FORTUNE — The worst credit squeeze in China in recent memory seems to be over. After the People’s Bank of China (PBOC), the country’s central bank, issued a reassuring statement on June 25 that dispelled investors’ worries about the lack of liquidity in China’s interbank loan market, Chinese stock markets halted their plunge, and the rates of China’s interbank loans fell from over 20% to around 6% (still two to three times greater than the average rate before the recent panic). China’s Lehman moment, for now at least, appears to have been averted.
However, many questions remain, both about the causes of the recent turmoil in China’s banking system and the implications for the Chinese economy.
As for what prompted the recent seizing-up of China’s interbank loan market, there is no shortage of theories. The PBOC, widely perceived as having engineered an artificial credit squeeze to crack down on China’s shadow banking sector, has come out with innocent but not very credible explanations. It blames the panic on a set of coincidental factors, such as the June deadline for banks to report their numbers (a requirement that forces many banks to reduce outstanding loans and embellish their risk profiles), tax due dates at the end of May and middle of June (tax payments suck cash out of the circulation), and increased demand for cash before a traditional Chinese holiday.
An alternative explanation, popular mainly among economists and investors, is that the PBOC was engaged in a high-stakes game with players in China’s shadow banking system, all with the blessing of China’s new political leadership. Because interbank loans constitute the bulk of funding for borrowers in the shadow banking system, making such loans less available sends a powerful message that the central government will no longer tolerate risky behavior and keep inflating China’s credit bubble. Some analysts went so far as to suggest that this is the first shot fired by the Chinese government to signal the start of a deleveraging process.
There is a third explanation, which is simpler and perhaps more reasonable. This incident is most likely a botched response by the Chinese monetary authorities to a problem that has been long in the making but exploded without warning and caught them completely by surprise.
The growth of China’s shadow banking system (with estimated outstanding credits equaling roughly 10-15% of the balance sheet of the formal banking sector) has long been flagged as a source of risk in China’s financial sector. Chinese policy-makers are fully aware of the risky activities within this sector but have opted to do nothing because the system serves several useful functions and has powerful interest groups. Local governments, real estate developers, and private entrepreneurs unable to obtain loans from the state-owned formal banking sector can tap this system for funding by paying a higher interest rate. State-owned banks and investment companies pocket lucrative transaction fees by peddling wealth management products (WMPs) issued by borrowers to depositors chasing high yields. When this game is going well, a lot of rich and powerful people make money while risk builds up in the financial sector.
As with similar instances of financial recklessness, confidence can evaporate quickly, setting off a panicked exit from the market. Even sophisticated and capable regulators are often ill-prepared for such unforeseen and highly disruptive events. If we analyze the recent gyrations in China’s interbank loan market from this perspective, we may gain a better understanding of the causes behind the short-lived panic and avoid overreacting to or over-interpreting this event.
Granted, the opacity of the decision-making process, the lack of a free press, and the insensitivity of policy-makers to the need to communicate their intentions to market participants all contribute to the difficulty in making the right call on China. To avoid making mistakes in the future, analysts should do themselves a favor by focusing more on political factors than on economics. In the case of the recent upheaval in China’s financial system, the idea that the squeeze was deliberately engineered by the PBOC to crack down on the shadow banking system makes little political sense. Only the Politburo Standing Committee, the ruling Communist Party’s most powerful body, could have made such a decision. But the Politburo would not likely authorize such a move at this delicate moment.
The Communist Party is scheduled to hold its third central committee plenum in the fall, when its most important economic initiatives will be unveiled. It is inconceivable that the party’s leadership would risk economic turmoil and disrupt its plans with a bold move on the shadow banking system before they head to the beach for the summer.
To implement any kind of meaningful reform to the shadow banking system, Chinese leadership will first have to reach a consensus at the top, overcome resistance from interest groups, and devise complex plans to address the consequences of reform. All this takes time and fierce bargaining. Based on the quick retreat sounded by the PBOC, it is quite obvious that the top leadership has no such plans in place for now.
However, this does not mean that Beijing can delay dealing with the massive risks in the banking system for very long. If anything, the recent bloodbath in the Chinese financial sector should prompt China’s top leaders that they must have a more comprehensive plan for financial deleveraging when they meet in the fall. Otherwise, they are almost certain to face a bursting of China’s credit bubble that will make last week’s turmoil look insignificant.
Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government at Claremont McKenna College and a non-resident senior fellow at the German Marshall Fund of the United States