Due to the limitation, here is the 2nd part of the post



The role of interest rates
The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low. The PBoC actually has been explicit about this policy. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. This slows the growth of NPLs by passing on part of the cost to someone else. Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised. Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds). Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers. But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did. The PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost). The second of the three sets of policy tools, and the only very explicit one, involved infusing the banks with additional equity. Part of this occurred directly with the sale of bank equity to government institutions, and part of this capital infusion occurred indirectly by creating AMCs to purchase bad loans at well above their liquidation value. In both cases the capital infusion was financed by government borrowing, which at artificially low rates, to repeat what I said above, has the effect of passing the repayment burden onto lenders. Since most of these bonds were held by banks, once again the cost of the capital infusion was passed on through the banks to depositors. (As an aside, because equity infusions were so explicit, and because the banks are no longer fully owned by the government and are even partly owned by foreigners, I suspect future recourse to this particular form of recapitalization may be limited.) Finally and most importantly, the third way of cleaning up the banking crisis involved the central bank mandating a wide spread – probably around 1.5 to 2.5 percentage points more than the normal spread – between the bank lending and the deposit rate, which increased bank profitability substantially and so helped to recapitalize the banks. In other words not only were depositors “taxed” for the clean-up by having to fund the very low lending rates, but they were taxed a second time to guarantee sufficient bank profitability to rebuild capital. With all these transfers from the household sector to the banks, amounting to several percentage points of GDP every year, households were forced to clean up the Chinese banking system. Beijing’s strategy to clean up the banks was very successful, and certainly prevented the banking crisis that many expected, but there was nonetheless a significant cost to the economy. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points .