adequate legal recourse, the banks have difficulties enforcing the loan contracts. In this context, implicit government guarantees for the loans given to SOEs are critical to banks biased lending decision. The customer relationship between state banks and SOEs may provide another reason. SOEs have longer relationship with state banks than the private businesses. Thus, it may be transaction-cost effective for state banks to channel more loans to the SOEs than to the private firms, other things being equal. H2: The banks do not ration credit to firms according to the latters risk ranking. Credit rationing is a condition of credit markets in which the supply of credit is less than the demand for credit at quoted contract terms. In credit market with asymmetric information, a certain group of borrowers is always granted credit, while other observably indistinguishable borrowers are not, even if they are willing to pay more than the prevailing market interest rate. The assumption of credit rationing theory is that banks behave to maximize the expected return. However, soft budget constraint of banks implies soft credit constraint on the borrowers. Zhang (1999) argues that the Chinese banks do not ration the credit to SOEs under soft budget constraint. The state banks

would lend money to SOEs up to their credit demand and tend to satisfy SOEs investment no matter how risky the latters business and projects. 2.3 Model A: the borrowing ratio model The most common approach to test lending bias is to compare the debt-equity ratios of SOEs with those of non-SOEs. This approach is, however, far from robust since it does not take into account all the factors affecting lending decisions. As we know, the loan size of a firm is determined by many factors, of which borrower risk and collateral are the most important ones. A bank is always willing to lend more money to a low-risk borrower than to a high-risk borrower. In addition, collateral reduces the risk of the secured loans and helps enhance debt capacity of a borrower. Further, loan size may be also affected by firm size and borrower-bank relationship. Thus, to test lending bias, we need t examine whether SOEs are able to borrow o more than non-SOEs if they have the same risk characteristics. For this purpose, we establish the following model to capture the relationship between the loan size and the risk characteristics of the firms. The borrowing ratio model or Model A is given as.
Lit = 0 + 2 R2 it + 3 R 3it + 4 R 4it + 5 FAit + 6TAX it + 7 SIZ it + 8 S1it + 1i + vit

(1)

The subscript i denotes the cross section unit and t denotes time period. 1i represents a random effect that is varying over cross section units and invariant over time for a given cross section unit. The dependent variable L is the borrowing ratio of firms, which represents the loan size. R2, R3 and R4 are dummy variables denoted the level of default risk. FA, TAX, SIZ are determinants of borrowing ratios, representing fixed assets ratio, sale tax ratio and firm size respectively. S1 is the state ownership dummy variable. More detailed variable descriptions are given in Section 3. R1 is excluded from

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the model to avoid the perfect multicollinearity among the intercept and the risk variables of R1, R2, R3 and R4. S2 is excluded for the same reason. As a result, the coefficient of Ri should be interpreted as the difference between the effects of Ri and R1 on borrowing ratio for all i 1.

The coefficient of S1, 8 , represents the difference between the borrowing ratios of SOEs and non-SOEs. In our model, 8 can be interpreted as lending bias. If banks are subject to hard budget constraint and are able to allocate credit efficiently, 8 will be close to zero, suggesting a very low lending bias. While the coefficient of S1 is of particular interest for us, it is also interesting to look at other coefficients in the model. First, as the collateral reduces loan risk and enhances firms debt capacity, we expect 5 to be negative. Second, if the banks lend more money to priority industries than to non-priority industries, 6 should be a negative number. Finally, if the banks favor large firms by granting them more loans, 7 should be positive. It is, however, difficult to anticipate the relative magnitudes of these coefficients. As for the coefficients of Ri, we need to consider the supply and demand side factors. On the demand side, a low-risk borrower usually needs less credit than a highrisk borrower because the former would be able to generate more cash flows to cover the investment expenditures. On the supply side, the banks will always meet a borrowers demand for credit if its default risk is low. When a borrowers risk is high, whether the banks will limit the loans to the firm depends on whether such risk is compensated by interest premiums. By using Germany credit file data, Machauer and Weber (1998) show empirically that credit line increase with borrowers risk, indicating that banks tend to 11

meet the borrowing needs that increase with the borrowers risk. In the case of China where interest rates are uniformly set by the Central Bank, it is possible to observe a nonlinear relationship between the borrowers risk and loan amount: The borrowing ratio rises with the borrowers risk to a certain level and begins to drop after the borrowers risk exceeds some critical value. This speculation is yet to be tested. 2.4 Model B: Investment-cash-flow sensitivity model Modigliani and Miller (1958) show theoretically that a firms financial structure is irrelevant to its market value in a perfect market. In this situation, all firms have the exact equal access to external capital, and a firms financial structure and financial policy will not affect the real investment. In other words, with a perfect capital market, internally generated cash flow will not affect a firms investment decisions because external finance provides a perfect substitute for internal finance. However, if the capital market is not perfect, financial structure and fluctuation in internal finance do affect investment decisions. Modern corporate finance theory emphasizes the importance role of information asymmetry in corporate financing decisions and investment decisions. Myer and Majluf (1984) showed that, in a capital market with information asymmetry, it is optimal for a firm to use up operating cash flow before going to capital market to raise money and low-risk debt is preferable to risky securities such as equity if a firm does need external financing. Because of capital market imperfection, availability of internal finance will constrain firms investment decisions. The more risky a firm, the more severe the asymmetric information problem and the more likely the firm will be credit rationed. In other words, internal finance will have greater effect on investment decisions of a high-risk firm than on those of a low-risk firm.

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In their pioneering study, Fazzari, Hubbard and Petersen (1988) show empirically that the sensitivities of investment to cash flow vary across firm groups with differing earning retention practices. Internal cash flow has greater effect on the investment of lowpayout firms than on that of high-payout firms. In their study, cash flow enters a reducedform investment model in order to examine how a firms investment responds to its internal cash flow. The general form of their formulations is:
( I / K )it = f ( X / K )it + g( CF / K )it +u it

(2)

where Iit is investment for firm i during period t; X represents a vector of determinants of investment; CF is the firms internal cash flow; and u is residual error. All variables are divided by the beginning-of-period capital stock K. In Fazzari, Hubbard and Petersen (1988), X vectors include four variables, such as Tobins q, sales, cash stock, working capital. Following Fazzari-Hubbard-Petersen (F-H-P) formulation, we define the following equation,
IKit = 0 + 21CFKit * R1it + 22CFKit * R2it + 23CFKit R3it + 24CFKit * R4 + 3CFK + 4 SKit + 5SKi,t 1 + 6Qi,t 1 + 1i + vit i,t 1
(3)

where 1i represents the random effect that is individually time -invariant; vit is the residual error. IK is the investment of a firm. CFK, Q and SK represent cash flow, Tobins q and sales, respectively, which are three determinants of investment. More detailed variable descriptions are given by section 3. The products of CFK and risk

dummies enable us to measure the investment-cash-flow sensitivities of the firms with differing risk categories. In a capital market with credit rationing, the investment of lowrisk firms is less sensitive to cash flow than that of high-risk firms. In other words, a

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good-risk firms investment is less constrained by cash flow generated from operation, which indicate 21 < 22 < 23 < 24 . In the case of China, our second hypothesis (H2) would imply that the differences among 2i are insignificant, i.e., 21 = 22 = 23 = 24 .

3. DATA COLLECTION AND PROCESSING The data is from Genius Database,5 which compiles all the financial data of public listing companies in China. The data is compiled from the annual financial reports of the 268 public listing companies from 1995 to 1999. Out of the 268 companies, 104 are listed in the Shenzhen Stock Exchange and 164 are listed in the Shanghai Stock Exchange. 3.1 Variable description TABLE 1 lists the variables used in our empirical analysis. Borrowing ratio, L and investment to capital stock ratio, IK, serve as dependent variables in Models A and B respectively. The borrowing ratio is defined as the ratio of corporate borrowing over total assets. Corporate borrowing is the sum of short-term borrowing, long-term borrowing and long-term debt with a remaining maturity of no more than one year. In the investment to capital stock ratio, investment consists of the expenditure on fixed assets, long-term investment and intangible assets. Capital stock is the book value of the existing fixed assets, long-term investment plus intangible assets. In our study, we use the book value instead of replacement cost because the time dimension in our sample is too short and hence there should be little difference between book value and replacement cost.
Genius Database is maintained by Genius Information Technology Co. Ltd., which is one of the largest information companies who specialize in the production and distribution of Chinese stock market information.
5

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The independent variables include risk dummy variables, ownership dummy variables, the determinants of borrowing ratio and the determinants of corporate investment. The four dummy variables, R1, R2, R3, and R4, are characterized by default risk. In our sample, we classified the 268 firms into four risk levels: level 1, level 2, level 3 and level 4. Level 1 represents the best risk and level 4 represents the worst risk. This risk classification is not based on the banks credit rating, which is not available to us. Instead, we use a logit model to evaluate each firms predicted default probability. Our borrower classification is then based on the predicted default probability generated by the logit model. A detailed description of the logit model is presented in Section 3.2. The dummy variables, S1 and S2, capture the ownership characteristics. A firm is classified as a SOE if its state-owned shares account for no less than 50% of total outstanding shares. State-owned shares are defined as the sum of government shares and legal entity shares. In Chinas stock exchange regime, there are five types of shares: (1) Government shares, which are retained in the state institutions and government departments, are not tradable; (2) Legal entity shares, which can only be held by other state-owned enterprises, are not listed in the two official exchanges; (3) Employee shares are non-tradable until the firm allows their convertibility; (4) Ordinary domestic individual shares, or A shares, can only be purchased and traded by private Chinese citizens in the two official exchanges; (5) Foreign individual shares, which are denominated in foreign currencies, can be purchased and traded in exchanges in China (B shares), in Hong Kong (H shares) or in NYSE (N shares).

TABLE 1

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Variable Description
Variable No. Variable name Dependent variables 1 2 L IK Borrowing ratio=Borrowing from banks /Total assets Investment/capital stock Independent variables 3 4 5 6 7 8 9 10 11 12 13 14 R1 R2 R3 R4 FA S1 S2 TAX SIZ Q CFK SK 1 if the firms risk is level 1, 0 otherwise 1 if the firms risk is level 2, 0 otherwise 1 if the firms risk is level 3, 0 otherwise 1 if the firms risk is level 4, 0 otherwise Fixed assets/total assets 1 if state-owned share/total share is over 0.5, 0 otherwise 1 if state-owned share/total share is below 0.5, 0 otherwise Sales-related tax payment/sales Firm size =log (Total assets) Tobins q Cash flow from operations/capital stock Sales/capital stock Description

Among determinants of borrowing ratios, FA, the ratio of fixed assets over total assets, is used as a proxy for collateral; SIZ, value of firms total assets, is used as a proxy for firm size; and TAX, the sales-related tax rate, is used as a proxy for the industrial policy. According to Lu (2000), favorable sales-related tax rate is one of the major means adopted by China government to support the priority industries designated by industrial policy. Therefore, a lower TAX should indicate a higher degree of state 16

support or protection. Following this argument, we use nominal sales-related tax rate as an indicator for the priority status of an industry. Among determinants of corporate investment, CFK is the cash flow divided by the capital stock at the beginning of a given period, SK is the sales normalized by the capital stock at the beginning of a given period, and Q is Tobins q. In the classical investment models, Tobins q, the ratio of market value of a firms equities over accounting value of its capital stock, measures the market valuation of the investment opportunities of a firm.

3.2

Credit rating To derive a credit rating for each of our sample firms, we construct a logistic

model for default prediction. Logit model is quite popular in the literature of predicting financial distress, bankruptcy or default. Ohlson (1980) constructed a logit model and used nine accounting ratios to predict probability of bankruptcy. Other applications include West (1985), Platt and Platt (1991), Lawrence et al. (1992), Lawrence (1995).6 The logit model produces a predicted default probability (PDP) for each firm each year. Based on their PDP, the sample firms are classified into four rating categories. A binary logistic model of predicted default probability can be described as follows: Let Xi denote a vector of predictors for the ith observation; let be a vector of unknown parameters. A logistic probability function of default for any given Xi and is given by:
6

See Altman (1998) for a review of credit risk measurement. Although other popular credit risk measurement schemes are available, such as the discriminant analysis model, the probit model and VAR (Value at risk) model (e.g. KMV model), we chose logit model mainly because of its well-known convenience.

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P( X i , ) = [ 1 + exp( ' X i )] 1

(4)

The unknown parameters are estimated by the maximum likelihood method. The logarithm of the likelihood function is given by: l( ) = log P( X i , ) + log(1 P( X i , ))
iS 1 iS 2

(5)

where S1 is the set of default firms and S2 is the set of non-default firms. Once the estimators for are obtained, the predicted default probability can be computed. The performance of a logit model can be evaluated by the prediction accuracy given a cutoff value of P. The cutoff value of P is usually set at 0.5; but it is allowed to change from 0 to 1. In this study, a default event is identified if a firm loses money in two years in a row. Let Eit be the event of default or non-default for firm i at time t. Eit equals to 1 if firm i suffers a loss in time t+1 and t+2. If a firm never makes a loss in two consecutive years during the sample period, Eit equals to 0 for any given i and t. We assume that a firm has difficulties in making repayment when two consecutive years of losses are incurred. The notion of financial distress if a firm suffers two-year losses is also used in Coats and Fant (1993). In fact, most of the defaulted firms defined in our study lose money in a successive three-year period. Chinas stock market watchdog, China Security Regulatory Commission, defines a firm as an ST firm 7 if it has experienced three-year losses in a row. In this case, the daily price fluctuation of an ST stock is restricted to a special limit of 5% rather than a normal limit of 10%. The most difficult task in the construction of a default prediction model is to identify a set of appropriate predictors. In most of the applications of the default
7

ST means specially treated.

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probability model, the predictors X are accounting ratios, such as returns on capital, i current ratio, etc. However, there is no consensus on this issue in the literature and the predictors vary considerably in different studies (ref. Altman, 1968; Altman, Haleman and Narayanan, 1977; Ohlson, 1980; Platt and Platt, 1991). For our purpose, we calculate 20 variables, among which 15 variables are key ratios or supplemental ratios used in S&P corporate bond rating. By using backward stepwise regression technique, we identify seven variables that are of the best predictive power. These seven variables include: return on capital (ROC), operating incomes/sales (OIC), total debt/EBITDA (DE) 8, total debt/market value of capitalization (DMC), working capital/total assets (WCA), log sales (LS), and log equity (LEQ). In TABLE 2, the estimation results of the logit model for default probability are given and a Newton-Raphson procedure is applied in the estimation exercise. 9 With a cutoff value of 0.05, our model classifies correctly 42 out of 52 default cases and 855 out of 1085 non-default cases. The classification accuracy is 78.8% for the non-default cases, 80.8% for default cases. The overall prediction accuracy is 78.9%. Raising the cutoff value increases the overall prediction performance but reduces prediction performance for default cases. Lowering the cutoff value reduces the overall prediction performance but increases prediction performance for default cases. Thus, there exists a trade-off between prediction accuracy for the non-default cases and that for the default cases.

TABLE 2 Estimation Results of the Logit Model for Default Probability Prediction
8

EBITDA represents earnings from continuing operations before interest, taxes, depreciation, and amortization. 9 The constant term is excluded because doing so improves the prediction performance.

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Variable ROC OIC DE DMC WCA LEQ LS

Coefficient Standard Error -5.749 -3.145 -0.002 4.502 1.330 0.359 -0.549 2.977 0.893 0.003 1.152 0.965 0.164 0.167

Prob. 0.053 0.000 0.539 0.000 0.168 0.029 0.001

The logit model described above produces a PDP for each firm in each year. Based on their PDP, we classify the firms into four risk levels. Let the dummy variable R1 denote risk level 1, R2 risk level 2, R3 risk level 3, and R4 risk level 4. We classify the firms according to the following scheme: (1) R1=1 if PDP R2=1 if 0.01 < PDP 0.01, or 0 otherwise; (2) 0.05, or 0

0.03, or 0 otherwise; (3) R3=1 if 0.03 < PDP

otherwise; (4) R4=1 if PDP > 0.05, or 0 otherwise. Recall that the cutoff value in our study is 0.05, which means that the firms with risk level 4 default on their loans or are going to default. From 1995 to 1999, out of 1340 cases, 175 cases are classified as risk level 1, 506 cases as risk level 2, 252 cases as risk level 3, and 407 cases as risk level 4. In terms of percentages, 13.1% of the total are of risk level 1, 37.8% are of risk level 2, 18.8% are of risk level 3, and 30.4% are of risk level 4. This classification makes our analysis consistent with the banking practice and allows us to analyze the possible non-linear relationship between borrower risk and borrowing ratio or investment sensitivity.

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TABLE 3 Debt Financing and Investment for the Firms Grouped by Rating Categories
Risk level 1 2 3 4

Borrowing ratio Mean Median Max Min Standard deviation 0.162 0.135 0.450 0 0.128 0.227 0.219 0.623 0 0.130 0.262 0.262 0.691 0 0.135 0.321 0.302 1.530 0 0.187

Investment/capital stock Mean Median Max Min Standard deviation Observations 0.276 0.159 3.582 -0.797 0.487 213 0.208 0.108 3.856 -0.885 0.409 617 0.215 0.075 4.739 -0.620 0.413 305 0.061 0.015 2.117 -0.678 0.310 473

3.3

Debt financing pattern and investment pattern The preliminary analysis of the data is given in TABLE 3 and TABLE 4. TABLE

3 displays the debt financing pattern and investment pattern of our sample firms grouped by the rating categories. Both the average borrowing ratio and the median borrowing ratio rise with borrower risk. The riskier a firm, the more it borrows from the banks. Average borrowing ratio rises from 16% for R1 firm to 32% for R4 firm. The maximum borrowing ratio for R4 firms in our sample is as high as 153%. This indicates that some

21

of the R4 firms continue to operate even though their total assets are insufficient to pay off their debts. TABLE 3 also shows that the capital growth rate (investment/capital stock) drops with borrower risk. The R1 firms invest most and the median annual growth reaches around 16%. The R4 firms invest the least and the median capital growth is only 1.5%. If the depreciation rate is 10%, then the investment by the R4 firms fails to keep pace with capital depreciation.

TABLE 4 Debt Financing and Investment of SOEs and Non-SOEs

Firm Groups SOE Borrowing ratio Mean Median Max Min Standard deviation 0.257 0.247 1.530 0 0.163 0.2404 0.242 0.850 0 0.144 Non-SOEs

Investment/capital stock Mean Median Max Min Standard deviation Observations 0.163 0.072 3.856 -0.885 0.405 1213 0.162 0.094 4.739 -0.633 0.391 395

TABLE 4 displays the debt financing and investment pattern for SOEs and nonSOEs. The average borrowing ratio of SOEs is 25.7%, about 2 percentage points higher than that of non-SOEs. However, the median borrowing ratio of SOEs is almost identical

22

with that of non-SOEs. On average, SOEs have the same investment growth as nonSOEs, but the median capital growth of SOEs is lower than that of non-SOEs. These figures do not give distinctive patterns of debt financing and investment for SOEs and non-SOEs.

4. EMPIRICAL RESULTS 4.1. Test for lending bias Without autocorrelation and heteroscedasticity, a standard random -effect model should have a known covariance structure where the correlation between any two residuals within a cross sectional unit is constant over time and it is identical for all crosssectional units as well. This assumption is, however, very unlikely to be realistic for Model A. In fact, both autocorrelation and heteroscedasticity are detected in the model. Following the two-step correction process described in Greene (2000), we removed autocorrelation and heteroscedasticity. Details are given in Appendix. The estimation results are showed in TABLE 5. Except for the coefficients of FA and R2, which are statistically significant at 10% level, all other coefficients are statistically significant at 5% level. The signs of coefficients of FA, S1, TAX and SIZ meet our prediction well. The ranking of the coefficients of R2, R3 and R4, however, are more in line with the findings of Machauer and Weber (1998) rather than having a nonlinear curve as was speculated earlier.

23

TABLE 5 Estimation Results of Model A with Autocorrelation and Heteroscedasticity

DEPENDENT VARIABLE: L Method: GLS (Variance Components) Number of cross-sections used: 268 Total panel (balanced) observations: 1340 Variable R2 R3 R4 FA SIZ TAX S1 R-squared: 0.41 Coefficient 0.013 0.020 0.040 0.047 0.009 -0.950 0.031 Std. Error 0.008 0.009 0.009 0.026 0.001 0.246 0.011 t-Statistic** 1.762 2.264 4.362 1.839 6.413 -3.864 2.827 Prob. 0.078 0.024 0.000 0.066 0.000 0.000 0.005

Durbin-Watson statistics: 1.66

** Critical value at 5% significance level is 1.96. Note: The constant term and the random effect terms are not reported since they are of no particular interest for our study .

The coefficient of S1 equals 0.031. This suggests that the borrowing ratios of SOEs would be 3.1 percentage points higher than those of non-SOEs on average even if they both had the same risk characteristics (i.e., the same default risk), the same collateral provision and the same firm size. This finding favors acceptance of our first hypothesis (H1). To test sensitivity and stability of our results, we estimate two alternative specifications of Model A. First, we replace R2, R3 and R4 with PDP. Second, we

24

partition the risk level 4 into level 5 and level 6 (denoted by the dummy variable R5 and R6) and replace R4 with R5 and R6. Out of 473 cases of R4 firms, 137 cases are classified as R5 firms of which PDP values are between 0.05 and 0.06; and 336 cases as R6 firms of which PDP values are over 0.06. The value of R5 is 1 if a firms PDP is between 0.05 and 0.06. R6 equals 1 if a firms PDP exceeds 0.06. These two specifications do not change the result of our findings, which appear to be not sensitive to different specifications.

4.2

Test for credit rationing The white test shows that Model B is heteroscedastic while the DW test fails to

detect autocorrelation. Again, we apply the partial deviation procedure described in the Appendix to remove the heteroscedastictiy. The GLS estimators are then computed by regressing the partial deviations of IK on the same transformation of the independent variables. TABLE 6 reports the estimation results. The coefficients of Ri*CFK indicate the existence of some degrees of credit rationing. However, firms investment sensitivities to internal cash flow do not increase monotonically with firms default risk. The coefficient of R1*CFK is less than a half of R2*CFK coefficient. The coefficient of R3*CFK is larger than that of R2*CFK while the difference is rather small. The F statistic shows that the null hypothesis that the coefficients of R2*CFK and R3*CFK are equal cannot be rejected at 5% significant level. The coefficient of R4*CFK is the smallest among the coefficients of cash flow.

25

TABLE 6 Estimation Results of Model B with Heteroscedasticity

DEPENDENT VARIABLE: IK Method: GLS (Variance Components) Number of cross-sections used: 268 Total panel (balanced) observations: 1072 Variable Q(-1) R1*CFK R2*CFK R3*CFK R4*CFK CFK(-1) SK SK(-1) R-squared: 0.10
** Critical value at 5% significance level is 1.96

Coefficient -0.010 0.382 0.908 0.924 0.159 0.110 -0.003 -0.002

Std. Error 0.003 0.047 0.088 0.138 0.063 0.038 0.010 0.010

t-Statistic** -4.074 8.084 10.367 6.720 2.533 2.915 -0.298 -0.181

Prob. 0.00 0.00 0.00 0.00 0.01 0.00 0.76 0.85

Durbin-Watson stat: 2.17

From the above, we can observe the following: (1) The fluctuation of internal funds has much smaller effect on the R1 firms investment than that on the R2 firms or the R3 firms investment. This suggests that the best-risk firms enjoy much greater credit availability than the moderaterisk firms. Therefore the best-risk firms are very unlikely to be subject to the banks credit rationing.

26

(2) The sizeable effects of internal finance on the R2 and the R3 firms investment indicate existence of banks credit rationing to these firms. The similarity of the effects of cash flow on the two firm groups investment also suggests that the banks might not differentiate moderate-risk firms in their lending decisions. (3) The investment of R4 firms is the least responsive to the availability of internal finance, suggesting that credit rationing is not effective on the worst-risk firms. A word of caution, however, must be given here: capital needs of a firm in financial distress could be very different from that of a firm in normal business. A very low investment-cash-flow sensitivity may not necessarily imply entire absence of credit rationing for a firm in financial distress. Note that the results in TABLE 6 have two irregularities. One is that the coefficient of Q (Tobins q) is negative. The other is that the coefficients of SK (sales/capital stock ratio) variables are statistically insignificant from zero. These two irregularities lead us to question whether Model B is correctly specified and thus prompt us to examine whether these results are sensitive to changes in the specifications. Three alternative specifications of Model B are proposed here: (1) dropping the Q term; (2) dropping the SK terms; (3) replacing R4 with R5 and R6. Our findings from the original model basically hold under the above alternative specifications. The pattern of the coefficients of cash flow terms in the alternative specifications resembles that of the original model. In all three alternative specifications, the coefficient of R1*CFK is found to be around one half of the R2*CFK coefficient. The coefficients of R2*CFK, R3*CFK and R5*CFK are very close in magnitude, and they are

27

substantially larger than the coefficient of R1*CFK as well as that of R4*CFK or R6*CFK.

4.3

Additional tests for lending bias and credit rationing Model A shows that the SOEs have higher borrowing ratios than the non-SOEs.

Borrowing ratio measures the credit availability in term of loan stock. However, it does not account for whether the SOEs gain greater access to new credit than the non-SOEs. In this section, we investigate whether the banks grant favorable credit access to the SOEs as a whole and whether the SOEs with a given risk level obtain greater access to new credit than the non-SOEs with the same risk level. We use the investment sensitivity to internal cash flow to measure the availability of new credit. For our purposes, we modify the original version of model B in two ways. First, the cash-flow terms in the original model are replaced by S1*CFK and S2*CFK. We call this specification as Model B1. The coefficients of S1*CFK and S2*CFK measure the investment-cash-flow sensitivities for SOEs and non-SOEs respectively. Second, the cash-flow terms in the original model are replaced by S1* R1*CFK, S1* R2*CFK, S1* R3*CFK, S1* R4*CFK and S2* R1*CFK, S2* R2*CFK, S2* R3*CFK, S1* R4*CFK. We call this specification as model B2. The products of risk dummy variables and ownership dummy variables allow us to classify our sample into eight sub-samples: R1 SOEs, R2 SOEs, R3 SOEs, R4 SOEs, R1 non-SOEs, R2 nonSOEs, R3 non-SOEs and R4 non-SOEs. R1 SOEs refer to the SOEs who are of risk level 1; R2 SOEs are the SOEs of risk level 2; etc. R1 non-SOEs refer to the non-SOEs who

28

are of risk level 1; R2 non-SOEs are the non-SOEs of risk level 2, etc. The coefficients of R1*S1*CFK, R2*S1*CFK, R3*S1*CFK, R4*S1*CFK measure the investment-cashflow sensitivities for R1 SOEs, R2 SOEs, R3 SOEs and R4 SOEs respectively. The interpretation is straightforward for the coefficients of R1*S2*CFK, R2*S2*CFK, R3*S2*CFK and R4*S2*CFK. TABLE 7 shows the estimation results for Model B1 and Model B2. Under Model B1, the coefficient of S1*CFK is only a half of the coefficient of S2*CFK. This suggests that the investments of SOEs are less sensitive to cash flow than those of non-SOEs. However, the results of Model B2 show that the SOEs at a given risk level do not always have a smaller investment-cash-low sensitivity than the non-SOEs with the same risk. The Wald tests show that: (1) R1 SOEs have smaller investment-cash-flow sensitivity than R1 non-SOEs; (2) R3 SOEs have smaller investment-cash-flow sensitivity than R3 non-SOEs; (3) the investments of R2 SOEs are more sensitive to cash flow than those of R2 non-SOEs; (4) the investment sensitivities of R4 SOEs are similar to those of R4 non-SOEs. In other words, R1 SOEs and R3 SOEs gain greater access to credit than their non-SOEs counterpart; however, the R2 non-SOEs have greater access to credit than R2 SOEs. In sum, SOEs do not always gain greater credit availability than non-SOEs at every risk level; but they do in general receive preferred treatment since the coefficient of S1*CFK is greater than that of S2*CFK under Model B1.

29

TABLE 7 Estimation Results for Model B1 and Model B2

ESTIMATION METHOD: GLS (VARIANCE COMPONENTS) Sample: 1996 1999 Number of cross-sections used: 268 Total panel (balanced) observations: 1072 Model B1 Variable Q S1*CFK S2*CFK CFK(-1) SK SK(-1) R-squared: 0.12 Model B2 Variable Q S1*R1*CFK S1*R2*CFK S1*R3*CFK S1*R4*CFK S2*R1*CFK S2*R2*CFK S2*R3*CFK S2*R4*CFK CFK(-1) SK SK(-1) R-squared: 0.26
** Critical value at 5% significance level is 1.96

Coefficient -0.007 0.240 0.553 0.152 0.017 0.003

Std. Error 0.002 0.044 0.098 0.047 0.011 0.011

t-Statistic** -2.788 5.391 5.645 3.213 1.581 0.247

Prob. 0.005 0.000 0.000 0.001 0.114 0.805

Durbin-Watson stat: 2.15

Coefficient -0.010 0.293 1.067 0.849 0.189 0.819 0.669 1.674 0.172 0.102 0.011 -0.003

Std. Error 0.003 0.054 0.097 0.187 0.072 0.171 0.180 0.213 0.173 0.045 0.011 0.011

t-Statistic** -3.490 5.420 10.971 4.551 2.622 4.786 3.716 7.869 1.000 2.236 0.981 -0.276

Prob. 0.00 0.00 0.00 0.00 0.01 0.00 0.00 0.00 0.32 0.03 0.33 0.78

Durbin-Watson stat: 2.10

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4.4

Structural changes after 1998 As mentioned in Section 1, 1998 was the year when the Chinese government

established four state-sponsored asset management companies to take over bad debts from the banks balance sheets. This policy was criticized by some for its possible aggravation of the banks moral hazard. On the other hand, that year also witnessed a series of reforms to improve banking management, including the introduction of a new accounting standard to better account for banks non-performing loans. To see whether Chinas banks improved their efficiency after these reforms, we conduct the following tests to test the structural changes.

TABLE 8 Tests for Structural Changes in Model A

Dependent Variable: L Method: GLS (Variance Components) Number of cross-sections used: 268 Total panel (balanced) observations: 1340 Variable R2 R3 R4 FA SIZ TAX S1 S1*Y1 R-squared Coefficient 0.015 0.025 0.046 0.049 0.009 -0.963 0.019 0.032 0.417 Std. Error 0.008 0.009 0.009 0.026 0.001 0.246 0.012 0.010 t-Statistic** 1.966 2.702 4.904 1.916 6.283 -3.923 1.612 3.106 Prob. 0.050 0.007 0.000 0.056 0.000 0.000 0.107 0.002 1.686

Durbin-Watson stat

** Critical value at 5% significance level is 1.96

31

In Model A, we add in a new term S1*Y1, where Y1 is a dummy variable equal to 1 if t=1998-1999 or zero otherwise. The results in TABLE 8 show that the coefficient of S1*Y1 is 0.032 and statistically significant, which implies that lending bias became more severe for the period 1998-1999.

TABLE 9 Tests for Structural Changes in Model B

Dependent Variable: IK Method: GLS (Variance Components) Number of cross-sections used: 268 Total panel (balanced) observations: 1072 Variable Q(-1) R1*CFK R1*CFK*Y1 R2*CFK R2*CFK*Y1 R3*CFK R3*CFK*Y1 R4*CFK R4*CFK*Y1 CFK?(-1) SK SK(-1) R-squared Coefficient -0.009 0.424 -0.075 0.953 -0.186 1.165 -0.769 0.089 0.117 0.072 0.001 0.003 Std. Error t-Statistic** 0.003 0.072 0.063 0.108 0.132 0.163 0.264 0.123 0.140 0.042 0.009 0.010 -3.658 5.912 -1.185 8.797 -1.409 7.166 -2.908 0.724 0.838 1.724 0.055 0.326 Prob. 0.000 0.000 0.236 0.000 0.159 0.000 0.004 0.470 0.402 0.085 0.956 0.745 2.163

0.098 Durbin-Watson stat

** Critical value at 5% significance level is 1.96

For Model B, we add in four terms, Ri*CFK*Y1 for i =1 to 4, to account for changes after 1998. As shown in TABLE 9, (1) the coefficients of R1*CFK*Y1 and R2*CFK*Y1 are negative but insignificant; (2) the coefficient of R3*CFK*Y1 is 32

negative, largest in magnitude, and significant; and (3) the coefficient of R4*CFK*Y1 is positive but insignificant. These results suggest that, in the period of 1998-99, the banks significantly relaxed credit rationing to the R3 firms (the worse-than-average-risk firms) while they failed to effectively tighten their credit lines to the worst-risk firms. It is worth noting that during the period 1998-1999, PBC, Chinas central bank, conducted an expansionary monetary policy by lowering prime interest and reducing banks reserve requirement rate from 13% to 8% (PBC, 2000). An overall relaxation of credit lines in the banking sector should be expected. The expansionary monetary policy, however, could explain neither an increased lending bias in favor of SOEs nor a biased relaxation of credit lines to the worse-than-average-risk firms.

5. CONCLUDING REMARKS In this study, based on a panel data of public listing companies, we attempt to observe a consistent type of lending behavior in Chinas banking sector throughout the sample period. Our empirical results support H1 (Bank lending is biased towards SOEs, other things being equal) but reject H2 (The banks do not ration credit to firms according to the latters risk ranking). Due to data constraint and limited time span, readers should be aware of the tentativeness of our findings. As regards H1, our findings confirm that the Chinese banks have a systematic lending bias in favor of SOEs. Our exercise also reveals that SOEs in general have smaller investment sensitivity to cash flow, indicating that SOEs are subject to less stringent credit rationing and thus enjoy greater access to new credit. Despite the fact that most public listing non-SOEs were transformed from former SOEs, the impact of

33

difference in state share ratios on firms borrowing ratios is robust in our results. It exactly testifies that bank lending bias is unfavorable even to those SOEs-transformed firms, which currently have smaller shares of state ownership. The implicit government guarantee for SOEs borrowings and excessive insider control provide two candidates for the explanation of lending bias phenomenon. It is highly plausible that the banks lend more money to SOEs in order to extract the benefits offered by implicit government guarantee. It seems also plausible that insider-controlled bank managers can gain by receiving kickbacks or other benefits from insider-controlled SOE-borrowers. The second explanation, however, does not consist well with our test results from Model B. Our analysis finds no compelling evidence supportive of H2, the hypothesis that there is no credit rationing in China. Our results show that the investment sensitivity to cash flows for the moderate-risk firms is substantially higher than that of the best-risk firms, although the investment sensitivity for the R4 firms is much smaller than that for the R1 firms, the R2 firms or the R3 firms. These findings suggest that the banks are very unlikely to restrict credits to the best-risk firms, but do impose a credit constraints upon the moderate-risk firms. However, we are not sure whether the banks ration loans to the worst-risk firms. All we can say is that worst-risk firms do not appear to be subject to effective credit rationing. The existence of credit rationing to the moderate-risk firms not only rejects H2 but also suggests that insider-control problem may not be the main cause of nonperforming loans. If it were, the moderate-risk firms would have done better, if not

34

equally good, to use under-the-table payment to bypass the banks credit rationing than the worst-risk firms. The only plausible explanation for the coexistence of lending bias and credit rationing on moderate-risk firms lies in banks expectation for implicit government guarantees for SOE loans. With such expectations, the banks are willing to provide liquidity to keep afloat the firms in financial distress despite that the latters cash flow is already trickling to zero or even has become negative. By keeping these firms from going bankrupt, the banks can avoid a straightforward default of the debts owed by these firms, holding on to the hope for a government-sponsored bailout or takeover. That is why the banks are reluctant to tighten or cut off credit lines to the worst-risk firms even t ough h they are rationing credits to best-to-moderate-risk firms. The practice is the main reason behind the extraordinary-low investment sensitivity to cash flow for the worst-risk firms. Slack credit lines to the worst-risk firms are a major source of non-performing loans and banking inefficiency in China. In an efficient market, assistance to financially troubled firms can only be arranged through a mutually beneficial agreement between the bank and the borrowing firm in the event of default. The pre-condition for such arrangement is adequate legal protection for creditors, which China still lacks. Without such protection, the banks should have resorted to credit-cutoff as a deterrence to the worst-risk firms irresponsible borrowing. Stiglitz and Weis (1983) argue that an effective threat of denying credit might have important incentive effects on borrowers behavior, causing the borrowers to take less risky projects. Such a sub-optimal scenario, unfortunately, did not emerge in China during the late 1990s, according to our results. Contrarily, the moral-hazard type of lending was

35

aggravated during 1998-99 when the Chinese government took over huge amount of bad loans from the major state banks through its four state-sponsored asset management companies. As shown in our tests for structural changes, the aggravated moral hazard overwhelmed the efforts to improve banking management, resulting in more severe lending bias, slacker credit rationing to the worse-than-average-risk firms and continuous credit liquidity to keep afloat the firms in deep financial distress. This moral hazard in banking business could contribute to a vicious credit cycle between the lenders and the borrowers. Continuous liquidity to the worst-risk firms makes the banks threat of credit cut-off incredible. Given the signal, the troubled borrowers may take advantage of information asymmetry to act against the interest of the bank by keeping risky projects with low or even negative present values or high probability of failures (Myers, 1976). Expecting a soft and non-binding credit rationing in the worst case, other borrowers would take riskier projects than they would if the threat of credit cut-off were effective. In the end, the whole economy would be unduly risktaking. The benefits of successful ventures would go to the managers and the stockholders. The costs of failed ventures are to be born by the banks, eventually by the taxpayers if the government takes over the bad loans. With non-performing loan ratio in Chinas banking sector standing as high as 25%, just removing the bad debt from the banks account is not enough. The good news from our study is that Chinese banks are practicing credit rationing to some extent. The bad news is that the lending bias got worse and credit rationing did not improve in the period 1998-99. Although, in time of transition, there could be good reasons for the government to take over bad loans to give banking business a fresh start, such

36

interventions must follow carefully specified legal procedures and must not cultivate expectations by the lenders and borrowers for implicit government guarantees for future loans. Firm government commitments to enforce hard budget constraints on both SOEs and state banks are badly needed to prevent the formation of a new vicious cycle of nonperforming loan accumulation.

37

APPENDIX: CORRECTION OF AUTOCORRELATION AND HETEROSCEDASTICITY

To remove autocorrelation, we apply the partial differencing procedure to transform Model A into the following equation: Lit Li ,t 1 = (1 )0 + ( X it X i ,t 1 ) + (1 )1i + (vit vi ,t 1 ) (A1)

where is the first-order autocorrelation coefficient of the least square residuals and Xit denotes the vector of independent variables for ith cross-sectional unit at period t. To get a consistent estimator of , we regress (Lit L i ) on ( Li ,t 1 L i , 1 ) and ( X i ,t 1 X i , 1 ) , where L i = (1 / T )t =1 Lit , L i , 1 = (1 / T 1) t = 2 Li ,t 1 and X i , 1 = (1 / T 1) t = 2 X i ,t 1 . The
T T T

coefficient of ( Li ,t 1 L i , 1 ) is treated as the estimated value of , which is 0.48 for our sample. Let PLit = Lit Li ,t 1 , PX it = X it X i ,t 1 , u i = (1 )1i and it = vit vi ,t 1 , then the equation (A1) can be rewritten as: PLit = (1 )0 + * PX it + u i + it (A2)

We apply the partial derivation procedure (See Greene, 2000) to remove heteroscedasticity. Equation (A2) is transformed into: PPLit = (1 i )(1 )0 + * PPX it + (1 i )u i + (it i i )

(A3)

38

where i = 1

2 Tui + 2

2 PPLit = PLit i PLit , PPX it = PX it i PX it , ui is an

estimator for the variance of ui in equation (A2), and 2 is an estimator for the variance of it in equation (A2).

39

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