China’s Central Bank Faces Policy Redirection By Investigation

THE ANTI-CORRUPTION INVESTIGATION of Fan Yifei, one of the six deputy governors of the People’s Bank of China, may suggest that all does not bode well for the central bank as Xi Jinping starts his second decade of leadership.

Xi has been investigating more than two dozen financial regulators, state banks, insurers and investment funds since last year to assert Party authority over a financial sector that Xi far from trusts. Fan is the most senior of several financial officials detained over the past year.

Fan spent most of his career as a banker with the Construction Bank of China, so there may be skeletons not as deeply buried in his cupboard as he may have thought. Over-closeness of party cadre to private sector business is now deeply out of favour.

Yet there a clues that there may be policy motivations behind his investigation. Earlier this year, the Central Commission for Discipline Inspection, the country’s top graft-buster, criticised the central bank for failing to meet Party objectives.

The central bank’s top leadership has been a stronghold of economic reformers and advocates of internationalisation of the Chinese financial system, a policy direction for which Xi has little instinctive enthusiasm.

The PBOC’s internationally respected governor, Yi Gang, and its party secretary, Guo Shuqing, were removed from the Party’s central committee during the 20th Party Congress last month. That is seen as a prelude to them leaving their positions early next year when senior government jobs get reallocated.

Their replacements are likely to be men who will ensure that the central bank — and the financial sector it regulates — fall into line with Party goals, just as the technology sector has been ‘rectified‘. This Bystander expects to be hearing more about financial inclusion for common prosperity.

Fan’s case is the more interesting because he was the vice-governor responsible for payments and financial technology, which involved overseeing the development of the central banks’ digital currency, the e-CNY or digital yuan. It is an area in which the PBOC has built a substantial lead over other central banks. Fan’s last public appearance, in September, was to announce a further expansion of its trial.

Putting Financial Stability Ahead Of Growth

IN THE SIX years since the International Monetary Fund last published a Financial System Stability Assessment of China, credit has boomed, spreading shadow banking has added complexity to the system, and moral hazard has grown as belief in the implicit state guarantee to firms and investors has remained unshakeable.

In short, financial instability risks have grown rapidly.

Within the constraint of maintaining growth and employment, authorities have responded to mitigate the risk and to put the expanding financial system on the right footing to support the ‘rebalancing’ of the economy from being led by infrastructure investment and export manufacturing to being more consumption and service driven.

There is much more to do, however, as the Fund outlines in its latest assessment.

Some of that will be politically challenging, notably allowing firms to fail, markets to fall and investors to lose money, which will be the consequences of removing the implicit guarantee that the state stands behind financial loans and products. They will also require detailed technical work on bankruptcy procedures, financial education and even social security safety nets.

Political priorities will also need to be adjusted to put financial stability ahead of economic growth. That is already starting to happen as job losses, particularly in heavy industry and primary production, and slowing economic growth more generally shows. However, the tolerance for both is greater at the higher levels of government than at the local one, where the expectation among officials that promotion depends on creating good economic growth numbers is proving hard to break. The massive task of reforming local government finances is probably a multi-decade, not just multi-year endeavour.

Improving the supervision of the financial sector is an easier piece to bite off, and authorities have been systematically expanding that for banks, insurance companies and securities firms in recent years. The Fund recommends setting up an umbrella regulator focusing solely on financial stability to coordinate the oversight of systemic risk across sectors.

This regulator, which would be an institutional version of the recently established Financial Stability and Development Committee, will need authority and independence over the sector supervisors and an improved flow of data given the scale and complexity of the country’s financial system, especially in some of the murkier areas of shadow banking. As was seen in the West with the 2008 financial crisis, failure to monitor risks outside the regulatory perimeter can be the most damaging failure of all.

The Fund also suggests that the well-advertised rapid growth of debt requires banks to hold a plumper cushion of capital, and particularly at the larger banks that are systemically important. Greater capital reserves would not only provide a buffer in the event of a sudden or severe economic downturn, but also against the particular risk with Chinese characteristics of the extensive off-balance-sheet borrowing, notably for wealth management products, that the banks implicitly guarantee.

In the same vein, banks and financial institutions should be nudged through lending rules to stop using short-term borrowing to finance their investments and instead both lend and fund longer-term. Should it come to it, and a financial institution goes under, regulators should have their powers expanded in line with international standards to let the firm to ‘fail safely’ rather than prop it up with public funds.

Another area that the Fund urges oversight is digital finance, or fintech, which as expanded significantly in China as elsewhere. Existing oversight frameworks are often ill-fitting for the innovation that comes with fintech, though the need for systemic safety and soundness is not diminished.

The Fund calls China ‘the global centre of fintech’, noting the growth of peer-to-peer lending and the emergence of payment systems run by internet retailers such as Alibaba that are competitors to the banks’. Smartphone app WeChat’s WeBank is already a competitor to banks’ lending.

The scale of this is still small compared to the overall size of the banking system and thus not a systemic risk — yet. Nonetheless, they will need to be brought into the regulatory and supervisory scheme of things. This is starting to happen following the State Council last year launching an overhaul of internet finance oversight.

 

China’s Growth Spurt Provides Scope To Tackle Debt

TALK OF A hard landing for the economy seems distant, now. China’s economy grew by 6.9% in the second quarter year-on-year, the same as in the first quarter and well ahead of the official target of 6.5%, the National Statistics Bureau reports.

Quater-to-quarter growth quickened to 1.7% from 1.3%. Industrial output (up 7.6% in the first half) and consumption (retail sales were up 11% in June year-on-year) picked up while investment remained strong, suggesting that measures to control the frothy housing market have not yet worked through, or perhaps are not working as effectively as policymakers intended. Property investment increased by 8.5% year-on-year in the first half.

The extent to which property prices cool over the rest of the year will be closely watched. If they do, despite the solid underpinnings of the recovery, the growth rate may moderate in the second half, though not to the extent the official target will be threatened.

The long-term build-up of structural imbalances, manifest in the growing levels of debt, remains, but the latest growth figures give the leadership some scope for pushing through financial reforms at the party plenum later this year.

Some of those, notably the expansion of bond markets to allow direct financing of local governments and enterprises in place of policy lending by banks, will have been thrashed out at the two-day National Financial Work Conference that ended at the weekend.

That this quinquennial meeting chaired by President Xi Jinping was convened a year late this time indicates how politically contentious economic reform remains, not least because they also intend to rein in the debt of state owned enterprises, themselves powerful political fiefdoms.

Markets Expose China’s Inherent Economic Contradiction

THE RECENT VOLATILITY in financial markets has brought into question the capacity and nerve of China’s policymakers when confronted with variables they cannot control politically. This heightens concern not so much about the gathering pace of the economic slowdown as about the country’s prospects for the next stage of the economy’s d development, ‘rebalancing’ away from export and capital investment-driven growth and towards domestic consumption.

In what was mostly a closed economy, policymakers had relatively few monetary and fiscal levers to pull, but they were effective when yanked. Administrative guidance was particularly efficient. As the financial system has been opened up, the less guidable animal spirits of market forces have come more destabilisingly into play. The new tools to control them have arrived piecemeal, an inevitable consequence of the deliberately measured pace of financial-sector liberalization.

The currency has been in the vanguard of the reforms in lockstep with freer capital flows, moving steadily along the path of full convertibility, whose final destination has allowed the yuan to achieve the accolade of inclusion in the International Monetary Fund’s basket of reserve currencies.

The People’s Bank of China has a deserved reputation in financial circles around the world for the high calibre of its officials. But even their competency has been questioned following their uneasy and unexpected guided devaluation of recent weeks and their attempts to bring the tightly managed onshore and market-driven offshore exchange rates into alignment, a move undertaken for SDR-related reasons as much as currency management, but done with a tin ear for timing.

The central bank’s switch to managing the yuan’s value against a basket of currencies was both poorly signaled and sent mixed signals to investors, who tend to focus on the exchange rate against the dollar.  If investors lose confidence in the central bank’s effectiveness in the execution of monetary policy, it will only feed the volatility of the equity markets, where officials have already revealed a far from sure touch in their attempts to stabilize the markets.

While it may be virgin territory for many of them, policymakers clearly miscalculated the linkage between tumbling equity prices and speculative pressure on the currency, and how quickly the currency would become the focal point of market unease about China’s economic prospects among investors. It also says something about how the world has changed that the competency of Chinese policymakers has supplanted U.S. monetary policy as the primary determinant of global investor sentiment.

It is the nature of financial markets to be volatile in greater or less degree. Policymakers will learn by experience the limits of their reach in such an environment. Three decades of history will have left them more naturally inclined to intervene than not, which will make that learning painful and slow — last summer’s lessons from the mishandling of the stock-market plunge were clearly not well learned this most recent time round.

However, the broader concern to this Bystander is that financial-market turbulence will encourage Beijing to backslide on further financial-sector reform and more broadly on rebalancing. For some months, it has been dialing back on talking up the need to reduce government intervention in the economy. The third Party plenum at which the top leadership pledged to give market competition a decisive role in the economy seems longer ago than the 30 months it was.

Similarly, the notions that powerful bureaucrats can be a panacea for all economic ills and that the state can trump the market are fading. With that will come doubts in the some senior minds that the Party can pull off the unprecedented trick of liberalizing China’s economy without doing the same to its political system, unacceptable to the Party though the later is.

The certainty that state control provides versus the benefits that free markets bring is the inherent contradiction that may have been manageable for the past 30 years of the economy’s modernization but which, as Japan and South Korea have shown on a smaller scale, becomes more not less contradictory as an economy advances and becomes too big and complex to answer to political imperatives — and to the bureaucrats imposing them.

Making The Half Empty Glass of Financial Reform Go Away

THAT CHINA’S FINANCIAL system is “unbalanced, repressed, costly to maintain and potentially unstable” will not brook many arguments among policymakers in Beijing. It is, after all, why they are deep into an extensive programme of financial reforms, reforms that are seen as central to the long-term rebalancing of the economy.

It is also why “a weakly regulated shadow banking system” and a tendency of “wasteful investment and over-indebtedness” that is the consequence of a “traditional investment-driven growth model shaped by heavy state intervention” are also being tackled as policy priorities.

However, it is one thing for officials to know that and quite another to have it told to them publicly by the World Bank.

The phrases quoted above were all contained in a section of the Bank’s latest China Economic Update, published mid-week, which called for a quickening of financial-sector reform. The entire section has now been removed from the update, because, the Bank says, “it had not gone through the World Bank’s usual internal review and clearance procedures.”

Whatever, this Bystander is tempted to say. Any red faces at the Bank are probably due as much to the tongue lashing that would have come from Beijing as from the embarrassment of having to redact a section of a report post-publication.

With share prices on the Shanghai exchange in meltdown and the signing ceremony earlier this week setting up the Asian Infrastructure Investment Bank (AIIB), a putative rival to the Bank’s regional clone, the Asian Development Bank, and longer term to the Bretton Woods’ multilateral institutions as a whole, there could be some understandable sensitivity on both sides. Also, China readily takes public offense at any perceived criticism by any institution seen to be in the pockets of the U.S. and the EU — and the World Bank has previous in this regard.

What, to our mind, lies behind this particular spat is that when the International Monetary Fund comes to consider in October whether to endorse the renminbi as an official reserve currency by including it alongside the dollar, sterling, euro and yen in the basket of currencies that comprise its Special Drawing Rights, progress on China’s financial reform — and particularly whether renminbi interest rates are market-based — will be a key criterion.

The IMF reviews the components of its SDRs every five years. It would be an unwelcoming rebuff for China, which is being ever more assertive in claiming its place at international top tables, if it were made to wait until 2020 for inclusion.

As recently as March, Prime Minister Li Keqiang told Christine Lagarde, the IMF’s managing director, that China intended to speed up the financial sector reforms needed to meet the stringent requirements of stability and liquidity demanded of a reserve currency.  With IMF staff preparing their internal assessments for the 2015 SDR review around now, this is not a time when Beijing will brook any public plain-speaking about the pace of financial reform.

China’s Financial Regulators’ 2014 Priorities

CHINA’S FOUR MAIN financial regulators have outlined their legislative priorities for the year: No great surprises. The introductions of catastrophe and food liability insurance, probably the least discussed reform proposals to date, are in line with the Party’s overall top priorities for the year, food security and improving the rural environment. In summary:

People’s Bank of China: Expand cross-border use of the yuan; maintain steady credit growth; improve the multi-tier capital market; and engage further in international financial regulation policy-making.

China Banking Regulatory Commission: Pilot three to five private banks, opening up the banking sector to domestic and foreign private capital; gradually reduce the threshold for foreign banks to enter the banking sector and ease their RMB operation requirements; keep a close eye on big housing developers, and reduce the risk of default through weak links in the construction industry’s money chain; restructure overcapacity industries, liquidating their assets and reducing the risk of default.

China Securities Regulatory Commission: switch IPOs from the current approval system to one based on registration; let the timing of IPOs and how shares are issued be determined by the market, as long as issuers disclose all relevant information as required; abolish approval requirements on 21 items over the next three years starting from 2014.

China Insurance Regulatory Commission: work with the finance and other ministries to implement catastrophe insurance; set up food liability insurance, given the importance of food safety in China.

Banking On Privately Owned Banks

THE ANNOUNCEMENT EARLIER this week of a pilot programme to establish three to five private banks this year is a tiny first step towards providing competition to China’s giant state-owned banks and easier access to mainstream banking services for small businesses. Don’t forget that many of China’s 3,000 banks are already majority privately owned but they collectively account for just 11% of the banking sector, underlining the embedded advantage the big state-owned banks derive from their national branch networks and the immense deposit bases those provide, as well as from their political connections and implicit state guarantees.

The pilot scheme is another piece in the mosaic of financial reform that is itself part of the grander design for rebalancing China’e economy. It starts to fulfill one of the pledges made at last November’s Third Plenum policy meeting, though the qualification requirements to establish one of these new banks remain unclear. But broadly what will make them different from existing private banks is that they are intended to be entirely privately financed, and would “bear their own risks” — no de facto policy role nor implicit state safety net.

Another way to further open up the financial sector, increase competition, and provide small businesses with an alternative source of finance to the shadow banking system would be to make it easier for foreign banks to enter or expand in the industry. The state’s banking overseer, the China Banking Regulatory Commission, is looking at that but it wants to let some home-grown “trusties” to get established first.

That could include restructuring some existing state owned local and regional banks under new private ownership. A range of non-financial sector players have expressed interest in getting into banking since the possibility was floated last year. Among them are Wang Jianlin, chairman of Dalian Wanda, one of China’s biggest property developers. Others include another developer, Macrolink Real Estate, retailers Shanxi Baiyuan and Suning, which already has millions of customers using its online payments system and a network of 1,700 stores, and Internet giant Tencent.

A Key Question For China’s Financial Reform: How Small Is A Large Role For SOEs?

Prime Minister Wen Jiabao’s comment about breaking up what he called the monopoly of the four big state-owned banks is the tip of the iceberg in the fierce internal debate about the role of state-owned enterprises (SOEs) in China’s economy. That debate falls under the general but misleading rubric, financial reform. Yet it is not about privatizing the banks and the SOEs. Nor is it about replacing China’s model of state-driven capitalism with a free-market version. It is, instead, about two critical but related political questions. First, can the Party can still achieve its policy goals–of which the overriding one is maintaining its monopoly on political power–while controlling, through the state, a smaller share of economic output? Second, how far dare it go in risking loosening its political control by shrinking the state sector in order to let the private sector create more of the economic growth it needs to legitimize its monopoly on power?

This debate is going on against the backdrop of a leadership transition, always an unsettling time, and compounded by now being in conjunction with a critical transition in China’s economy. It is widely if not universally accepted among the top leadership, that China’s three decades of rapid fixed-investment and export-fueled growth are coming to their close. The country needs to rebalance its economy to get the sustainable growth that will let it slow the economy without coming to a full-stop, to defuse the debt bombs and deflate the asset bubbles caused by its investment-fueled growth, and to make the great leap forward to clear the middle-income trap and land as a developed economy.

How much structural change does that require, not just economically, but politically? More pointedly, how much further can economic reform go without political reform? It is a debate that has been off-limits, in public and much of the Party, since 1989, not least because it questions the trade-off of continuing rising living standards for living under of one-party rule (with the acceptance of the corruption and cronyism that involves rather than concern for the absence of Western-style civil rights and liberties.)

Hard-line statists and Mao revivalists, the so-called neo-Comms, maintain that the SOEs–and a firm stabilizing social hand–are a tried and trusted means to steer the economy through its present challenges, validated by the 2008 global economic crisis that laid low Western free-market economies. They provide the Party through the state with a mechanism for the administrative guidance of the economy. In the absence of market-based monetary policy tools, the big four banks sit at the center of this web of control dialing up or down the available supply of funds to their SOE customers as required to regulate investment levels.

Economic reformers fear This model are no longer fit for the new task at hand. The banks are inefficient allocators of capital, as the mounting piles of bad bank debt attest, while the SOEs crowd out the private sector, notably small and medium-sized enterprises that will be needed to create the productivity growth, jobs and innovation that China will need for the next stage of its economic development. With the inopportune political demise of Bao Xilai, the ex-boss of Chongqing and poster boy for the post-Maoist revivalists, putting the old guard on the back foot for now, the reformers are taking the opportunity to press their case. They are not calling for the abolition of SOEs, but saying that they need shaking up and scaling back, a case also argued by the Development Research Council/World Bank report on China in 2030, which we described as a “political manifesto disguised as an economic blueprint”.

China has more than 110,000 SOEs, but the 121 “national champions” in the strategically important “pillar industries” that report to the State Assets Supervision and Administration Commission (SASAC) and their big state-owed lenders (separately regulated) are the nexus of the country’s state-directed capitalism. They have a sway over the economy disproportionate to their number–5% of corporations but 40% of GDP at best guesses (nearer 50%, if thousands of small rural local-authority-controlled enterprises are included). In the pillar industries, which include both strategically important sectors and emerging technologies, SOEs control more than 90% of the assets. Their political and economic power have become so entwined at all levels that they have become deep redoubts of vested interest.

Consolidation, driven by merger and acquisition (the number of national champions, for example, has been reduced from 193 in 2003), now means that 40 or the 46 Chinese companies that rank among the world’s 500 largest corporations are SOEs. That only gives the biggest even more economic and political clout with which to defend the privileges they enjoy. The most topical of these is their ready and cheap access to loans from the big state-owned banks. Private companies are mostly forced to turn to unofficial sources and pay usurious interest rates–the issue Wen highlighted and the experiment in Wenzhou is seeking to address. SOEs get favorable tax treatment, and land and raw material subsidies. They are first choice when it comes to government procurement. As with bank loans, it keeps it all within the club. SOE staff have a powerful incentive to defend their turf, too: salaries are five times the average in the non-state sector. The benefits are better, too, and the political access unrivaled.

With the caveat that SOEs as a group are no more monolithic than any other large group of companies across multiple industries, privilege has not turned into performance. Qiao Liu of the University of Hong Kong has calculated that the average return on equity for SOEs to be 4%, compared to 14% for unlisted private firms. But there is a great range among the profitability of SOEs: those in industries dominated by the state are highly profitable; those in sectors with high levels of competition, not so. (Gao Xu, while working as an economist at the World Bank’s Beijing office, made a detailed analysis of SOE performance by industrial sector.)

China’s WTO membership committed Beijing not to interfere in the commercial decisions of SOEs, but as top executives are appointed by the Party, SOEs tend to be politically self-regulating. They take it as a patriotic duty to fall in behind the goals of five-year plans. That is not to say they are docile handmaidens. As players in the patchwork of power and patronage that rules China, they have their own agendas to promote and turf to defend, as well as those of factional interests allied to them. One reason that the pace of financial reform has been so glacial in recent years is that it is seen by SOEs as a threat to their position.

That has not prevented reformers’ long-standing efforts to at least improve the governance of SOEs, by structuring them less like ministry departments and more like shareholder corporations, even if government at some level is the sole or controlling shareholder. The creation of SASAC in 2003 was an attempt to provide external institutional oversight that would promote more professional management of SOEs. More recently, foreign investors have been brought in via offshore listings of SOE subsidiaries in the hope that international management best practice will arrive along with new equity. The biggest SOEs have been pushed overseas in part to experience business in competitive, rule-bound markets that China will, eventually, have to create at home if it is to have balanced growth. This experience has also provided them with a stark lesson in how the rest of the world assumes that even the most commercially-oriented SOEs are an arm of government, as companies like Chinalco and Huawei have recently found out.

Loosening the ties that bind SOEs to state and Party is necessary if China is to give the private sector more scope to drive the growth the county needs to move to the next phase of its development. This goes far beyond just making more credit available to small and medium-sized enterprises, a welcome start though that would be for China’s entrepreneurs. However, socialism with Chinese characteristics, or even capitalism with Chinese characteristics, means that state-owned companies will continue to play a large role in the economy. Privatization, as happened in the former Soviet Union and Eastern Europe, is not on the cards. It is a matter of how small is large.

For foreign companies and investors, some sectors will become more open to them as they will to private Chinese companies. Others, strategically important, will remain off-limits not just to foreigners but domestic private firms as well. SOEs will strongly resist being reined in, as they have successfully done before. They may find the fight tougher this time. The political stakes are certainly higher as the Party confronts its defining dilemma: how to loosen the ties that bind without endangering either economic or, worse, political stability.

Breaking Up China’s Big Banks

Every leading nation’s big banks wield political clout. China’s, being state-owned and run by big political players in their own right, sit more easily at the center of power than most. They see it as their rightful place. Both they and the government see their role as providing conduits of national policy. Administrative guidance to the banks sets the course for their customers in business and industry in the cause of economic growth, be that slowing inflation, deflating bubbles or stimulating growth. So when Prime Minister Wen Jiabao says the big banks’ monopoly needs to be broken as they make easy money for themselves while denying loans to cash-strapped small and medium-sized enterprises he needs to be assured that he is safe in rattling such powerful cages and that the need to do so is urgent.

In the words of the song, breaking up is hard to do. Yet Wen’s words at least get the idea on the table and add to the determined thrust by the economic reformers to use the leadership transition now underway to revitalize near moribund financial reform. Wen again pointed to the pilot scheme in Wenzhou to create alternative financing channels for small and medium-sized enterprises in the city that have hitherto been forced into the usurious shadow banking system. This is being seen by some as an experiment that if successful will be expanded more broadly as a necessary underpinning of the rebalancing of the economy towards domestic demand.

The prime minister’s words came as regulators further opened capital markets to foreign investors. That, though, is politically easier to do than taking on the big banks, large redoubts of vested interests that they are. The opportunity to do so may lie in the slowing economy turning more bank loans sour. Government has had to step in once before to clean up the state-owned banks’ balance sheets. The price for doing so again could be more conditional. And might it even include the big banks improving their rudimentary credit-risk analysis? A bit more competition wouldn’t go amiss in that regard, while plenty of entrepreneurs would be happy to have their creditworthiness judged on their business prospects rather than their political connections.

Bringing Wenzhou’s Black Lenders Out Of The Shadows

Wenzhou is a case study in the deep fault lines underlying China’s financial system. While big state-owned enterprises could get credit easily and cheaply, even in the face of the official squeeze on bank lending to cool inflation, small and medium sized company owners and entrepreneurs had to turn to the underground banking system where interest rates can top 60%. In Wenzhou, it is estimated that lending through the shadow banks, also known as black banks and which run from unregulated lending pools to loan sharks, amounts to $78 billion a year — accounting for a fifth of the lending in the city. Some 90% of its households supply the capital in an attempt to get a higher yield on their savings than is available from official banks.

Yet the city, which prides itself on its entrepreneurial flair, has also seen a rash of suicides and absconsions by heavily indebted borrowers unable to meet their crushing interest payments, especially as the economy slowed and speculative real estate and stock market investments, into which much of the borrowed money had been directed, fell in value. Around 100 business owners from the city disappeared or declared bankruptcy. Though only a few firms have collapsed, the interconnectedness of small businesses causes cash-flow reverberations up and down supplier and customer chains. One in five of Wenzhou’s  360,000 small and medium-sized enterprises reportedly stopped operating last year due to cash shortages.

So serious has the credit crunch and the risk of a bad-debt implosion become in Wenzhou that, a police crackdown on borrowers having failed to deter the lending, the State Council has now approved a pilot project to bring this shadow system into the light. Some lenders will be allowed to convert to rural banks or micro-finance companies, big state-owned banks will be directed to make more credit available in the city (as they already have been), and new savings and investment vehicles, including offshore ones, will be opened up to city residents and small and medium-sized enterprises. These vehicles will offer potentially better returns than bank savings accounts. (With the persistence of inflation over the past 18 months, real interest rates have been negative.)

The proposals are also intended as a test of expanded financing channels for small and medium-sized businesses, as well as an attempt to drain the property and stock markets of speculative capital that authorities would prefer used to keep growth and employment going in the real economy. What is not yet clear is whether these new  institutions will experiment with market-set interest rates, as the original set of proposals put forward by the city government last November had called for. That may still be a reform too far.

Nationally, the underground banking system was officially said last year to have $470 billion in outstanding loans, though unofficial estimates are half as much again. Fitch, a U.S. ratings agency, has estimated that every other yuan now lent in China comes through a shadow bank. That is a scary share for an unregulated sector surrounded by still inflated asset bubbles. It is fault line that runs deep and far beyond Wenzhou.