The five-year transition period for China will, not long from now, come to an end following its ascendancy to World Trade Organization (WTO) membership in 2001.

Within two years, China is expected to allow foreign banks into renminbi businesses. The potential shock to domestic financial institutes is worth analyzing.

The real threat to China's banking system is that State-owned commercial banks would have no other means to "dilute" their bad assets once the foreign banks attract deposits. A possible aftermath of such a situation would be a financial crisis.

Given the astonishing speed of bad assets accumulation in State-owned commercial banks, the central government made two major moves to ease this gigantic pressure in 1998.

The State issued special treasury bonds, which totalled at 270 billion yuan (US$32.53 billion), to increase the capital of State-owned commercial banks.

And the government also established four financial assets management corporations to dispose of the bad assets of State-owned commercial banks worth of 1.4 trillion yuan (US$168.67 billion).

However, since the four State-owned commercial banks have not seen any substantial changes in management, their bad assets have continued to grow at a fast pace.

By the end of 2000, the average ratio of non-performing loans in the four State-owned commercial banks rose to 33.37 per cent.

Even after the central government sent special teams to work with the banks in trying to lower the ratio, the number was still as high as 20.36 per cent by the end of 2003.

Such a decrease does not have an affect because many other factors have contributed to it.

The non-performing loans rate was lowered after a steep rise in total loans, which does not necessarily mean an improved return.

A large percentage in the newly added bank loans are long-term, many of which would involve uncertainty against the overall backdrop of blind investment and economic overheating.

But more importantly, the mechanism producing the "financial black hole" - non-performing loans - is still in position.

Its existence is verified in the recent series of financial scandals at China Southern Securities Corporation, Minfa Stock Corporation and Foshan Industrial and Commercial Bank.

In the later half of 2003, many researchers pointed out that China's low-efficiency method of economic growth is maintained by the foreign exchange regulation and the monopoly of State-owned commercial banks.

If the two conditions are no longer in position, the loopholes in the financial system would be exposed.

Therefore, if a financial system is to fit well, a modern market economy must be established before the country fully opens the renminbi business in 2006 to foreign banks.

The financial reforms should be focused on two aspects: speeding up the restructuring of State-owned commercial banks and establishing new private banks.

The Bank of China and the China Construction Bank received US$45 billion cash from the government to prepare for going public. This is the first part of the State's efforts to restructure the State-owned commercial banks.

The key to the success of such restructuring is to establish an efficient company governance system. But the current restructuring is primarily led by managers instead of owners, which will probably fail to realize the key conditions.

Apart from these State-owned commercial banks, there are 11 State-holding banks and numerous city banks and rural credit co-operatives. These financial institutes should also be restructured to become well-regulated commercial banks.

On the other hand, the private banks should also be developed.

The experiences of the reform in the former Soviet Union and other countries indicate that purely focusing on restructuring the State-owned enterprises is not a good strategy.

The secret of China's success in reform and opening-up is that it put the priority on fostering the private economy.

Similarly, the reform in the financial field should also encourage the development of private banks. Before the foreign banks are fully allowed into all financial businesses, private banks should have a foothold in the market.

As a result, the authorities should take an active stance to promote setting up private banks.

Yet the fact is, the authorities are reluctant to support private banks for fear they would be too small to withstand the risks in competition and crisis or too easily manipulated by someone bent on devouring the capital.

As a matter of fact, these possible scandal scenarios can be prevented by well-designed arrangements.

Of course, the financial reform should also include reforming the securities market.

Substantial measures must be taken to make the stock market a real source of financing for the businesses.

The listed companies must improve their company governance so as to lay a solid base for further development of the stock market.

The authorities should take prudent policies to avoid dramatic fluctuations of the stock market and enhance the supervision to the market dealers and the listed companies.

The legislature should also draft and perfect necessary laws and regulations about securities and relative issues.

The most important element in financial reform is to improve the financial supervision because this is a market where the information can never be fully disclosed. And the financial risks could be spread quickly without any reason.

Therefore, a strict supervision on every link of financial operation should be put into effect.

Such supervision should first of all be embodied in a complete set of basic rules in the financial market, like the regulations about market order, corporate governance and credit checking.

Watchdogs in different financial sectors should co-ordinate with each other to create a network to monitor all financial activities.

Financial supervision should not intervene into the operation of the financial institutes. Otherwise, it would be against the trend of deregulation and probably harm the market.