Reformers aiming to achieve bank liberalisation by stealth
China bulls and China bears display a truly astonishing ability to look at exactly the same information and reach diametrically opposite conclusions.
The country's shadow financing market is a case in point.
To the bears the shadow market is a symptom of everything that's wrong with China's financial system. They regard the rapid growth of underground financing and unregulated off-balance-sheet lending by China's state banks as dangerously destabilising. They see the market as a sign that credit growth has run out of control and, drawing a lesson from the US financial crisis, warn that a debt crisis is looming.
The bulls take an altogether different view.
They argue that the shadow market only exists because the central bank wants it to. They say it performs a vital dual function, allowing savers to earn higher returns than they can get on conventional bank deposits, and channelling much-needed capital to a private sector starved of bank financing.
What's more, the bulls believe that far from being a crisis in the making, the shadow system will play a key role in furthering China's financial liberalisation.
The bulls might have a point. Last week China's state council charged the authorities in Wenzhou with regulating the eastern city's private financing system, effectively legitimising the underground lending market and bringing it into the open.
To the reform-minded officials of the central bank and their allies, this is a crucial experiment, whose success or failure will help determine the country's future growth path.
In recent years, China's growth has been powered by high investment rates in the state sector. In turn, that investment has been funded by keeping interest rates artificially low, which has allowed the banking system to channel capital from captive savings deposits to state companies at lending rates scarcely above the rate of inflation.
More and more, however, this growth model is looking unsustainable. To see why, take a look at the first chart, which shows China's incremental capital output ratio: how many yuan China has to invest to produce each additional yuan of output.
As the trend line shows, this number is rising, a worrying sign that capital is being wasted on unproductive investments.
If China is to avoid the so-called middle-income trap and continue growing, future growth will have to rely less on investment and more on private consumption.
Rebalancing the economic mix will require-interest rate liberalisation. Depositors must be allowed to earn a decent return on their savings to encourage them to spend. And credit will have to be priced at market rates if capital is to be allocated efficiently.
Unfortunately, there is a problem. Over the years, state-sector officials and their families have built up powerful business empires which are heavily dependent on privileged access to cheap loans from state banks. These entrenched interests form a powerful political lobby deeply resistant to financial liberalisation.
This is where the shadow market comes in. To some degree, underground and off-balance-sheet lending are already achieving by stealth reforms which it would be difficult or even impossible to push through openly.
After seven years during which the real return on 12-month time deposits has averaged minus 0.5 per cent, savers are beginning to desert conventional bank accounts. As the second chart shows, over recent months China's deposit growth has slumped to its lowest level in 10 years.
Instead, savers are lending directly in the underground market or investing in structured notes and other shadow products which channel capital to private-sector borrowers for higher rates of interest.
Now, by legitimising this market in the private-sector heartland of Wenzhou, the reformers hope to introduce market forces into the financial system, providing state-owned banks with genuine competition for the first time.
Forced to compete for deposits, state banks will have to price credit more aggressively, which in turn will mean stepping up lending to more productive private-sector borrowers at the expense of inefficient but well-connected state companies.
The result, if the experiment succeeds, will drive a more general liberalisation of the financial system, accomplishing much-needed reforms by the backdoor, and helping China to rebalance its growth along more sustainable lines.
At least, that's the way the China bulls see it.