Meet the New Model (Actually Different from the Old Model)

The term of art is that China needs to "rebalance."

It needs to move from export-led to consumption-led growth. Which means it needs to scrap its system of subsidies that transfer money from households to companies—everything from caps on the interest rates banks can offer customers to its artificially-weak currency. But these aren't easy things to do. It's not just that the big exporters are politically powerful. It's that the government is worried about doing anything that would hurt growth short-term, even if it would help long-term.

So there haven't been any big reforms. There's been a big credit bubble instead. Local governments and developers have gone on a borrowing binge the past five years to build new infrastructure and new cities, including ghost ones. In other words, China is getting rich now by building the things it needs to be rich, and putting it all on the credit card. The result, as the ratings agency Fitch points out, has been a bigger credit increase relative to GDP than just about anywhere else in history. As you can see in the chart below from Credit Suisse, total credit shot up from around 120 percent of GDP in 2008 to 190 percent today—most of it from so-called "shadow banks" that aren't regulated. In comparison, U.S. credit "only" went up 40 percentage points of GDP in the five years before the housing bubble popped.

Nobody knows how much we should worry about China's shadow banks, because nobody knows much about them. Not even the people buying their bonds. Reuters, for example, looked into one shadow bank product called "Golden Elephant No. 38" that promises a 7.2 percent return, but doesn't say what's backing the security. After some digging, Reuters found out it was an almost-abandoned housing project in a rural province. This might sound like a scare story, but it's actually a fairly typical one. They looked at 50 other products, and didn't find much better—or any—disclosure.

But it's hard to generalize too much, because China's shadow banks are so diverse. To name a few, there are trusts, wealth management products (WMPs), local government financing vehicles (LGFVs), guarantors, and pawn shops. Some of them are actually pretty sober lenders who fill the credit void for small companies that can't get any from big, state-owned banks—for a high enough interest rate, of course. Some of them are just credit conduits for local governments that are barred from borrowing directly from banks. And some of them sure look like semi-glorified Ponzi schemes. But all of them promise better returns than people can get from traditional banks, which are required to offer meager interest rates so exporters can borrow more cheaply.

Is This Time Different?

What happens if the shadow-bank boom turns to bust? Bad, bad things.