have been injecting foreign reserves into the largest state-owned banks in order to boost their capital reserves and balance sheets so that they can become publicly listed companies. USing official data on NPLs, we conclude that it is feasible for the government to assume a large fraction of the existing NPLS, provided that current economic growth rates(and hence the governments tax receipts)can be sustained. However, since the official data may significantly underestimate the amount of NPLs, we view the reform of state-owned banks and the improvement of the banking sector as the ultimate solution to npls Our second conclusion concerns China's financial markets. Two domestic stock exchanges the Shanghai Stock Exchange(ShSE hereafter)and Shenzhen Stock Exchange (SZSE hereafter) were established in 1990, and have been growing very fast since then. However, their scale and importance are not comparable to the banking sector for the entire economy. Moreover, the financial markets have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. Going forward, financial markets are likely to play an increasingly important role in the economy, and the further development of the financial markets is the most important long-term objective for China's financial system. We propose several measures that can increase the size and scope and help to improve the efficiency of the markets More specifically, the regulatory environment should be improved; in particular, corporate and trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth, domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed Third, in a companion paper(Allen, Qian, and Qian, 2005), we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or stock market, but rather a sector of alternative financing channels, such as internal financing and trade credits, and coalitions of various forms among firms, investors, and local overnments. Many of these financing channels rely on alternative governance mechanisms, such competition in product and input markets, and trust, reputation, and relationships. Together these methods of financing and governance have supported the growth of a"Hybrid Sector"of non-state,3 have been injecting foreign reserves into the largest state-owned banks in order to boost their capital reserves and balance sheets so that they can become publicly listed companies. Using official data on NPLs, we conclude that it is feasible for the government to assume a large fraction of the existing NPLs, provided that current economic growth rates (and hence the government’s tax receipts) can be sustained. However, since the official data may significantly underestimate the amount of NPLs, we view the reform of state-owned banks and the improvement of the banking sector as the ultimate solution to NPLs. Our second conclusion concerns China’s financial markets. Two domestic stock exchanges, the Shanghai Stock Exchange (SHSE hereafter) and Shenzhen Stock Exchange (SZSE hereafter), were established in 1990, and have been growing very fast since then. However, their scale and importance are not comparable to the banking sector for the entire economy. Moreover, the financial markets have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. Going forward, financial markets are likely to play an increasingly important role in the economy, and the further development of the financial markets is the most important long-term objective for China’s financial system. We propose several measures that can increase the size and scope and help to improve the efficiency of the markets. More specifically, the regulatory environment should be improved; in particular, corporate and trading laws and legal protection of investors, as well as institutions governing the enforcement of contracts should be further developed. Second, the large blocks of shares held by various government entities in listed companies (including state-owned banks) should be reduced by announcing and carrying out a plan to sell them off slowly over time. Third, more professionals such as accountants, investment bankers, and (business) lawyers, should be trained. Fourth, domestic financial intermediaries that act as institutional investors should be encouraged, as they will play a critical role in improving the efficiency of the markets and strengthening the corporate governance of listed firms. Finally, new financial products and markets should be developed. Third, in a companion paper (Allen, Qian, and Qian, 2005), we find that the most successful part of the financial system, in terms of supporting the growth of the overall economy, is not the banking sector or stock market, but rather a sector of alternative financing channels, such as internal financing and trade credits, and coalitions of various forms among firms, investors, and local governments. Many of these financing channels rely on alternative governance mechanisms, such as competition in product and input markets, and trust, reputation, and relationships. Together these methods of financing and governance have supported the growth of a “Hybrid Sector” of non-state