Fears that China is heading for a hard economic landing or even a systemic crisis because of problems in its shadow banking sector are exaggerated.
The spectacular growth in credit has lifted China's debt-to-GDP ratio to over 200 per cent and loan quality has worsened. That has increased the risk of defaults this year. Policy changes from a government keen to rein in excessive lending are adding to the pressure on borrowers.
And foreign media have seized on predictions from some economists that shadow banking will lead to China's own "Lehman moment". Several events have fed that view: China's first true bond default last month, high-profile bailouts for two shadow banking investments and, most recently, a temporary bank run on a small rural lender.
They do not amount to a systemic threat, however. Despite its reputation, large swathes of the shadow banking sector appear to be relatively low risk. Alongside the high-risk, high-return vehicles causing so much concern, investors also buy large volumes of lower-risk products, a sizeable portion of which is provisioned and on banks' balance sheets.
Corporate debt is high but average profitability looks sound and problems of overcapacity and financial stress among corporates are overblown. China has its problem sectors, with steel a good example, but it is not representative of all industries.
If things do get a lot worse, the government has the capacity to absorb financial losses. Total government debt - including that of local governments and their investment vehicles - is a relatively modest 57 per cent of gross domestic product. China also has national savings of around 50 per cent of national output, should the government need to issue more debt.
In a situation of severe financial stress and bailout, total public debt might rise. Policymakers in Beijing might feel uncomfortable about that, but many other, slower-growing countries have a worse fiscal situation.
China's financial system remains robust too. The bulk of credit is domestically financed, making it much less vulnerable to the kind of reversal in foreign sentiment that has led to emerging market crises in the past. Its loan-to-deposit ratio is also far lower than in countries that have endured financial crisis in recent decades.
A major credit event could badly shake confidence in shadow banking and have a serious impact on growth. But there is no obvious reason why this should lead to systemic instability or a hard landing.
I have said for some time that China's growing indebtedness merits a policy response. Policymakers have started to firm up China's monetary stance and tried to rein in leverage and lenders' reliance on funding from the interbank market. Beijing is imposing harder budget constraints on lenders such as local governments and state-owned enterprises. And by allowing China's first corporate bond default in March, the government has sent a message that it will not unquestionably stand behind all issuers.
The necessary job of reining in credit growth could be delayed, however, if worries about China's growth rate lead the government to ease policy. Though we expect growth of 7.7 per cent this year on the back of exports, private-sector investment and consumption, the threat of growth slipping below 7 per cent may well lead to fresh fiscal and monetary measures. That would rightly raise questions about the government's commitment to slow credit growth.
Markets are bound to remain nervous as they continue to see credit growth exceeding output growth by a large margin, particularly if we also see more defaults. But they should understand this does not equate to a systemic threat to China's financial stability or growth prospects.
Louis Kuijs is chief economist for Greater China at RBS