loans unless they receive help from the national ernment financing vehicles that fund much of the government or forbearance by lenders. This is a nations infrastructure investment. Many observ large-scale problem, with some analysts seeing it ers believe that banks and trusts implicitly back as substantially higher than the government and the loans they make that are packaged into wealth the banks currently admit. But even the more pes- management products. Even deposits operate simistic estimates remain in a range where a res- with an implicit guarantee and not an explicit one cue by the national government would be feasible without seriously compromising the strength of The widespread use of implicit support represents Chinas sovereign debt. a serious risk to the Chinese financial system, because of the large volume of these contingent There are also concerns about loans to industries obligations and because their informal nature with over-capacity, such as shipbuilding and solar can easily lead to misunderstandings. Should a energy, and to small and medium-size enterprises financial crisis begin somewhere in the nations that are squeezed by the weaker export environ- complex financial system, contagion could spread ment through a sudden loss of confidence in these im plicit guarantees Another key debate is the degree to which China will experience a real estate crisis and the resul- Overall, we tend towards guarded optimism or tant effects that would have on the banking sys- the points in debate, while conceding that the tem. The central government has concluded that level of uncertainty about the current and future real estate bubbles have built up in at least some workings of the financial system make it impos sectors and geographic areas, and is taking explic- sible to be sure that the problems that inevitably it action to restrain real estate speculation. Pessi- arise will be worked through effectively. However, mists fear that the problems are more extensive China has earned the right to a presumption that than admitted and that it will be impossible to it will continue to find the way through its growth successfully balance the twin goals of restraining challenges, although both the Chinese leadership estate prices, with attendant huge damage to the things actually develop and not become comp bubble behavior while avoiding a crash of real and outside observers need to watch carefully how lenders and the economy. Optimists see the prob- cent as a result of past successes lems as both smaller and more capable of being managed by the leadership. In order to assist the reader in navigating the complexities of China's opaque financial system, The real estate debate ties into a parallel debate on the remainder of this paper is organized as a se bad loans, since many of the loans to local govern- ries of questions and answers. This is intended to ments and their affiliated parties are based either provide a coherent conceptual framework while on real estate as collateral or on the ability of the allowing the reader to easily jump from topic to governments to sell land in order to maintain an topic, depending on interest. Please note that we adequate flow of revenues attempt to show what is not known, as well as to lay out the facts and circumstances as we knor There is an analytical debate in China on the level them. Given the degree of opacity and uncertain of implicit support given to various financial ob- ty pervading this complex subject, it is important ligations by governments or financial institutions. not to be lulled by a false sense of certainty, but Implicit government support of state-owned en- instead to remain aware of what is unknown terprises is a major factor allowing them to bor- w so much at such a low cost. A similar logic, The questions that will be addressed are listed be with somewhat more risk, applies to the local gov-low The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGSThe Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 6 loans unless they receive help from the national government or forbearance by lenders. This is a large-scale problem, with some analysts seeing it as substantially higher than the government and the banks currently admit. But even the more pes￾simistic estimates remain in a range where a res￾cue by the national government would be feasible without seriously compromising the strength of China’s sovereign debt. There are also concerns about loans to industries with over-capacity, such as shipbuilding and solar energy, and to small and medium-size enterprises that are squeezed by the weaker export environ￾ment. Another key debate is the degree to which China will experience a real estate crisis and the resul￾tant effects that would have on the banking sys￾tem. The central government has concluded that real estate bubbles have built up in at least some sectors and geographic areas, and is taking explic￾it action to restrain real estate speculation. Pessi￾mists fear that the problems are more extensive than admitted and that it will be impossible to successfully balance the twin goals of restraining bubble behavior while avoiding a crash of real estate prices, with attendant huge damage to the lenders and the economy. Optimists see the prob￾lems as both smaller and more capable of being managed by the leadership. The real estate debate ties into a parallel debate on bad loans, since many of the loans to local govern￾ments and their affiliated parties are based either on real estate as collateral or on the ability of the governments to sell land in order to maintain an adequate flow of revenues. There is an analytical debate in China on the level of implicit support given to various financial ob￾ligations by governments or financial institutions. Implicit government support of state-owned en￾terprises is a major factor allowing them to bor￾row so much at such a low cost. A similar logic, with somewhat more risk, applies to the local gov￾ernment financing vehicles that fund much of the nation’s infrastructure investment. Many observ￾ers believe that banks and trusts implicitly back the loans they make that are packaged into wealth management products. Even deposits operate with an implicit guarantee and not an explicit one. The widespread use of implicit support represents a serious risk to the Chinese financial system, because of the large volume of these contingent obligations and because their informal nature can easily lead to misunderstandings. Should a financial crisis begin somewhere in the nation’s complex financial system, contagion could spread through a sudden loss of confidence in these im￾plicit guarantees. Overall, we tend towards guarded optimism on the points in debate, while conceding that the level of uncertainty about the current and future workings of the financial system make it impos￾sible to be sure that the problems that inevitably arise will be worked through effectively. However, China has earned the right to a presumption that it will continue to find the way through its growth challenges, although both the Chinese leadership and outside observers need to watch carefully how things actually develop and not become compla￾cent as a result of past successes. In order to assist the reader in navigating the complexities of China’s opaque financial system, the remainder of this paper is organized as a se￾ries of questions and answers. This is intended to provide a coherent conceptual framework while allowing the reader to easily jump from topic to topic, depending on interest. Please note that we attempt to show what is not known, as well as to lay out the facts and circumstances as we know them. Given the degree of opacity and uncertain￾ty pervading this complex subject, it is important not to be lulled by a false sense of certainty, but instead to remain aware of what is unknown. The questions that will be addressed are listed be￾low: