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How China hurts its own economy

August 4, 2011, 1:00 PM UTC

When lending, Beijing favors state companies over private ones. Trouble is, that’s not where innovation happens.

The outside world is finally coming to grips with the realization that China has some serious economic problems of its own. Moody’s recently issued a report saying that bad debts in the Chinese banking system could rise from 1.1% to as much as 12% of the nation’s $7.83 trillion in total loans. The mounting bad-debt problem obscures an equally important, and related, phenomenon: For the past three years, at least, the huge credit explosion in China has overwhelmingly ended up in the hands of China’s state-owned companies. In the wake of the global economic crisis, Beijing’s state-owned banks have frantically shoveled money to their state-owned brethren in the hope of mitigating its impact (particularly on employment). A former executive at Bank of China remembers meeting with a branch manager in central China last year and asking him how much they were lending to local state-owned firms. The answer: “Whatever they want.”

By contrast, the private sector has been starved of capital. (Remarkably, no reliable data exist that parse state and private sector credit, but no one doubts it’s a very lopsided picture.) To the extent that private firms have been able to get credit, they have to pay more for it. A study on China’s A-share market by the brokerage firm CLSA Asia-Pacific Markets shows that the overall cost of capital (debt and equity financing) for big private firms is on average 100 basis points higher than for state-owned ones. For smaller companies, anecdotal evidence suggests the gap is much greater.

Private sector executives in China, understandably, are not happy with this. Few are willing to stick their heads above the parapet and complain publicly for fear of angering the government. But to judge by conversations Fortune has had with CEOs of private companies, they’re furious. “Our only hope is that the new government [which assumes power next year] understands this and makes the necessary changes.” Whether that new government — expected to be led by Xi Jinping as President and Li Keqiang as Premier — will be responsive to those complaints is decidedly unclear.

Given China’s economic success, why does credit allocation need to be overhauled? As Daniel Rosen, principal at the New York consultancy Rhodium Group, puts it: “China has the potential for a lot more growth, but it needs to come now from innovation — not more steel mills. The question is, Which ownership group [state vs. private] is capable of delivering that growth?” Most people feel it’s the private sector, which over time tends to be more efficient and more innovative than big, state-owned companies. Think Geely in autos or Alibaba Taobao in e-commerce. But with the institutional bias in lending so entrenched, Rosen asks: “How do they make that happen?”

That’s the right question. And if it doesn’t happen, China’s “miracle” years of growth may be over.

This article is from the August 15, 2011 issue of Fortune.