China’s massive bank financed stimulus was intended to keep the economy moving. It may instead lead to economic disaster.

Financial collapses may have different immediate triggers, but they all originate from the same cause: an explosion of credit.  This iron law of financial calamity should make us very worried about the consequences of easy credit in China in recent years.  From the beginning of 2009 to the end of June this year, Chinese banks have issued roughly 35 trillion yuan ($5.4 trillion) in new loans, equal to 73 percent of China’s GDP in 2011. About two-thirds of these loans were made in 2009 and 2010, as part of Beijing’s stimulus package.  Unlike deficit-financed stimulus packages in the West, China’s colossal stimulus package of 2009 was funded mainly by bank credit (at least 60 percent, to be exact), not government borrowing.

Flooding the economy with trillions of yuan in new loans did accomplish the principal objective of the Chinese government — maintaining high economic growth in the midst of a global recession.  While Beijing earned plaudits around the world for its decisiveness and economic success, excessive loose credit was fueling a property bubble, funding the profligacy of state-owned enterprises, and underwriting ill-conceived infrastructure investments by local governments.  The result was predictable: years of painstaking efforts to strengthen the Chinese banking system were undone by a spate of careless lending as new bad loans began to build up inside the financial sector.

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