Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise. By Carl Walter and Fraser Howie. Wiley; 250 pages; $29.95 and £19.99. Buy from Amazon.com, Amazon.co.uk

IT COULD be said that any financial system that appears to be robust will, in time, reveal some underlying rot. In the late 1990s, for instance, the Asian financial crisis appeared to confirm the virtues of London and New York—then the global financial crisis happened.

Anyone who is overly impressed with the apparent resilience of China today would do well to read a new book by two bankers who have worked there for many years, Carl Walter and Fraser Howie. “Red Capitalism” avoids the standard approach to Chinese analysis, which uses mounds of macroeconomic data that even Chinese regulators acknowledge are replete with flaws. Instead, the authors examine how China's financial system has grown from pretty much nothing three decades ago into the dynamic, bewildering and possibly doomed set of institutions that fill the landscape today.

The book is, in many ways, a story of remarkable progress. In 1974 a delegation to the United Nations led by the future Chinese leader, Deng Xiaoping, almost never left home because there wasn't enough cash in the banking system—the entire Chinese banking system—to pay for the delegates' plane tickets. Conditions worsened even further after that. By 1978, when Mr Deng returned from yet another political exile to assume power, China's formal financial system had shrunk to a single institution, the People's Bank, whose head office was made up of 80 people buried within the Ministry of Finance.

Skipping ahead, China now has more dollars than it can spend and its financial system is populated by a constantly expanding array of institutions. This is no accident. As “Red Capitalism” describes, it was Mr Deng's goal, pursued with the vital support of his immediate successors, President Jiang Zemin and Prime Minister Zhu Rongji, who pushed through changes that were thoughtful, often brutal, and sometimes mistaken.

China's system opened with a bang in 1979. During the decade that followed, it created 20 banks, 745 trust companies, 34 securities firms, and 180 pawn shops, the authors have calculated. The consequences were disastrous and led to a radical clean up. During the 1990s hundreds of financial institutions tied to local governments were closed, along with Guangdong International Trust & Investment Corporation (GITIC), the second-largest non-bank financial institution. Losses were huge both inside and outside of China, and in the ensuing credit tightening, the collateral damage was not limited to the malign and the corrupt. Many jobs were eliminated. Growth in pivotal Guangdong province slowed and business on Hainan Island was brought to a virtual standstill by a real-estate bubble, now once more a problem.

Despite the evident pain, reform continued. Obstructive institutions and ministries were crushed or reconfigured; crooked party members jailed. Bit by bit, the standard components of modernity were put into place, including stock, bond and commodity markets, asset management and credit analysis.

The process culminated in 2005 and 2006 with public listings in Hong Kong of China's three largest banks. By that time, however, President Jiang and Prime Minister Zhu had already been out of office for two years and a key ally for reform, Vice Prime Minister Huang Ju, was terminally ill. With their departure went the willingness of the top leadership to endure the brutal volatility of market-oriented systems, and that, in turn, weakened the push for a floating currency, independent pricing of debt and other securities and international access to China's capital markets. The appetite for turning financial institutions into real commercial operations disappeared also.

Reform was relegated to an expanding number of squabbling bureaucracies. China's new senior leaders, having risen, unlike their predecessors, during years of strong growth, were concerned less with the threat posed by a stunted financial system than with widening income disparities and the possibility of social unrest. Their aims shifted to social goals, notably achieving a “harmonious society”. As a result, China's financial reform stalled and the country has never truly opened itself up to the world. Foreign firms hold trivial amounts of domestic financial assets (under 2%), and play only a marginal role in any domestic sector.

There have been some advantages in this. Chinese banks were not, in the main, exposed to toxic Western debt and, perhaps more importantly, never adopted dangerous Western methods of hiding risks. But China's own approach presents these problems in a different form.

To the extent that risk has been distributed, it is largely from state-controlled banks to other state entities in increasingly arcane ways. This distorts external perceptions of China's solvency. State debt appears to be quite low by international standards (just under 20% of GDP) but when all government obligations are lumped together, the authors reckon it is actually 76%.

The bigger problem, though, is that the system trades almost entirely with itself. Critical information about liabilities and pricing is deliberately concealed or impossible to discern; there are no outside entities establishing prices by bidding in the market. That undermines efficient capital allocation and allows excesses to fester.

Many officials are aware of this, but conflicts of interest get in the way of resolving the problem. As the book details, the whole business of providing, receiving and regulating money involves one state entity or another. It may be in China's overall interest for the system to open itself up, but doing so would pit the government against itself. That will not happen without commitment from those on top.

“Red Capitalism” shines an unprecedented light on a remarkable effort to build a system that appears to be comprised of sophisticated companies and markets. But the book also shows that a more primitive system, with vices as well as virtues, lives behind this façade. There is enough in “Red Capitalism” to provide China bulls with facts to justify enthusiasm for all that has changed, and yet still leave them wary of the future.