Chinese economy

Why China's bank squeeze is good for China

June 26, 2013: 10:57 AM ET

Slowing growth of the world's second-largest economy might put it on the right path.

121206055857-china-brands-chin-construction-bank-3-monsterFORTUNE – China's cash shortage has roiled markets over the past few weeks, as investors fear a liquidity squeeze across the nation's banks could further hurt growth in the world's second-largest economy.

While that might likely happen, the credit crunch is actually a good thing for China and the rest of the world.

China's banking system is opaque, if not deeply troubled. Over the years a shadow industry has quickly risen: Banks borrow from each other at low rates, then lend to a mishmash of trust companies, insurance firms, leasing companies and other informal lenders, which in turn, make riskier loans to others.

MORE: China should bail out its shadow banks, U.S. style

The fear among some analysts is that such a system masks whatever risky and bad loans made -- a problem that could put banks out of business and, worst case, possibly trigger another financial crisis nobody in the world wants to relive.

But the party of easy money may be over -- at least if you believe the Chinese government. On Monday, the People's Bank of China, the central bank, publicly announced that the country's banks needed to be more prudent; the easy lending and speculation it helped propel for years needed to end.

Banks were warned a week earlier, which panicked markets and led to a sharp selloff in stocks worldwide. China's banks have been squeezed, and the shortage of cash sent lending rates at which banks borrow from each other way up.

The cash crunch could certainly do some serious damage: It could cause some smaller banks to go under, although most economists don't think the problem carries huge systemic risks.

A cash shortage could also further slow China's economy. But don't panic, Wall Street! A slower growing China may not necessarily be a bad thing. In fact, it likely signals that China's authorities are finally putting the economy on the right path.

For the past two decades, China has seen extraordinary growth. Unlike the U.S.and other industrialized countries, China's economy has largely been driven by manufacturing and heavy spending in big infrastructure projects such as roads, bridges, and the like. And unlike the U.S, where consumption makes up more than 70% of the economy, Chinese consumers don't spend nearly as much. More than that, they don't buy the bulk of what the country produces; it's sold to the rest of the world by way of exports.

MORE: Sany's bold U.S. move

China is trying to change the way it grows; it can't continue for a host of reasons, including huge pollution problems. This is bad news for companies like China-based Sany Heavy Industry and Peoria, Ill.-based Caterpillar (CAT) that have banked on the exploding growth of China's construction industry. And while news that China's central bank will narrow its money spigot has caused markets to react, the move ties to the country's broader plans to rebalance growth so that it's driven more by U.S.-style consumption and less on manufacturing and construction.

That will surely slow down the Chinese economy -- a welcomed development if you ask experts like Stephen Roach, a Yale University fellow and former chief economist at Morgan Stanley Asia.

So long as China rebalances its economy, it can still create enough jobs and reduce poverty with slower growth, Roach wrote recently in Project Syndicate.

That's because China's old model relied heavily on manufacturing and construction, which needed many more machines than people and didn't produce nearly as many jobs as a more service-oriented economy. It's the difference between -- say, an advertising agency that depend on the creative minds of workers vs. a manufacturing plant that count on the speed of machines. Roach offers an interesting statistic: China's services sector requires about 35% more jobs per unit of GDP than do manufacturing and construction.

Achieving this is tricky. And that's partly why we always hear Wall Street ask if China is in for a "soft" or "hard landing." China needs to find a delicate balance between implementing reforms while avoiding financial turmoil.

MORE: Fed's Bernanke talk tab $151 billion and counting

Even if markets reacted, Roach says the message delivered by China's central bank is ultimately positive: "It's painful short-term because it puts a lot of pressure on financial institutions, but it's a visible sign of a government that is really determined to change the course of unsustainable growth."

On Tuesday, China's central bank soothed jittery markets, saying that it would guide interbank interest rates to reasonable levels. It's unclear what those rates might look like, but the remarks seemed to have calmed investors. The overnight lending rate fell to 5.8% from 6.6% Monday. Before June rates were lower -- at around 2% to 3%.

As China continues to make changes, we'll probably see volatile spurts again. But know it likely has more to do with good news than bad.

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