THERE may as yet be no official confirmation that the Chinese Government is going to shake up the management of the People's Bank, but there are no denials from Beijing that the banking sector is running out of its control. The problems in the sector are particularly urgent because they are central to almost all areas of China's economic reform programme. The central bank's research and statistics department spokesman Zhang Xinze recently went to the roots of the problem facing China's banking system. He pointed out that China was rapidly moving toward a market economy, but fiscal reform and credit system reform could not keep pace. Consequently, the specialised banks have been burdened with too many policy loans as against commercial loans. Their ambiguous dual role of supporting state-owned firms and maximising profit has left the banks in an awkward position. ''One-third of the state-owned enterprises are running at a deficit and are depending on these specialised banks' loan for funding,'' says Hongkong Baptist College Professor Tsang Shu-ki. ''But about 20 per cent to 30 per cent of the specialised banks' funding comes from the central bank. That means these banks' balance sheets are very fragile and cannot stand on their own.'' Once the banks stop lending to the state enterprises, the firms will run into financial trouble and will have fewer tax contribution which, in turn, will affect the central bank's funding source. ''It is a vicious cycle,'' he adds. On the other hand, ever since paramount leader Deng Xiaoping set off an investment frenzy, banks have stretched their credit limits to lend in the booming property market and investment projects. At the same time, banking regulations make lending through official channels difficult. ''The result, not surprisingly, has been a surge in the use of unofficial channels. Both banks and non-bank institutions have found creative ways to lend,'' says an HG Asia report. While financial institutions other than banks are not subject to lending limit, some borrow heavily from specialised banks to grant loans and engage in investments. Some banks even set up subsidiaries to invest directly in projects, such as property development. Instead of lending, the bank takes a stake. ''The profusion of new investment trust corporations and underground money lenders has been a similar bid to raise and invest capital,'' the report says. Compared with the government-set interest rate of around 9.5 per cent a year - which can hardly match inflation of 17 per cent in coastal areas - the interest rate non-bank institutions offers is in the range of 20 per cent to 40 per cent. Some institutions in Guangdong province are reported to charging up to 50 per cent. ''It is estimated that around HK$100 billion to $200 billion was lent through unofficial channels last year,'' Professor Tsang says. What is so frightening about unofficial lending is its immense multiplier effect because there is no reserve requirement. Consequently, as Mr Zhang said: ''We [the government] cannot successfully achieve the goal of money supply management through credit amount prescription.'' Another negative effect is the draining away of funds from the banking sector. ''Low deposit rates kept customers away, while the negative real interest rates caused a lending boom. Money quickly left the official banking system,'' the HG Asia report says. The report further estimates that in the second half of last year, about 47 per cent of the currency was held outside the official banking system. The wider measure of money supply (such as M3) would show a higher growth rate than the 30 per cent for M1. At the same time, because funds are being tied up in investments, banks are facing cash shortages. Failure to pay farmers has already sparkled rural riots, giving the banking problem a strong political overtone. To rectify the chaotic situation it is necessary to transform specialised banks to truly commercial banks and separate policy lending from commercial lending. But the timing is important. ''It is not feasible in the short term. It can be done only after the state enterprise sector has been restructured,'' a Smith New Court China report says. Secondly, unofficial lending has to be curbed. Tight regulation is needed to halt the rampant lending which disrupts any organised monetary policy. Control over banks' lending should be maintained so that funds can be directed to state priority projects and neglected areas like procurement of agricultural products. Interest rates have to be brought up to a reasonable level, Professor Tsang suggested. ''They should be substantially increased so as to narrow the differentials between banks and non-banks.'' Above all, there is a need for a strong central bank, not involved in commercial activities, and capable of enforcing strong monetary policy. ''Individual branches engage in commercial lending, in conflict with their central banks role. They have been contributing to excessive credit creation,'' Smith New Court says. It says the PBOC should strengthen its financial supervision over the banking sector and equip itself with effective monetary instruments like open market operations through bills and bonds. Furthermore, interest rates should gradually be liberalised so that they reflect truly the demand and supply forces in the market. All these changes warrant a revised banking law which banks can fall back on, and it has been reported that China would publish its draft banking law shortly. Under the law policy loans for the specialised banks will be hived off into a new state investment bank or separated from loans made on strictly commercial lines.