China’s Scary Financial System

China’s financial system isn’t just inefficient, it’s built on quicksand.

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 Mr. Hahn is director of economics at the Smith School, University of Oxford and chief economist at the Legatum Institute. Mr. Passell is a senior fellow at the Milken Institute and the economics editor of the Legatum Institute's Democracy Lab. They are co-founders of Regulation2point0.org, a web portal on regulatory policy.

As China's economy slows, skepticism about the sustainability of the Chinese miracle is gaining traction. But the reasons offered for why Beijing's ducks may finally be coming home to roost are all over the place.

The granddaddy of explanations is the inherent contradiction between free markets and an authoritarian government. There are alternatives, though. China-watchers are pointing to deep divisions in the ruling Communist Party, to the stresses created by widening income inequality, to the toxic wasteland left by helter-skelter industrialization, to the weak protection of intellectual property, to cultural restraints on innovation. (Pick all that apply.) Our own candidate is the failure to build a financial system that is up to the challenges of efficient intermediation in a very large, very complex economy. In theory, this problem is eminently fixable. But that doesn't mean it will be fixed before the fallout takes a big toll.

Banks have been a primary vehicle for funneling Chinese households' formidable savings into capital since Mao consolidated power in the early 1950s. And while the banks' organizational structure has grown more byzantine since Deng Xiaoping made China safe for private enterprise in the 1980s, they remain creatures of the state.

[See a collection of political cartoons on the economy.]

In the 1980s and 1990s, the banks were drafted for the job of bailing out hopelessly inefficient (but politically connected) state-owned enterprises with the vast deposits of the country's household sector. In turn, the government was forced to bail out the banks, which were all but technically insolvent thanks to all their nonperforming loans from the above-mentioned state-owned enterprises. And the cycle apparently began again in 2008, in response to Beijing's decision to stimulate the economy in the wake of the global downturn—and to manage the feat without running up a public debt.

The government ordered the banks to lend the equivalent of hundreds of billions of dollars to various provincial and local authorities charged with creating jobs and income with public works projects. No one has a clue at this point what percentage of those loans will ever be repaid, or at least nobody who knows is talking. But, then, nobody believes these giant lenders—the biggest, the Industrial and Commercial Bank of China, has nominal assets equivalent to $2.5 trillion—would ever be allowed to fail.

Actually, the problem is worse. Bank managers seeking higher returns having increasingly lent to less regulated (but probably legal) "shadow banks"—insurance companies, trust companies, securities companies—that make loans to the private sector, yet maintain very low reserves. In fact, loans from this bank-funded parallel system—a system that could easily become insolvent in an economic downturn—now represent 40 percent of total credit outstanding.

[Read the U.S. News debate: Should Congress Interfere with China's Currency Policies?]

This is no way to run a capital market, even if the government ultimately stands prepared to socialize the banks' losses when they grow too big to hide. The banks, operating with fuzzy incentives and often unstated mandates from the central government, are not efficient at channeling deposits into their most productive uses. Indeed, the best guess is that a large portion of Chinese households' (very) hard-earned savings is being sucked into a crony capitalist hole.

Wait, this dreary story gets even scarier. The government's failure to decentralize banking—or to allow the state-owned and controlled banks to operate as profit-maximizers—has spawned a large informal (and unregulated) credit market. Small businesses, which have a tough time obtaining  bank credit, do much of their borrowing from private entrepreneurs who've gotten very rich operating under the government radar—though presumably with the knowledge of influential government officials. The Chinese Banking Regulatory Commission, which regulates the banks, conservatively estimates that the size of this informal lending market at between $500 billion and $800 billion. 

In an economic downturn, these borrowers would presumably suffer disproportionately. Yet, nobody knows how the resulting insolvencies would ripple through the unregulated portion of China's capital market, or whether Beijing would come to the rescue before the above-ground banks caught the bug.

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This is the spot in articles of this sort where you expect to find the authors' prescriptions for making China's financial markets more transparent, more competitive and less responsible for the care and feeding of state-owned enterprises. We'll spare you: Suffice it to say China does not lack the expertise to reform the system.

Indeed, the question is not whether it could be done, but whether the complex mix of interest groups—the big exporters, the state enterprises, the sprawling central and provincial bureaucracies, the military—are up to the task. Many powerful people are doing just fine in this hybrid system, and it's far from clear that they would do as well in an economy that more uniformly rewarded productivity and punished crony enterprise, private and public.

Stay tuned.

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