The idea of “dangerous” lending that is likely to be caused by excess control of parts of the system (their forced piling up of PBoC bills and minimum reserves) and by current monetary and credit conditions is something about which I have had a surprisingly hard time arguing, both with Chinese and with foreign analysts.  I am not sure why, since in most markets this is fairly well understood, and given the ongoing crisis in the US, the idea that seemingly smart banks can do some pretty dumb things during optimal times is getting quite a lot of newspaper coverage. 

None of this is new.  Hyman Minsky in particular, has long argued that it is impossible to protect financial systems from periodic crises because the very conditions designed to prevent instability are the ones that create the incentives for bankers to take excessive risk – usually in less well-monitored areas – that end up ensuring that at some point the system will go through a period of “adjustment” and distress.  The empirical evidence that loose monetary conditions and implicit or explicit credit guarantees lead to banking crises is also pretty ample.

I can’t prove it, of course, and no one will be able to prove it until we have our own contraction, but I would be willing to bet that over the last few years the banks and the financial sector in China have been engaging in behavior that will one day seem self-evidently dangerous.  That is both the biggest risk of a sudden revaluation and the strongest argument for doing it as soon as possible.

Speaking of monitoring the banking system, I saw another very interesting piece, this time in ChinaStakes.com (“Government Moves to Legitimize Underground Lending in Zhejiang”).  The title says it all, but here is what the article says:

In Zhejiang Province, with the most developed private companies and private capital in China, the government is trying to legitimize private capital, and set up small-sum loan companies to connect private capital with capital-hungry private companies.  The tight credit policy has driven many small and medium enterprises into hardship and even bankruptcy in coastal provinces like Zhejiang Province. Normally, formal banks, especially the state-owned banks, are reluctant to lend to private companies.

However, Zhejiang is also famous for its so-called underground banking, or back-alley banks as some analysts put it. The government has never issued lending licenses to them.  For some central bankers, like Wu Xiaoling, the former deputy governor of the People’s Bank of China, small-sum loans are an alternative under the current tight monetary policy in place in China.

So now Zhejiang is carrying out a pilot scheme for petty loan firms. If everything goes well, the first small-sum loan companies will start operations in September this year, and their experiences will help to set up more companies of this kind.  Zhejiang is the first province to react to the Guiding Opinions of the China Banking Regulatory Commission and the People’s Bank of China on the Pilot Operation of Small-Sum Loan Companies, which was released in May.

The article goes on to say:

The government has set strict limits for the establishment of small-sum loan companies in order to guarantee their development. According to the regulations in Zhejiang, investors in these loan companies should be chosen from private companies with regular management, sound credit, and are well-operated. The net assets of these companies should not be less than 50 million yuan (or 20 million yuan in less developed areas), and the asset liability ratio no higher than 70%. They should have made profits for three straight years and the total profits should be no less than 15 million yuan (or 6 million yuan in less developed areas).

The government has also banned these companies from collecting deposits or illegally raising funds from the public. Their loans should be dispersed to different businesses in small sums.

The “informal” banks are in many ways among the better-functioning parts of the financial system, although their dubious legal status means that it is probably hard for them to raise money and to collect on bad loans.  This of course raises their cost and forces them into otherwise non-economic behavior – for example I suspect that they tend to insist on short-term loans even when longer-maturities might be optimal – but at least their capital allocation process is probably better in many ways than that of the commercial banks.  Bringing them into the regulatory fold and improving their legal status will almost certainly improve China’s financial system.