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The Decoder: Is China headed for financial meltdown?

China may be losing control of its economy to dubious financial engineering and loan sharks.

Buildings topple in a controlled explosion in Shenzhen, China, May 22, 2005. (AFP/Getty Images)

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BOSTON — Over the past several years, China has been the engine of global growth and the world’s most important creditor. Its economy muscled its way through the financial crisis largely unscathed. When bad debt knocked Western banks to their knees, China emerged as the global creditor of last resort, financing the U.S. government’s massive bailout programs.

But now, experts are warning that China’s red-hot economy is catching a contagion of its own. The country is increasingly awash in runaway loans, a development that could have serious implications for China and the global economy.

The situation has become so precarious that Fitch Ratings, a global credit analysis firm, issued a report last month revealing a litany of messy banking practices associated with aggressive Chinese loan making. The report stated that these practices — involving transferring loans off of banks’ books — constitute “the most disconcerting trend Fitch has observed in China’s banking sector in recent years.”

Credit is the lifeblood of an economy, the vital fuel of the marketplace. But too much credit can derail an economy. And that’s what China is now confronting.

In 2010, central planners struggled to restrain the unbridled banking sector. They capped lending at 7.5 trillion renminbi (about $1.1 trillion). That failed. Instead, lending exceeded an estimated $2 trillion, according to China Confidential, a research service connected to the Financial Times. That’s more than $1,500 for every Chinese citizen, a substantial sum in a country with a (nominal) per-capita income of about $4,000.

The credit explosion is fueling inflation. That’s a worrying development for a government whose legitimacy relies on improving living standards year after year. Rising prices triggered unrest in China in the run-up to the 1989 Tiananmen Square massacre; now with rice jumping as much as 30 percent, officials are wary of renewed discontent.

It’s also possible that this excessive lending could cause a financial crisis — especially since nearly half of the new loans are being made in a subterranean world of opaque, unregulated finance. And given the U.S. government’s addiction to huge loans from the Chinese government, there could be a significant impact stateside if Beijing were to need to divert its financial might toward rescuing its own banks.

The runaway loan problem stems from China’s quirky socialist-market approach to managing its economy. To grasp the predicament, it’s important to understand how Beijing strays from the usual market management practices.

In capitalist countries, central bankers use interest rates as the brake and gas pedal of growth. During a recession, they reduce interest rates, making money cheaper for spending and investment, thereby accelerating growth. When inflation rises, they boost interest rates to slow growth and bring price increases under control. The system doesn’t always work well — as illustrated by the bubble-and-bust cycle in the United States in recent decades. But it is widely regarded as the most effective method for expanding wealth over the longterm.

The Chinese government takes a different approach. Instead of relying solely on interest rates, it regulates the volume of loans that banks issue. When the Chinese economy sputters, as it did in 2009, central planners instruct the country’s banks to increase lending. When inflation rises, regulators decrease loan quotas.

But now, Chinese consumers and businesses are hungry for more credit than the government will allow. As a result, bankers, entrepreneurs and even neighborhood loan sharks have taken matters in their own hands.