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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.

At the high finance end, Chinese banks have larded credit markets with “off-balance sheet loans.” These “invisible loans” reached nearly $350 billion by July 2010, according to the December Fitch report.

On the surface, this off balance sheet scheme is nifty financial engineering: bankers make loans and then sell them as wealth-management products — sort of like bonds or CDs (but with far more risk, as you’ll see below). This essentially lets underwriters lend money without calling them loans, enabling banks to circumvent the government’s loan quotas (as well as other safeguards that keep banks solvent).

These wealth-management products pay a higher interest rate than savings accounts do, so Chinese investors have been eagerly snatching them up. “Nearly every week text messages advertising new [wealth management products] are sent to retail investors, and Chinese corporations have become the fastest growing investor base,” Fitch wrote.

Ironically, the Communist country’s off balance sheet loans resemble a notorious financial innovation from Wall Street — the mortgage backed security. Nicknamed “toxic assets” by the media during the financial crisis, mortgage-backed securities deployed a similar scheme, moving mortgages off the banks’ balance sheets and into wealth management products.

But this is risky business. Removing loans from a financial institution’s books creates a moral hazard: bankers earn profits from issuing loans, but no longer have a direct stake in whether they get paid back. As a result, there’s little incentive for the banker to assure that the borrower is creditworthy. (Here’s a rough analogy: Imagine that I lend $100 to my uncle, who promises to pay me $110 next year, then I sell that promise to you for $105; in theory everyone wins, but if my uncle fails to pay you back, is it your problem or mine?)

Charlene Chu, senior director of Fitch’s Beijing office, told GlobalPost that while her firm doesn’t audit the quality of individual loans, “local government and property loans have been among the more popular to be moved off-balance-sheet, and there are widespread concerns about future asset quality of each.”

And it’s not only the banks that are engaging in risky financial alchemy. Unsatisfied with the paltry investment options allowed by the Chinese government, both wealthy and middle-class individuals are flocking to alternative (and risky) loan schemes.

These investments are even more difficult to track, but according to China Confidential, the research service, up to $150 billion “is under management by the almost unregulated ‘private’ funds industry — which is centered in Shanghai and typically involves ‘star’ managers investing funds for wealthy individuals.”

On a shadier note, China Confidential’s research found that underground lenders — loan sharks, in other words — issued as much as $600 billion in credit in 2010. These lenders borrow from Chinese citizens and lend at interest rates of 12 to 120 percent. Middle-class Chinese willingly participate, given that the alternative — savings accounts — pay interest at a rate lower than inflation (meaning that depositors basically pay the bank to hold their money).

The Chinese government has limited options for dealing with the runaway loan problem. In July, regulators attempted to halt off balance sheet lending, and directed banks to bring outstanding loans back onto their books by the end of 2011. But in the months that followed, the practice appears to have become even more prevalent.

Meanwhile, regulators have hinted at an official 2011 loan quota of about $1 trillion, halving the total credit issued in 2010. Abiding by such a quota, however, would be messy, if not impossible. A multitude of real estate and infrastructure projects across the country will need additional loans. A strict clampdown could result in a landscape laden with unfinished roads, buildings and bridges.

“An economy that will have received more than 11 trillion Renminbi [$1.65 trillion] in new credit for two consecutive years cannot get by with trillions less overnight … without seriously stunting growth,” Fitch’s Charlene Chu wrote. “We expect that hidden channels will continue to fill this gap.”

David Case directs GlobalPost Research. Follow him on Twitter: @DavidCaseReport