On October 10, the Chinese government announced that it will increase its stakes in the four largest commercial banks, which are already largely public-owned. The move is designed to ''support the healthy operations and development of key state-owned financial institutions and stabilise the share prices of state-owned commercial banks''.

But why was this move considered necessary at all? In the period just before this, investors were dumping Chinese bank shares, anticipating a slowing down not just of the economy as a whole, but in particular the property market, which had experienced a bubble of massive proportions. But the underlying concern about the health of Chinese banks reflects a deeper concern, about the extent of entanglement of these commercial banks with the growing ''shadow banking sector''.

What exactly is shadow banking? Basically, this refers to non-depository banks and other financial entities like investment banks, mutual funds, hedge funds, money market funds and insurers, who typically do not fall under banking regulation. The growth of this sector has been explosive in the last decade: in the United States, in the run-up to the financial crisis, its size was estimated to be significantly bigger than that of the formal banking sector. In the aftermath of the crisis, many of these institutions, and banks that were exposed to them, had to be rescued.

UNCTAD's Trade and Development Report 2011 noted that ''The shadow banking system depends on wholesale funding, which is extremely unstable and renders the system very fragile, as evidenced by the crisis'' (page 94). It argued strongly in favour of bringing shadow banking under regulation; not just money market mutual funds, but also the asset-backed securities market financed with repos.

Even at the IMF, a recent meeting of regulators held during the Autumn meetings called for greater regulatory focus on shadow banking. Participants noted that shadow banking operations, that firms doing these bank-like activities outside the banking system can pose systemic threats, and to have some effect regulators need more and different data to understand this fast-changing sector.

But China was known to have a much more regulated banking sector. Indeed, the ability of the Chinese authorities to control the four important commercial banks (Bank of China, Agricultural Bank of China, China Construction Bank and Industrial and Commercial Bank of China, which together were earlier estimated to control more than three quarters of total domestic credit) was seen as important macroeconomic tool in the hands of the state as well as an instrument of ensuring directed credit, both of which have been crucial to China's economic success.

Before the 1978 reform, the financial system of China was vastly different from that in most countries. Starting from 1951, banks and other financial institutions were taken over by the state and assimilated into a system dominated by the People's Bank of China (PBC). Until 1984 this system essentially implemented the cash and credit plans formulated by the central authorities, which supported the physical plan for mobilisation, allocation and utilisation of real resources. All public sector transactions, including those between various levels of government and the state enterprises, were through transfers on their accounts with the PBC. These account transfers at the PBC accounted for an overwhelming share (of up to 95 per cent) of all transactions.

Moreover, cash (to serve the needs of households and non-state owned enterprises) was printed and issued by the PBC on demand by the central government and allocated according to instructions issued. The main elements of money in circulation were wage payments to workers and staff, the purchase of agricultural products by the government, other purchases of goods in the rural sector, and the withdrawing of savings deposits by individuals. The banking system was not responsible for provision of resources for fixed asset investments by the state owned enterprises (SOEs) and for much of their working capital requirements, which were made available free of charge by the Ministry of Finance. The banking system was merely responsible for providing additional working capital and some loans, for accepting deposits from households and other non-government entities and for settlement of transactions.

There was little role for monetary policy, since credit provision was centralised and strictly controlled. Enterprises and other economic entities received grants and loans directly from the PBC. Bank branches had to merely meet credit targets. And lower level banking entities had to hand over deposits that exceeded their credit provision targets to higher-level units. If the government felt the need for restricting economic activity, it did so directly through administrative means rather than using levers of monetary policy. To manage the supply of cash and its utilisation, the central authorities could adjust (administered) prices relative to money wages (using a turnover tax if necessary). However, since the objective was to keep prices mostly stable, excess cash in circulation was absorbed through rationing, when commodity supplies fell short of demand, and by encouraging savings.

Financial reform created a situation in which banks, financial institutions and enterprises at provincial and local levels had more flexibility in providing and accessing loans, so the ability of the government to control sharp increases in investment and consumption was to an extent reduced. So the government has increasingly relied more on countercyclical fiscal policy to correct for recessionary or inflationary tendencies. Meanwhile, price reform has meant that a growing number of commodities have been removed from the administered price category, so that excess demand can lead to inflation.

In the early phases of the economic reform, along with price reform, certain significant changes were made in the financial field as well. In 1979, the government declared its intention to reduce the share of investment funds for enterprises granted exclusively from the cost-free state budget, and to gradually replace budgetary grants with bank loans which were subject to interest charges. This did result in major changes in the financing of investment. The share of budgetary appropriations in financing capital construction declined dramatically and that of loans and self-raised funds increased quite significantly.

A two-tiered banking system was established in 1984 by converting the PBC into the country's central bank and getting the specialised banks to undertake the commercial banking business. Further in 1986, reform of the non-bank financial sector resulted in the creation of a number of trust and investment companies, and financial intermediaries such as leasing companies, pension funds and insurance companies. Subsequently, foreign banks were allowed to begin business for the first time.

However, even under the new arrangement it was in principle possible for the PBC to rein in overdrafts being run by these banks and prevent them from exceeding loan limits or quotas. Further, now the PBC could control the terms of its lending by charging lower rates of interest for loans within the credit plan and penalize unauthorised borrowing. Thus the ability of the PBC to realize its credit plan was strengthened by the reform.

However, with a greater degree of decentralisation of financial activity and the ability of local officials to influence provincial and local appointments in the banks, it was possible for provincial and local governments to easily obtain finance for special projects adding another element to the investment hunger determined by soft budget constraints in the SOE sector. Over time this problem has only increased with an increase in the number of financial entities, a change in property rights in the financial sector and a far greater degree of functional autonomy. In the process, the capacity of the central bank to use monetary levers to control investment expenditures is weakened.

The changes accelerated after 2008, when the urge to provide more stimulus meant that the government allowed or encouraged more ''informal'' credit flows that went through new shadow banking intermediaries. As a result, the government's control over actual flows of domestic liquidity is weaker than it has been for more than half a century. In addition to trust companies and private banks, which are not regulated but at least are registered businesses with established offices, there has been a proliferation of underground operators, usually no better than loan sharks operating in a world of largely unsecured loans. Such has been the profitability of these operations that even large local state-owned firms whose main business was not finance are now expanding into operating guarantee companies, pawnshops and trusts, arbitraging their own access to cheap loans to lend out at many multiples of the official interest rates.

On the face of it, China's household sector appears to be not excessively leveraged at all - rather, they are substantial net financial savers, as Chart 1 indicates. Unfortunately, however, China's official financial statistics still do not cover shadow banking entities, though there are plans to reform the statistical system to being these under the purview of the data collection. But even without these, the data indicate that the ratio of liabilities to assets has been rising quite rapidly.

The growing but opaque interlinkages between the formal credit system and the world of shadow banking are cause for concern. This is because the formal banks are also more attracted to indirect lending that generates at least double or triple the official 6.5 per cent one-year lending rate, and can even go up to 30-70 per cent in underground banks. The most profitable activity of state-owned banks in the first half of 2011 was not lending to businesses, but funding trusts and underground banks.

Much of that went into the overheated housing market, associated not just with a construction boom but with urban real estate prices that are now the highest in the world for cities like Shanghai and Beijing. Chart 2 shows that even formally, direct loans from Chinese banks for real estate and housing increased significantly in the previous two years.

But these relate only to the direct lending by banks. Increasingly, commercial banks find it more profitable to lend to other agencies, which then redirect the funds in this parallel or shadow banking activity that demands much higher interest rates. Chart 3 shows how this became a significant and even increasing share of banking assets especially for the small and medium sized Chinese banks. The chart takes claims on ''other depository corporations'', ''other financial corporations'' and ''other resident sectors'' (excluding non-financial corporations, government and central bank) as shares of total assets of banks according to size. This is only an approximate estimation of the shadow banking sector, since these categories also include other lending. But some analysts have already estimated that the value of China's shadow banking sector could amount to as much as RMB 14 to 15 trillion.

Since official curbs on lending to this sector were tightened in early 2011, this parallel market expanded even further. However, the tighter interest rate policies and credit curbs have finally affected the real estate market. Recently the market has wobbled and real estate prices have finally started falling.

The bursting of this bubble could be painful. In an attempt to provide some protection, the government has encouraged the growth of credit guarantee companies - but many of these are also highly leveraged and themselves far from creditworthy.

For a very long time, China's ability to control finance was an important (some would say essential) ingredient of its macroeconomic success. Now that this control looks more tenuous, the future of the overall growth strategy also looks that much less rosy.

* This article was originally published in the Business Line, 31 October, 2011.

November 1, 2011.