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Without a cash flow impact the reserve could be used

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Unformatted text preview: tio increased to 1%22 . However the reserves are inadequate compared to the magnitude of NPLs of major banks. Without a cash flow impact, the reserve could be used to write off NPLs gradually and thus smooth the bottom line of the bank and avoid the accumulation of NPLs in the balance sheet. Nicholas R. Lardy, China's Unfinished Economic Revolution, 1998, p.97, Brooking Institution Press, Washington D.C. 22 The reserve, however, would make the bank look less profitable. The reluctance to impose a higher NPL reserve provision was a result of the tax concern. The SOBs, paying income tax at 33% and business tax at 6% and other taxes such as real estate tax and stamp duty, have been one of the major contributors to the country's fiscal revenue. The Ministry of Finance is concerned that a lenient NPL reserve provision could possibly be used by the banks as an accounting mechanism to pay less taxes, resulting in the reduction of fiscal revenue. However, if the SOBs had set up the NPL reserve earlier, the NPL magnitude would not have been so significant today. Even though making reserve is only an accounting issue, it helps to explain the a large amount of NPLs in the balance sheets of SOBs. Fundamental Issue - Irrational Allocation of Resources The fundamental issue of China's NPL problem is the irrational allocation of resources in the economy. The government has kept pouring capital into these loss-making SOEs because they have been regarded as "the political, economic and social pillars" of China. China's "sot market economy" is a compromise between the communist ideology and the economic reality. Without the existence of SOEs, China's economy would be dominated by collective and private enterprises. From the political standpoint, SOEs are still one of the corner stones of the communist ruling in China. SOEs also take the lion's share in key industrial sectors. Even though the slow growth of SOEs led to a reduction in their share of industrial output from 80% in 1978 to 28% in 1996, the decline is more in the service sector than in the manufacturing. In construction, for example, SOEs by value in 1995 continued to account for more than 60% of all building projects in urban areas; Telecommunications and long-distance transportation remain almost entirely within the domain of state ownership23 . Meanwhile, SOEs are also key to maintain social stability in China. Chinese people always say "Qiye ban shehui", meaning that each SOE hosts a small society. As the major sources of employment, SOEs had always been the major social welfare provider for the large number of urban residents until the initiation of SOEs reform several years ago. SOEs' political, economical and social importance forced the government to provide the with constant and enormous financial support. The protectionist behavior eventually resulted in a misallocation of the resources and put the Chinese banking system in danger. Potential Impact Why should any increase in NPLs be a matter of concern? First, banks are involved in the money...
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