China could nip the budding problem of dud loans resulting from its 2009 fiscal-stimulus package by securitising assets and allowing them to be sold at distressed levels, says Victor Shih, a political scientist at Northwestern University in Chicago.

A native Hongkonger, Shih has spent the past two years studying the mainland's policy response to the global financial crisis. To finance $4 trillion worth of infrastructure projects, the authorities instructed banks to make loans to hundreds of local investment companies, because the federal and provincial governments aren't supposed to invest directly in such projects.

Shih believes much of this capital has been allocated badly. "If China's infrastructure had been poor prior to 2008, then all this spending would be useful," he says. "But even in western China, the government under former premier Zhu Rongji began building infrastructure in 2000. Now you've got six-lane highways that go unused."

The 2009 stimulus went to projects including 'special technical zones' that involve laying the groundwork to promote technology and other industries, he adds. While this sort of thing has its place, Shih says, there are plenty of cases where smaller, rural cities would have two or three such projects.

"Everyone is trying to build the next Silicon Valley or Route-128," he observes. "This makes sense if you're Beijing or Hangzhou -- but is every mid-sized city in China going to become the next Silicon Valley?"

The same goes for infrastructure projects, argues Shih. While the interior regions still lack infrastructure, he questions the need for massive investments in provinces such as Gansu, when its population is actually declining, as more of its people head for coastal cities.

While Beijing officials are aware there is waste, he says, efforts by the China Banking Regulatory Commission (CBRC) to curb lending are perfunctory, and there has been no ban on additional lending to local investment corporations. Last week, Thomson Reuters reported that Chinese bank loans hit a new high in January, of $203 billion, more than during the entire fourth quarter of 2009.

In fact, banks may be reluctant to slow their lending because, once they do so, there is a risk that their non-performing loan (NPL) levels will rise. To what degree lending to these local investment companies is refinancing existing debt is not clear. "China should accept some of the pain today, otherwise it will only get worse," Shih cautions.

However, the situation can be contained, he says. First, the CBRC must ban any more lending to these local investment companies for new projects. In addition, the central bank, the People's Bank of China (PBoC), may need to assume the liabilities of the poorest counties and their investment arms, despite the impact this could have on the national debt-to-GDP ratio.

Such acts would create a new wave of NPLs, and Shih says the government should allow banks to sell these directly to foreign and domestic investors. Unlike in the late 1990s, when China's banks suffered a severe NPL problem, these banks are now owned by shareholders, rather than the state. This means it should be easier to create a market-based structure for the sale of distressed assets.

To do so implies creating a market for securitising these assets, based on cash flows from infrastructure projects. Shih acknowledges this would involve a major regulatory overhaul, but warns that the alternative is a situation in which healthy investment companies must use their positive returns to subsidise the wasteful.

For global investors, the risk of such subprime asset sales would be mitigated by the attractiveness of holding them in renminbi; as the currency gradually appreciates against the dollar, investors would enjoy the upside.

However, the PBoC forbids the sale of NPLs to foreigners, so banks' only recourse is to keep rolling over loans, which only exacerbates the problem. Shih says this restriction is outdated because private shareholders, including foreigners, now have stakes in these banks. NPLs could therefore be packaged and sold on a strategic basis, assuming shareholders were to approve.

Shih says he has sent his findings to the PBoC. He is scheduled to visit Beijing in March to present his ideas in person and expects a fair hearing. "It's in the interest of the next generation of leaders who take over in 2012 to solve this problem now," says Shih.

He will also be speaking at AsianInvestor's conference on distressed-asset investing on May 3-5 in Hong Kong.