Shadow Banking Poses Threat to China’s Economy

Frank Langfitt delves into how China’s new leaders are confronting  threats to their economy:

Last week was a wild one for China’s economy.

Interest rates on the loans that banks make to one another soared to alarming levels, and lending began to freeze up. Shanghai stocks nose-dived, taking Asian markets and the Dow, briefly, with them.

Things have calmed down, but the crisis showed how China’s new leaders are trying to confront threats to the health of the world’s second-largest economy.

In this particular case, the People’s Bank of China — the nation’s central bank — wants to cut down on rampant and risky lending. So earlier this month, in a departure from the past, it refused to pump money into the system when some banks desperately needed it.

Of particular concern is what’s known as China’s “Shadow Banking” sector:

Here is an example of how shadow banking can work and why it concerns the government: A state-owned company borrows from a state-owned bank at a government-set low interest rate, maybe 5 percent.

The company then re-lends the money at a much higher rate of return, say 10 or 12 percent, to a private trust company that is part of the shadow banking sector. That trust company then lends the money into a more speculative part of the economy, such as real estate.

In order to avoid a crises, not unlike America’s subprime mortgage meltdown, the Chinese leaders are putting pressure on the shadow banking sector as a first step in a long process to build a new, more sustainable and efficient economic model.