China's hidden banking system is coming out of the shadows as the government seeks to rein in the excessive lending that it fears could spin out of control.
The People's Bank of China, the central bank, let the world know on Monday that it was putting the nation's banks on notice: the loose money and the speculation it fed had to stop. It said banks had to step up risk controls and improve cash management. And they had to do it, the bank said, by avoiding a "stampede" mentality.
The banks had quietly received that very message a week earlier, which set off, if not a rush for the exits, certainly widespread worry in China and financial centers around the world.
It precipitated a cash squeeze among the banks that sent their short-term interest rates sharply higher last week. The crackdown, which appears aimed at reining in banks engaged in complex deals that involve hiding and repackaging risky loans so that regulators cannot notice them, also led to a sharp sell-off in stocks worldwide during the last week. Investors feared it might further slow the Chinese economy.
China, the world's second-largest economy after the United States, has a huge influence on the world economy so the actions of its central bank are closely watched across the globe. But its financial and banking system remains opaque to Chinese and foreigners alike. Within the government's own warnings about lending lies its dilemma: it needs to control where money is being lent at the same time it wants to reform a banking system that has grown dependent on government direction.
"The government knows some banks are doing things that aren't prudent," says Yukon Huang, a senior associate at the Carnegie Endowment for International Peace in Washington. "Some of them are taking easy money and putting it in Ponzi schemes. The government is saying, 'Don't do that any more. And don't count on the government to bail you out.' "
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Li Keqiang, China's prime minister, who took office last March, has promised a more market-oriented approach to managing the economy. And analysts say his economic advisers are pressing to reorganize the economy in a way that will allow it to respond better to market forces.
But to put such reforms in place, the new government is going to have to take on powerful state-run companies and interest groups that sometimes resist pressure from the center or turn to allies in the central leadership who block such moves.
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The government's target is the sharp and potentially dangerous rise in the so-called shadow banking. Banks borrow at the low interbank rate, then lend to trust companies and smaller banks who in turn make riskier loans. The fear among some analysts is that the vast amount of bad debt and hidden liabilities the shadow banking system masks could start sinking banks. Those excesses could start a chain of other economic setbacks.
Most economists say China's financial system is not facing huge systemic risks, and that growth could even come in at 7 percent, which would still make it the world's fastest-growing major economy. But there are mounting concerns here that the good times could be over partly because the banking sector is hiding piles of bad debt.
The Chinese government has the policy tools to deal with a crisis, including huge foreign exchange reserves and the ability to force state banks to lend in a time of crisis. The People's Bank of China is not an independent institution, like many central banks in major economies are; it reports to the central government.
But after years of pumping money into the economy, the central bank can see signs of diminishing returns. Banks lent a huge amount of money in the first half of this year, and yet growth has been tepid. Manufacturing has begun to contract, according to a recent survey, and banks seem desperate for more cash.
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Last Friday, Fitch Ratings said in a report that less money in the market for interbank loans could hamper some banks from making payouts when high-interest financial instruments for China's rich,called wealth management products, mature later this month.
Fitch said about $244 billion would come due later this month and that the effort to make the payout could send short-term borrowing rates even higher.
Wall Street analysts are now revising their economic growth forecasts downward and warning that the Chinese central bank's refusal to alleviate commercial banks' cash shortages by pumping more money into the economy could lead some smaller banks to default.
They warn of other dangers facing China's economic policy makers. If the property market stumbles, some analysts fear that could wallop the broader economy.
China's exports, long a strength, had been buoyant early in the year, according to official statistics. But some analysts have questioned whether trade statistics were being manipulated by speculators pretending to sell goods overseas in order to bring money into the country that they would then use to speculate in the financial markets.
The most recent export figures have been less robust, possibly hurt by China's currency, the renminbi, which has strengthened over the last year against the dollar and the Japanese yen.
The prime minister and his economic team are trying to move swiftly to guard against a crisis down the road, after years of loose credit and heavy spending on manufacturing, property and infrastructure. But if they press too hard, analysts say, an already weakening economy could lock up, and see growth dip below 7 percent, starting even more trouble with the banking sector.
(Read More: China's Central Bank Drains Funds, Again)
"To push through their reforms I think Li Keqiang and Xi Jinping are willing to accept lower growth," says Nicholas Lardy, an expert on China's economy at the Peterson Institute for International Economics in Washington.
Last Friday, a large group of bankers and entrepreneurs surveyed by the central bank said their confidence in the country's macroeconomic conditions was weakening.
Loan demand was falling, said Xiang Songzuo, chief economist of the Agricultural Bank of China, according to the English language China Daily.
"Even a monetary easing is not going to solve the problem," he said.