What the shadow market enthusiasts don't tell you

China's shadow banking system has attracted something of a fan club lately. More and more analysts and commentators seem to regard the rapid growth of off-balance-sheet and underground lending as a good and healthy development; in effect, a stealth liberalisation of financial markets.

I can follow their reasoning. Unfortunately, they are missing the point.

There can be little doubt about the speed with which the shadow market has ballooned. As the authorities sought to crack down on regular bank lending in order to cool overinvestment and inflation, lenders and borrowers turned to informal channels to keep the supply of credit flowing.

There are a range of ruses banks use to disguise their lending and evade government loan quotas. Typically, the banks might charge a fee for arranging a loan directly from a cash-rich corporation to another company in need of funds. Alternatively they might arrange structured notes which they sell to their depositors as wealth management products, with the proceeds used to finance local- government-backed infrastructure projects.

Either way, the effect is much the same. Depositors are promised a premium return on their savings, while cash-starved companies and projects get access to credit, albeit at a higher interest rate than they would pay for a regular bank loan.

Enthusiasts believe the growth of this shadow market is a thoroughly good thing. They argue that it amounts to interest rate deregulation by the back door. Thanks to the shadow market, savers who would otherwise be earning a negative real interest rate on their bank deposits can now get a decent return. And borrowers who would otherwise be denied access to loans can get credit, simply by paying a market-determined rate. Market forces triumph again.

It's a seductive argument. But it misses a couple of key points.