06.24.131:49 PM ET

China’s Market Shivers and the World Freaks Out

After years of injecting money into its financial system, China’s central bank held off last week—and global markets reeled. Daniel Gross on why we should be nervous.

Last week’s meme: Blame U.S. central bank for financial market freak-out.

This week’s meme: Blame China central bank for financial market freak-out.

Financial memes move with the same speed as Internet memes. Last week, investors around the world had a collective fit after Federal Reserve chairman Ben Bernanke said the Fed might start to scale back its purchases of bonds in the not-too-distant future. They sold stocks and bonds with abandon, pushing market indexes down and interest rates up.

On Monday, the markets fell out of bed again, as investors around sold stocks and bonds with abandon. But now the problem is Asia—and more specifically, China.

Wait, what? China, we’re always told, is the paragon of economic strength. It grow at 7 or 8 percent, year in and year out. The U.S. is Becoming China’s Bitch, as a bestseller from last year put it. But that’s last year’s story. In the last couple of decades, much of China’s growth was fueled by the process of a giant country breaking out of decades of self-imposed torpor, discovering capitalism, connecting to global markets, and producing its way to prosperity. Sure, China had a shaky, fragile, immature, and frequently corrupt financial system that was largely owned and controlled by the government. But whenever the banks got into trouble, as they did in 2003 and 2009, China’s government and central bank would bail them out. The party continued.

Things have changed in recent years. First, since the global recession of 2008 and 2009, China has come to rely on a fuel other than exports for its growth: credit. With orders from abroad tapering off, China’s economic mandarins pumped up economic activity by flooding loans into the corporate market, the housing market, and the financial sector at large. In China, credit has risen from 125 percent of gross domestic product in 2009 to nearly 200 percent today, according to the ratings agency Fitch. Which is pretty stunning when you consider how much bigger China’s economy is today than it was in 2009. It’s kind of like America during the Bush-Greenspan years: they staged a credit and housing boom and called it prosperity.

Oh, and there’s a second potentially dangerous analogy between China today and the U.S. in the 2001–07 time frame. Prior to 2008, the U.S. effectively had two financial systems. The banking system was regulated and backstopped—implicitly and explicitly—by the government. Then there was the rapidly growing shadow banking system, composed of investment banks (Lehman, Bear, Stearns), subprime lenders, and giant insurers like AIG, which wasn’t really regulated or backstopped and yet was allowed to grow massively. The constituents of the U.S. shadow banking industry were furiously lending to and borrowing from one another, from the capital markets, and from regulated banks. And it was the slow-motion collapse of this system in 2007 and 2008, combined with the government’s ultimate willingness to let one big shadow bank (Lehman) go bust in the fall of 2008, that precipitated a global crisis.

Quiet as it is kept, China has a shadow banking system in addition to its official, state-dominated banking sector. Here’s a good primer from Dexter Roberts at Bloomberg Business Week and another from Reuters. China’s shadow banking system is composed of trust companies, investment firms, brokerages, informal lenders, companies that extend credit to other companies and to their customers. “S&P has estimated that outstanding shadow banking credit totaled $3.7 trillion by the end of 2012, equal to 44 percent of GDP,” according to Reuters. But nobody knows. China isn’t exactly known for financial transparency.

As the shadow banking system has run into trouble in recent weeks—defaults, rising interest rates—the government isn’t exactly rushing to the rescue. The hypothesis is that Li Keqiang, the Chinese premier who took office in March, and central bank head Zhou Xiaochuan are using this crisis as an opportunity to push for reform. It’s no secret China’s economic mandarins want to change the nature of the economy from one that is heavily reliant on investment, real estate, and credit to one that is fueled more by consumption and services (i.e., something that looks a little more like the U.S.) Shrinking the shadow banking system will help move that process along more quickly. And so the message emerging from Beijing and Shanghai is that we shouldn’t expect the government to bail out China’s shadow banking system. At least not yet.

That’s bad news for the global economy for two reasons. First, economic growth in China, which has already slowed down to about 7.6 percent per year, could slow further. That spells trouble for all the people around the world—soybean farmers in Brazil, iron-ore miners in Australia, zinc producers in sub-Saharan Africa, luxury retailers in Paris, university administrators in the U.S.—who have come to rely on Chinese demand.

Second, just as happened in the U.S. in 2008, there are always huge unforeseen and unintended consequences when the government lets a piece of the financial system go bust. Credit—which stems from the Latin root “credo,” meaning belief—is very emotional and dependent on psychology. The credit system functions only if people can sleep at night secure in the knowledge that their loans will be repaid. Once that belief is lost, markets seize up. China has generally been immune to such virtual bank runs because everybody knew that, should push come to shove, the government would stand behind the debts of state-owned companies and banks. Officials needed to do so to save face, to maintain credibility, and to keep the economy growing. Now, however, for the first time, China’s economic bureaucracy is suggesting that it may be willing to tolerate some systemic failure for the sake of reform.