A recent liquidity crunch that saw Chinas money markets freeze up for a short period is just one of the symptoms of a financial system in which growth of unregulated non-bank financing is outpacing traditional bank lending to a perilous degree. Total social financing (TSF), a money supply measurement the central bank uses to track total financing to the economy, surged by 22% in May from the same period in 2012, bringing total outstanding credit to Rmb106.3 trillion ($17.3 trillion), according to official figures. The central bank and regulatory authorities have been battling to rein in an expansion of credit of epic proportions initially unleashed in response to the global financial crisis. It has developed into a credit-fuelled investment boom thanks, in part, to the massive growth of the shadow banking sector. One of the few tools the Peoples Bank of China (PBoC) has to control the growth of TSF is by adjusting interbank market liquidity hence the recent credit crunch. However, the effectiveness of this weapon is proportionate to the share of TSF made up by bank loans and that is on the decline. In May 2012, outstanding RMB bank loans accounted for 69% of TSF. By this May, that figure had shrunk to 65%, even as banks expanded their balance sheets by more than Rmb8 trillion. Loans made by trust companies, which model themselves on investment banks, saw the biggest increase more than doubling to Rmb4 trillion, while foreign currency loans, entrusted loans and corporate bonds saw large rises, filling the gap left by bank lending. The magnitude is unknown since the sector is mostly unregulated. Shadow financing is far easier to obtain but typically far more expensive than that available in the tightly regulated banking sector. Systemic risk is injected into the equation not only because a lot of shadow financing has gone into bad investments local governments grandiose plans, property developments and speculative projects that wont generate sufficient returns to keep up repayments, but that it is closely bound up with state-run banks. Banks might hold controlling stakes in trust companies, which therefore look to the parent for funding since they cannot accept retail deposits. Large state-owned companies obtain cheap bank loans which are rate-capped and then lend the funds on to SMEs at a higher interest. As a result, the quality of these loans is placed at risk from the lending daisy chain. Then there are the wealth management products provided by shadow banks to fund projects and pay their other investors but marketed by banks, off balance-sheet. These are mostly savings products that offer higher rates of interest than those on offer from banks but without the implicit guarantee of deposits in a government-owned bank. With an already slowing economy, markets are nervously watching to see if the funding squeeze will have a further chilling effect on Chinas investment-led growth that could spark a full-blown debt crisis. The real worry with shadow banking is that no one really knows how big it is; how much of the loans that have gone out there are actually underwater, says Michael Hewson, senior market analyst at CMC Markets. The recent credit crunch occurred when banks suddenly realised that if they cant get any money from the central bank they didnt really want to lend it to anyone else because they couldnt trust how much theyve got on their balance sheets. Youre looking at Lehmans mark two, only in China. If shadow banks are unable to continue to get financing then loans are going to start to go sour, which isnt necessarily a bad thing. But it will constrain economic growth longer term because youll get a whole host of failures as banks write down the value of their bad loan books. Shadow banks dragging down the banks this could be Chinas sub-prime crisis. China juiced its economy in 2008 and 2009, and pumped all this liquidity into the system but no one knows where all of it has gone, says Hewson. Theres an awful lot of junk assets out there. The PBoC, he adds, has fired a shot across the bows of reckless lending, letting banks know they are on their own with bad loans, that they will not be bailed out, and that just enough liquidity will be provided but at a cost that will compel them to lend more responsibly. Others are less concerned, arguing that because overall central government debt is low and the buffer provided by Chinas massive $3.4 trillion foreign exchange reserves, the country could weather a banking crisis. A sharp increase in non-performing loans, or if the government in some way mishandles the tightening of credit, could see growth slow very sharply, says Rain Newton-Smith, head of emerging markets at Oxford Economics. But I dont think the most likely case is for that to lead to significant stagnation for a prolonged period because the government does have the resources to recapitalize the banking sector ultimately. If the central government has a clear mandate that theyre not going to tolerate the growth in shadow banking beyond a certain level, they are able to take action and they can quite easily legislate what sort of lending products banks are able to offer. They have already made some regulatory changes to this effect. She adds: The issue for China is that managing that transition of trying to curb the growth in shadow banking is a difficult one because they want overall GDP growth to slow, but not too sharply and too fast. If the government can prevent the overall level of credit in the economy growing at the rate it has been without growth falling below 5%, then they can manage that transition quite well and that means overall risk, that ticking time-bomb, has been diffused. However, Newton-Smith warns: The slowdown in investment that the government is engineering is predicated on consumers stepping in to fill the gap and continuing strong consumption, but any rise in social instability could derail the whole venture.