The moves could cause bankruptcies for hundreds of Chinese firms and major losses for Western investors.

China began its move this week by allowing one of its biggest vehicles for foreign investment, the Guangdong International Trust and Investment Company (Gitic), to go bankrupt with debts of over $4bn.

It has also published new regulations for reigning in China's freewheeling stock markets, which have caused them to plummet.

Now the government says that more bankruptcies are likely, and many of China's banks may already by insolvent. An official Chinese newspaper warned on Friday:

"Beneath calm waters, mounting financial bad debts have been piling up. Some financial institutions have been dragged in the mire and cannot extricate themselves."

Response to the Asian crisis

Behind the crackdown is China's response to the Asian crisis. The country has so far avoided any currency devaluation, and its economy grew by some 7.8% in 1998, spurred by public investment.

But growth is likely to be much slower this year, as export growth has slowed to a halt. Meanwhile, many companies involved in foreign investment have got into trouble by speculating on property and shares in Hong Kong. China is determined to take action before the growing debts of these banks and investment houses bring about a foreign currency crisis and loss of confidence.

But it will be treading a difficult line in trying to reign in the freewheeling foreign investment sector without drying up the flow of funds that has made China the favourite location for foreign investment in Asia.

No bail-out

Many Chinese banks are vulnerable

China's foreign ministry Thursday justified the closure of insolvent financial institutions as a necessary step to ward off financial risk.

Asked about the handling of Gitic's bankruptcy, spokesman Sun Yuxi said China had protected the interests of both local and foreign investors.

He said the move "has demonstrated the strong determination of the Chinese government to, on its own initiative, settle and ward off financial risks."

"At the same time, it has protected the interests and rights of investors both in China and abroad and it has also played a positive role in enhancing the supervision role of the financial situation in China," he added.

Foreign creditors were disappointed that they were not promised preferential treatment when Gitic was declared insolvent.

Government liquidators announced Gitic's bankruptcy Sunday.

It was the first bankruptcy of a financial institution in communist China since 1949.

The People's Bank of China had ordered Gitic closed in October after it failed to meet its loan obligations.

Gitic's closure is expected to lead to the rationalisation of some 240 trust and investment companies, most of which, are badly managed and financially troubled although not to the same extent as Gitic.

Market rumours suggest that two other investment trusts, Guangzhou, and Fujin, are also in serious trouble.

And the government has admitted that one in five of all state bank loans may be non-performing, mainly those to the inefficent state industries.

Stock market falls

Heavy selling in the China stocks continued this week in Hong Kong following Guangdong Enterprise Ltd's announcement of higher-than-expected group debt.

Brokers said the bankruptcy of Gitic had complicated the planned restructuring of the group and investors were anticipating a tighter credit squeeze for the red chip sector.

"Investor confidence has been totally shattered by the credit tightening problem and that has a big impact on China plays," said one analyst.

A third Guangdong province company has been added to the list of insolvent state-backed firms that has sparked a major alert over the financial health of Chinese enterprises.

The Nam Yue (Group), the provincial government's window company in the Portuguese enclave of Macau, was declared insolvent with debts of $333m against cash reserves of just $250,000.

Amidst increasing investor concern, at a creditors' meeting in Macau on Wednesday, Guangdong governor's assistant Wu Jiesi criticised foreign bankers for failing to adopt prudent lending policies, and said they could expect no more than 50 cents on the dollar.

Strengthening China's credit

The latest developments concerning China's troubled trust companies may have give investors pause, but sorting out the financial sector could bring long-term benefits.

Foreign banks' interest in lending to Chinese companies already was waning in the wake of Gitic's closure and bankers said the settlement announced on Sunday had dealt a further blow to confidence.

"I was talking to an investor yesterday, and he said (the failures) has put him off China completely...and that he is not going to buy any China risk at all going forward," said a Hong Kong banker.

But for all the unhappiness it has brought to foreign lenders, the debacle has not fundamentally changed the creditworthiness of China, whose foreign reserves of $145bn at end of 1998 were sufficient to cover outstanding sovereign debt about 26 times over.

"(China's) ability to pay has not changed as a result of the Gitic saga," said Eden Wong, of Barclays Capital in Hong Kong, who said the tough stance would reduce China's liabilities.

"In the past, the credit rating of the Chinese government has incorporated the risk factor that China would bail out all of its weak financial institutions," said Mr. Wong. "But clearly China is not doing that in the Gitic case, which means these weaker institutions would not affect the government's credit standing."

China plans to raise more money on international financial markets to finance its growing public sector deficit, and may borrow soon in euros.