By Minxin Pei

Minxin Pei is a professor of government at Claremont McKenna College. His research has been published in Foreign Policy, Foreign Affairs, The National Interest, Modern China, China Quarterly, Journal of Democracy and many edited books and his op-eds have appeared in the Financial Times, New York Times, Washington Post, Newsweek International, and International Herald Tribune, and other major newspapers.

• inShare19

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For quite some time, analysts of China have been puzzled by a strange phenomenon: the country’s public and financial institutions are decidedly subpar by any international standard, but its economic growth rate is anything but. This puzzle can only be explained by two conclusions: either China has been fudging its growth data, or Chinese institutions aren’t as bad as outsiders commonly think.

There is, however, a third possibility. During the peak of the credit bubble in the United States, bankers on Wall Street had a popular saying: “When the tide is high, nobody knows you are swimming naked.”  What this aphorism means is that apparent economic prosperity can cover up many dubious if not outright shady practices that eventually lead to financial calamities.

So if we apply this expensive lesson learned from Wall Street, it’s hard not to suspect that a lot of people have been swimming naked in China in recent years as well. The prudish Communist Party hasn’t acquired Scandinavian-level tolerance and allowed nudist beaches in China (it has not). Instead, based on the recent spate of worrying financial news out of China, it’s obvious that high economic growth has concealed many high-risk and illegal activities and practices that may have bolstered growth, but also sowed the seeds for financial mass destruction.

Of all the disquieting news from China these days, such as stubborn inflation, slowing growth, and social unrest, the sudden bankruptcy of a large number of private firms in Zhejiang, the most entrepreneurial province in all of China, is by far the most disturbing. Press reports suggest that most of the bankruptcies involved small and medium-sized private firms that couldn’t service their debt or had their credit lines withdrawn by China’s “shadow banking system.” This consists of state-controlled banks and illegal private financial intermediaries that funnel loans to credit-starved private firms.

Of course, the bankruptcies themselves have led to a panicked reaction in Beijing because they not only made tens of thousands of workers jobless and ignited some protests, but because they also could cause financial contagion within China, leading to the “shadow banking system” to call in loans and triggering a cascade of new bankruptcies. So Chinese Premier Wen Jiabao and senior officials hurried to Wenzhou, the epicenter of the emerging financial distress, to try to restore calm and confidence.

But the task of stanching off this incipient financial panic is daunting.  In the short-term, this involves the formulation and execution of policies that would effectively bail out those who have been swimming naked in China’s high but turbulent economic tide. For years, China’s state-owned banks systematically restricted credit to China’s dynamic private sector. While Chinese private firms are the fastest-growing economic entities and creating most of the new jobs, the Chinese government channels the bulk of bank loans to state-owned companies. The data on bank loans show that, as of 2009, explicitly identified non-state firms accounted for only 2 percent of all outstanding loans.

This discriminatory policy forces private firms to tap the “shadow banking system.” Such a system came into being because state-owned banks wanted to make more money with their low-cost (if not free) household deposits, because when state-owned banks lend to state-owned firms, they can charge only regulated (low) interest rates and repayment is not assured. Generally, such lending is politically safe (since no bank managers go to jail for making bad loans to state-owned enterprises) but economically unprofitable. On the other hand, lending money to private firms is politically unsafe (bank managers risk corruption charges should loans go sour) but economically lucrative (as they can charge high rates).

To manage the political risks of lending to private firms, Chinese state-owned banks created new investment options for their depositors, who are eager to invest their hard-earned savings at rates higher than government-controlled rates for deposits. Called “wealth management vehicles,” these new financial instruments effectively enabled state-owned banks to channel consumer deposits into loans targeting credit-starved private firms at rates that, when annualized, normally reach double digits. Effectively, the “shadow banking system” has been siphoning off credit from the state-owned banks. In the last few years, when Beijing opened the credit spigot to stimulate the economy following the global financial crisis, few noticed the effects of such leakage, which has grown enormously. Estimates by economists put the total amount of outstanding loans made by the “shadow banking system” at close to 20 percent of all outstanding bank loans.

However, as in the case of a falling tide, Beijing has been tightening credit to fight inflation for a year now. In this process, state-owned banks have been forced to call in the loans made through the “shadow banking system,” thus hurting the debtors and triggering a spate of bankruptcies.

The proposed short-term solutions – making more loans available, restructuring the terms or rolling over maturing loans – will do no more than put a dent in a more serious systemic problem. As long as the Chinese state monopolizes the financial sector and discriminates against private firms, corrupt and high-risk behavior such as lending hundreds of billions of dollars through an unregulated informal banking system will continue.

The question on everybody’s mind is whether the massive leakage from the formal banking sector into the “shadow banking system” will be big enough to sink the Chinese financial sector. While nobody knows the real answer (in all probability, private firms are better risks than China’s traditional deadbeats, such as local government entities and SOEs), what makes a Chinese financial meltdown a more probable catastrophe would be a combination of several similar disasters. While each of them may be financially manageable in isolation, their total severity and simultaneous eruption could overwhelm the Chinese state.

Of course, here we are talking about the other two big holes in the Chinese financial system: local government debt (roughly 30 percent of GDP) and loans to real estate developers (the magnitude of which nobody knows).

So it appears that Chinese private entrepreneurs are not the only naked swimmers. They are in some distinguished company.