The best way to dispose of renewed non-performing loans is not to issue funds time and time again to defaulting institutions but to prevent new cases from re-emerging.

The central bank can renew loans to commercial banks, credit co-operatives and other financial institutions.

The People's Bank of China (PBOC), China's central bank, is to set up an asset management company (AMC) later this month to handle non-performing loans.

Huida Asset Management Ltd Co will be the country's fifth State-run AMC.

The central bank has been renewing loans since the early 1980s. Its re-lending had functioned as a tool both for macroeconomic control and social stability until 1998, when its main function became maintaining financial stability.

Issuing loans to help financial institutions facing strains on capital flow out of trouble is a common responsibility central banks must shoulder.

The PBOC's re-lending to financial institutions amounted to 1,875.5 billion yuan (US$231.3 billion) by the end of May, of which a significant amount is believed to be non-performing.

Perhaps it is because of this mounting pressure from a large volume of non-performing loans that PBOC initiated the idea of setting up Huida AMC.

The establishment of the AMC is expected to play a role in financial reform, considering the circumstances in which it has been established and its unique goal.

Huida's debut will have an immediate impact on the four existing AMCs Xinda, Huarong, Great Wall and Dongfang.

When these companies were founded in 1999, PBOC lent them 550 billion yuan (US$68 billion). Their combined registered capital is 40 billion yuan (US$4.94 billion).

Huida, the entity entrusted with managing the funds PBOC lent to the four AMCs, will be able to intervene in their corporate affairs.

Similarly, because PBOC has also lent money to other financial institutions, it is possible Huida will have some level of input into their operations.

If so, Huida will become a sort of covert regulator. Whether Huida will be able to operate effectively and retrieve PBOC's non-performing renewed loans is open to debate.

Unlike commercial banks, which lend to enterprises, the central bank mainly lends to commercial banks and other financial institutions.

So how will Huida dispose of non-performing loans? One option is to follow the model adopted by the other AMCs - the loan-for-share scheme under which defaulting financial institutions' debt to Huida will be transformed into its shares in the institutions concerned.

In that case the number of State shares in financial institutions would increase - a course that goes against proposed market reforms.

The second strategy that could be pursued is auctioning defaulting financial institutions' assets. But the outlook for this option is gloomy.

In recent years an increasing amount of PBOC's renewed loans had been directed towards rescuing problematic financial institutions at critical junctures.

The assets of the current AMCs themselves are non-performing assets transferred to them by the country's big four State-owned commercial banks, indicating that not much capital could be recovered even if they were to be auctioned off.

In addition, many recipients of PBOC funds do not consider borrowed money to be a loan, but rather a kind of subsidy. From the very beginning they are not serious about repayment.

Disposing of non-performing loans will be made even harder if new cases emerge because of continued lending.

In a way central bank loans are public funds, meaning the repeated emergence of non-performing loans is inevitable.

Therefore the central bank should be prudent when issuing loans to minimize the impact of an unknown number of non-performing loans.

The central bank should think twice before issuing emergency loan packages to rescue floundering financial institutions.

It should seek to implement a stronger financial stability mechanism under which beneficiaries not only enjoy the loaned capital but also shoulder some of the risk.

Setting up a deposit insurance system is the first step. Under such a system deposit insurance collected from commercial banks would be used to provide insurance cover for depositors at troubled commercial banks. Such a system is also conducive to introducing a market-oriented bankruptcy settlement mechanism for insolvent commercial banks.

Next, a joint stability fund for securities firms should be launched. If a securities company found itself in temporary difficulties the joint fund would bail it out.

There would be no need for the central bank to extend loans to such a firm, when doing so would increase the chances of creating yet another non-performing loan case.

Similar funds should be set up for trust investment companies.