Runaway loan growth in China reflects the structural deficiency of the system. Bankers at local levels tend to entertain the credit needs of large, local business/politically vested interest groups. The networking and allegiance of these groups are to relationships in their local areas, not to the top management of banks with headquarters in Beijing or Shanghai.

Banks in China therefore have a tendency to over-lend. The central bank sets overall lending targets annually, and at the start of every year a new accounting period begins. Thus, for years, more loans are made during the first half of a year, as by the second half, the system is usually already over-loaned, and the central bank may step in with quotas.

When loan flood gates are initially opened, borrowers grab what they can because if they don't, others will; and if enough borrowers think that way, the bigger the rush will be, eventually forcing the gates to close, which happened in 2009. This year is again the start of a new accounting period and, sure enough, the rush is on. Over Rmb1,000 billion in loans were made in the first three weeks of January (vs. Rmb9,600 billion net loan growth for the whole of 2009, in itself a record).

The problem, therefore, is not about credit tightening, which is the market's current (wrong) interpretation. So much has already been loaned that even if no loans are made for the rest of 1Q10 (an unlikely event), the economy would still be flush with liquidity. The problem is structural: how to reform bank management so that credit extension is based on economic terms rather than on social/political relationships. The stock market fall has already discounted a rise in CPI to 3% to 4% over coming months, including a modest rise in interest rates. CPI pressure should abate by mid-year (low base effect from the plunge in commodity prices in 1H09). Government policy in China is definitely very much pro-growth, and domestic consumption (especially in the rural sector) will be the key engine.

Eoin Treacy's view Reform of how banks allocate credit gets to the heart of the cronyism that is associated with any communist system. One of the benefits of an authoritarian, controlled economy is that policy decisions can be carried out quickly and efficiently when the full force of government attention comes to bear. However, such a system lacks the checks and balances of more open societies; allowing corruption to flourish since those with connections to the ruling party can avoid regulation that might otherwise be onerous.

Improving the efficiency and integrity of the banking system are priorities for the Chinese but these are mammoth tasks and require greater leeway for the banks in how they issue credit and a crackdown on kickbacks and the inherent corruption of the system. This is likely to be an evolutionary process and could take years to achieve.

On another front, this story from Bloomberg News highlights progress in the development of the consumer economy by bringing more people into the social security net. Here is a section:

The government will allow so-called "qualified farmers" to become official residents in cities, Chen Xiwen, head of the agricultural affairs office under the State Council, said at a press conference today. Rural migrant workers who qualify will enjoy benefits including social security coverage, government- subsidized housing and education for their children, Chen said.

China had an estimated 149 million migrant workers at the end of 2009, Ma Jiantang, head of the National Bureau of Statistics said Jan. 21. Premier Wen Jiabao aims to boost consumption by strengthening the social safety net in a nation where most people live in the countryside on incomes of less than 5,000 yuan ($730) a year.

A more "balanced development" with an emphasis on accommodating migrant workers will help boost economic growth, Chen said. The Chinese economy expanded 10.7 percent during the last quarter of 2009 from a year earlier, the fastest pace since 2007, buoyed by new loans.

Rural migrant workers will qualify for city living and can apply for legal residency if they meet certain requirements including having held down a stable job and have a permanent address, Chen said, without elaborating.

Rural immigrants are currently not entitled to benefits afforded city dwellers if they live in urban areas.

We have been arguing for some time that if the consumer economy is to flourish in China, greater access to basic healthcare and social security would need to be part of any solution so that people could reallocate savings. This now seems to be forming a greater part of government policy which is to be welcomed.