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bankruptcies involved small and medium-sized private firms that couldn’t service their debt or had their credit lines withdrawn by China’s “shadow banking system.”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.