Credit's Merits

On the other hand, the big jump in credit lending has helped to quickly stabilize the capital market. The Shanghai Composite Index has climbed 600 points, or nearly 30 percent, so far this year. And any talk of an equity bubble has been muted.

"Chinese authorities now think some bubbles are better than none," said a research chief at an international investment bank.

Credit is also seen as a deflation fighter. Deflation is considered more damaging to businesses than mild, single-digit inflation. And when commodity prices sink, deflationary pressure far exceeds the threat of inflation.

When the Chinese economy slumped in 1998 and 2003, state economic stimulus plans led to new rounds of rapid growth. If the world economy recovers from the current crisis and external demand rises again, China will have realized its goal of adjustment by ironing out wrinkles during the darkest period of the economic cycle.

Richard W. Fisher, president of the Federal Reserve Bank of Dallas, said in an interview with Caijing that corporate credit demand in China is less sensitive toward interest rate policy than in the United States. Therefore, the Chinese government can more precisely control the scale and direction of credit expansion, and may intervene in microeconomic activities.

Bankers that are writing the loans clearly understand that bank financial performance is closely related to the economic cycle.

Several senior executives at state-owned banks told Caijing that, to prevent a rise in non-performing loans in the wake of the latest lending surge, the economy must be kept from deteriorating. They said banks are now in a good position to support economic development.

Indeed, hints of economic recovery appeared in the most recent macroeconomic data. First quarter indicators for fixed-asset investment, retail sales and industrial production were positive.

Fixed-asset investment grew 28.8 percent year-on-year in the first quarter. In particular, new urban construction projects nationwide rose 87.7 percent year-on-year, after declining 4.4 percent in the first quarter 2008 year-on-year.

Local Trouble

Beyond the national statistics, however, the enormous amount of new lending has focused attention on the financial activities of local governments. Not all of the talk is positive.
 
For example, local governments have come under fire for using land as a capital base. A former central bank governor, Dai Xianglong, was being critical when he said at this year's Boao Forum for Asia that some local governments "have used income from land leasing as a capital base or guarantees, which are special loans as foreign financial institutions see them."

Risks attached to local investments and financing platforms mainly stem from the capital bases for projects. The greatest dangers surface when a capital base is lacking.

Beijing regulators have signaled that the capital bases for some projects are seriously inadequate. This came when regulators gave a green light to bridge loans for financing projects approved by the National Development and Reform Committee, which plans to lower capital base requirements for certain projects.

At the same time, regulatory authorities are concerned about loan misappropriation at the local level.

Several bankers told Caijing that many local banks have been under pressure to issue loans for local projects in response to the central government's economic stimulus plan. Now, some fear that cash may have been misappropriated.

Such abuse could be tied to bank loans issued to meet local liquidity needs, to back letters of credit, and for buying securities.

Moreover, a corporate banking executive said some big enterprises have been known to concentrate capital by pooling their loans and recycling the cash. When that happens, banks lose control over the direction of their loans.

And when big companies are unwilling to increase capital investments, citing concerns about the economic cycle, borrowed money is likely to flow into the stock market and real estate for speculation.

Indeed, the executive said controlling capital flow and credit lending are long-term issues for the banking system.

How much misappropriation may be linked to this year's increase in lending activity? That answer may never come.

But as the international investment bank executive explained, "For a long time into the future, it is very likely to have economic recession together with big, crazy bubbles in the stock and real estate markets."

"This will be a new, messy and distorted situation."

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