First, it was U.S. subprime mortgages, which regulators thought could be handled with barely a blip on the collective financial system. Then, it was EU sovereigns and the banks that love them – again, regulators crossed their fingers and promised nothing really bad would go wrong. And, now, let’s take a look at China. Regulators too are talking happy, but the latest batch of signals from afar are, we think, profoundly frightening. Do they foretell yet another bout with systemic risk? Let’s hope not, as financial institutions remain largely unprepared and national economies are weak, at best.

Why so wary? We read with alarm the latest report from the China Banking Regulatory Commission (CBRC). In it, a stalwart bureaucrat trying to head off disaster discloses the consequences of an order the year before from higher ups to fire up the banking system. In 2008, the word went out to stimulate a flagging economy and, the top-brass hoped, to keep at bay the political instability that always threatens the Chinese capital from the struggling hinterlands. But, the boom they mandated sowed the seeds for the dangerous bust foretold in the CBRC data.

The Financial Times has rightly called the China market a “credit binge.” The CBRC 2009 data showed an astounding increase in outstanding bank loans in one year of $1.4 trillion. This might not sound like so much in a big, developed economy, but the total is 25 percent of all outstanding bank loans in China. And, if the sheer volume of new loans doesn’t scare you, then take a look at who got lots of them: the already way over-heated Chinese real-estate sector and the special vehicles established by local governments to funnel money otherwise forbidden them from the banking system. Loans to these local-government entities – all run by fine upstanding officials who wouldn’t dream of opening an account or two in Macao – now account for about twenty percent of all bank loans in China.

The Chinese government is trying – at least sort of – to deal with this mounting risk. On the Sunday before the CBRC report was released, it told the local-government vehicles to straighten up. It has also tightened the banking system’s reserve and capital requirements. This was nice, given how lax the prior rules were, but it doesn’t solve much of the problem because the CBRC’s ability to enforce its will is, at best, still a work in progress.

So, can we isolate China from the rest of the world and let its banking system go bust? Of course not. As China has integrated into the global economy, so has its banking system. U.S. banks have nothing like the exposure to China and Chinese banks that they do to the EU. Still, it isn’t negligible and EU banks don’t need any more trouble should their Asian exposures – for China will cast a wide pall – prove risky. There’s nothing anyone can do about China except cheer on its hard-working regulator. But, other financial regulators need to look very carefully and very quickly at any potential contagion risk. And, the G-20 might spare a thought about China’s banks as it takes a hard whack at that nation’s currency valuation when it meets later this week in Toronto.

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