Why China's financial jitters matter

China's construction boom may have left its financial system in a precarious position

Pay attention to China. The US has had its crisis, and so has Europe. Now it's China's turn.

The immediate cause of the recent freeze-up of China's bank-to-bank lending market is still being debated.

What is clear, and potentially more important, is that China's central bank resisted riding to the rescue with cheap loans.

That decision is what sent a shiver through the Shanghai Stock Exchange.

It has highlighted the bigger story: The newly-ensconced government of President Xi Jinping is deadly serious about "rebalancing" China's economy.

If President Xi pulls off this Herculean task, it will mean an end to the era of cheap lending, the winding down of the country's enormous construction boom, and much slower economic growth.

It is a tectonic shift, of which the recent market jitters are an early tremor.

Big borrowers

After the 2008 financial crisis, China faced recession in its main US and European export markets.

Beijing responded with a massive stimulus package, accelerating the already-rapid building of roads, railway lines, steel plants, blocks of flats, and so on, to keep the workforce busy and the economy expanding at 9%-10% a year.

Much of the construction boom was financed by cheap loans, made readily available by the state-owned banks on orders from Beijing.

Here are some of the big beneficiaries of the cheap money era:

• property developers who did the building work

• local governments who sold or leased the land (often after expropriating it from farmers)

• heavy industries that produced the construction materials and tools

• the large state-owned monopolists, many of whom borrowed and speculated in property and other bubbly areas

If the authorities press ahead with rebalancing, then anyone making a living in these sectors can expect much leaner times ahead.

Delicate task

Delay no longer appears an option. The lending-cum-building boom is running out of steam. Total indebtedness in the economy has risen steadily.

China may already have too many roads, office blocks and so on. And too much of the economy is geared towards making even more of those things - too many steel-makers, cement-makers, even tyre-makers.

What's more, in the mad rush, a lot of the money may have been completely wasted on white elephants or disappeared into black holes.

Yet the market jitters highlight just how delicate the government's task will be.

If they take a hard line, forcing banks to raise interest rates and cut back their lending, then many of the loans extended during the boom may prove unrepayable.

The government does not want to trigger a collapse in confidence and a cascade of loan defaults and bankruptcies, not to mention the lay-off of millions of construction and industrial workers.

But allowing the banks and their borrowers more time may simply be delaying the inevitable.

Unintended victims

The government is particularly concerned about "wealth management products" (WMPs) - high-yielding investments sold to citizens with spare cash.

WMPs have been increasingly churned out by the banks - particularly the smaller banks.

The authorities fear that they are being used as a sneaky way to raise extra money to pour into the property market and other speculative activities.

However, WMPs also play a vital role in financing small privately-owned businesses, including China's dynamic small-scale exporters.

These small borrowers find themselves marginalised from the mainstream financial system.

The state-owned banks have prioritised funnelling cheap loans to the state-owned companies and investment projects targeted by the government's stimulus plans.

They are often accused of being more concerned about a borrower's political standing than its cashflow or profitability.

The risk is that if the squeeze on WMPs and other types of shadowy, but more profit-oriented, lending persists, small businesses may find themselves cut off from credit altogether - although thus far rising interest rates have had the exact opposite effect.

Well connected

A lot of very wealthy Chinese also have much to lose from the end of cheap money.

Many of the officials who have been directing the flow of borrowed money, as well as private businessmen enjoying good government connections ("guanxi"), have done very well for themselves these past five years.

If the boom is over, then much of the country's elite will have to accept a commensurate reduction in their living standards.

Indeed, this has been made explicit by Beijing, who is clamping down on conspicuous spending by apparatchiks.

But the problems go deeper than this. If loans have been squandered, then as money becomes tighter, the squanderers face the risk of exposure, with serious personal consequences.

The allocation of pain within the elite could become very political, with some factions taking the fall for the years of profligacy. Bo Xilai springs to mind.

Day of reckoning?

A common assumption in China is that, because the banks are state-owned and information tightly controlled by the state, a Lehman-style financial crisis is unlikely.

This may not be entirely correct.

China's censorship, and the resulting public uncertainty, could actually make its citizens more prone to sudden, overwhelming panic, as exemplified by the 2003 Sars crisis.

Prof Michael Pettis of Beijing University argues that the 2003 Sars panic resembled a financial panic

And many wealthy and middle-class Chinese do stand to lose out on their investments if things go wrong.

They have bought those high-yielding WMPs. But - much like the repackaged mortgage debts that caused havoc in 2008 - if the murky loans underlying these products go bad, the losses are passed straight through to the end investor.

They have also invested in property (and wealthier Chinese, in multiple properties that often sit empty).

But the end of cheap money could kick the legs out from under the frothy housing market - for instance if struggling developers, businessmen and local governments are forced to sell.

All this raises a big risk for the whole country.

If China's super-wealthy, particularly those concerned about their political future, see the writing on the wall, then they may try to cash in their assets and move their money to the safest place they can - outside China.

And if panic spreads to the middle classes, they may decide a low-interest account at a state-owned bank is a much safer bet than owning property or those tantalising WMPs.

Yet any such rush for the doors would simply accelerate the day of reckoning.