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.' "
(Read More: Is China Right to Brush Aside Credit Squeeze?)
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.