I recently gave a talk to a group of sophisticated business practitioners and students from China and asked how many of them were aware their own four major banks were fully bankrupt in 2003. Out of the approximately 60 people in the audience, only one raised her hand explaining she was aware of the problem from a relative who was in a management position at one of the big four. My guess is that to date most Chinese still do not understand the precarious position China's financial system found itself in 1998-2003.

What is more remarkable is that banks are the most significant way that Chinese hold their wealth, representing 60 to 70 percent of how their savings are channeled in the formal sector of the economy. The free dissemination of information (or its absence) and the role it plays in financial crises is just one of many striking differences and similarities between the Chinese situation then and the U.S. situation now.

HOUSING WOES: A woman walks past Fannie Mae headquarters in Washington, D.C. on September 8, 2008. The day before, the U.S. Government announced a decision to place mortgage giants Fannie Mae and Freddie Mac into conservatorship (XINHUA)

Unsurprisingly, what triggered both crises was a huge pool of loans to borrowers who could not pay, spurred on in part by government policy directives. In China's case, the major banks were directed to lend to the industrial sector and to large-scale state-owned enterprises, many in the northeast, which ultimately became part of a vast rust belt.

Between 1998 and 2003, outstanding loans of the Chinese banking system nearly doubled from $1.2 trillion to $2.3 trillion. Loans fueled by massive savings in turn generated massive increases in employment in companies destined for bankruptcy. Even more loans were then needed to keep those companies temporarily afloat, thereby deferring huge job losses. For the United States, the idea of using the financial system to achieve a policy goal of home ownership (the two government-sponsored enterprises Fannie Mae and Freddie Mac serve as prime examples) similarly created a vast pool of loans and jobs in housing construction, which ultimately proved unsustainable. Excessively easy credit for home purchases was supercharged via the process of securitization and now the U.S. Government finds itself in a similarly difficult position of making even more loans and running ever larger budget deficits to prevent collateral damage.

One major difference was in China the lending was done by banks and bankers with little or no experience of banking and risk management (a new financial system was just being created); in the U.S. case, lenders should have known better.

Estimates for the fiscal costs alone (ignoring the significant impact on real GDP in the United States) of the banking crisis in China are around $500 billion and for the United States may end up being at least $2 trillion. On a GDP basis, the pain looks much more severe for China (42 percent of contemporaneous GDP) compared to the United States (14 percent). But when using the share of national savings as our yardstick, the costs of the crises look remarkably similar. The obvious difference is the incredibly high savings rates in China as compared to the United States. While the weight of the economic cost may have been greater for China, the time required to rebuild wealth is approximately the same in both economies.

Unlike the United States, there was never any real political discussion in China on the merits of bailouts or whether the fiscal cost was worth the effort.The Chinese Government and the People's Bank of China decided simply to buy the bad assets from the banking system and replace the bad assets at face value with government obligations. The government already owned the banks, so the notion of nationalization or impacting the liability/equity side of the banks' balance sheets was never an issue. That and the fact that citizens/depositors never fully understood the cost of the crisis, allowed for relatively swift action. Those bad assets were moved to four asset management companies (similar to the Resolution Trust Corporation in the savings and loan crisis in the United States in the 1980s), which became equity holders in the failed companies. Sale and rehabilitation of those assets has been slow but at least orderly. Some of the assets have turned into remarkably profitable entities and others complete losses. The Chinese Government came to realize that with time some companies would be able to accumulate profits, build up equity and be viable in the long run. The nation's rapid economic growth and high savings rate allowed the government to buy time.

In the aftermath of the crisis in China, putting the financial system and especially the banks on a firm footing became a top priority. Policy loans no longer were part of the banks' mandate and the focus moved to normal commercial, real estate and consumer loans. Investments from foreign financial institutions in the major banks were welcomed and upgrading the skill set of bankers moved forward with urgency.

But in the end, citizens/depositors bore most of the costs of the crisis. Interest rates on deposits remained regulated at below market rates while rates on loans were deregulated providing a substantial cushion of profits to the banks. In the United States, the process of bank consolidation will likely also have some positive impact on profits and corresponding cost to consumers. Much of the focus now is on expanding regulations, but the United States also ought to look at how to restore the culture of risk management and institutional reform as longer-term solutions.

Confidence matters

China has been extremely cautious in allowing any type of financial innovation (even for something as simple as a forward contract for foreign exchange) before making sure a regulatory framework has been put in place. Before such innovations are permitted to occur nationally in China, they are typically experimented with in a few cities and then refined based on the experience. It would appear in recent years that the United States financial system forgot its own lessons dating back to the time of Alexander Hamilton where institutional and legal developments went hand-in-hand with financial innovation. If China has too few financial instruments as a result of its very conservative approach, the United States probably has too many or at least too many that are outside the common sense boundaries of intelligibility and regulation.

Taking the comparison of the two countries' experience in financial crises to a more macro level, we see that savings are a double-edged sword. Too great an amount of savings, as in the case of China, can allow for a lot of bad investment decisions to be swept under the rug without notice but can also hasten the process of recovery for even a country that is still relatively poor. For a rich country such as the United States, too few savings invite in large foreign savings--the counterpart to borrowing--to pay for current account deficits. Being rich allows for borrowing from the rest of the world even when those foreign-sourced savings are not put to good use.

Perhaps the broadest lesson to be learned in thinking about the two nations' crises relates to the role for government and public confidence. Both countries have acted swiftly and decisively to deal with the problem--the Europeans and Japanese may serve as good counterexamples. Even the small number of Chinese who actually understood their financial system was in crisis had no doubt that the government would protect at least the principal they held in banks. There was no formal system of deposit insurance in China at the time, but given the role of confidence and absence of transparency there were no bank runs in China. Since non-disclosure is clearly not a desirable path for the United States (although there are those who have called for the abandonment of mark-to-market accounting), the United States must rely more heavily on confidence. Citizens need to be reassured policies will be undertaken promoting not just stability in the short term but sufficient savings and investment over the long run to restore what has been lost. China achieved its highest growth rates in the years following its crisis. Sound government policies can make a huge difference.