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In the midst of the global financial crisis that followed the collapse of Lehman Brothers Holdings in 2008, China embarked on one of the world’s largest stimulus packages, injecting 4 trillion yuan ($630 billion) into its economy through a massive bank lending program. The policy succeeded brilliantly, boosting growth to a rate of more than 9 percent in 2009 and more than 10 percent in 2010.

The stimulus spending also reignited China’s red-hot property market, leading real estate prices in some major cities to triple over the past three years and driving consumer price inflation up to a three-year high of 6.5 percent in July. To prevent a destabilizing inflationary outburst, the People’s Bank of China tightened policy aggressively in the past year, raising interest rates three times in 2011 and lifting bank reserve requirements six times. The reverberations have been felt throughout China as banks have pulled in credit lines, forcing some companies into bankruptcy.

Now the authorities stand at a critical juncture. Their tightening efforts have combined with weakness in China’s main export markets, Europe and the U.S., to raise the threat of an economic hard landing, with sharply slower growth and rising unemployment. That’s a chilling prospect for the global economy at a time when Western countries are struggling under a mountain of debt. Can Chinese policymakers fine-tune their economy to avoid a downturn and maintain growth at a strong and sustainable rate?

Most analysts are confident that Beijing can avoid a crash. They point to the unexpected easing by the central bank, which cut reserve requirements at the start of December in the first such move since 2008, as evidence that the authorities are aware of the risks to growth and have sufficient means to respond.

“The Chinese government still has multiple tools to deal with any liquidity or illiquidity issue,” says Victor Shih, an associate professor of political science at Northwestern University, in Evanston, Illinois, who warned about the borrowing binge unleashed by the stimulus program. “Up until now they have reacted in a timely manner.”

Paul Schulte, Hong Kong–based global head of financial strategy and Asia banks research at CCB International Securities, a subsidiary of China Construction Bank Corp., estimates that in the past 12 months Chinese regulators have removed 4.4 trillion yuan in liquidity from the financial system—well in excess of the original stimulus spending—through tightening; he predicts that they are about ready to reverse course and ease. “Credit growth is running at about 6 percent, while nominal growth is running at about 18 percent,” he says. “This is clearly unsustainable.”

Beijing still faces tough challenges ahead, though. The 2009 stimulus may have succeeded in the short term, but it did so only by increasing the economy’s reliance on government-driven investment. Policymakers need to reduce that dependency and encourage more private sector growth and consumer spending to sustain a durable expansion in the long run, analysts say.

“If China fails to transform its development pattern over the next five years, then the risks of a major crisis could increase exponentially,” says Huang Yiping, Hong Kong–based chief economist for emerging Asia at Barclays Capital. Until now the government has always stretched the financial and fiscal systems to contain near-term downside risks, Huang says, but there is a limit to how much longer policymakers can take this approach. After the Asian financial crisis of 1997–’98, for instance, it took several years for China to reduce banks’ nonperforming loans and the government’s contingent fiscal liabilities. “But China may not always have the luxury of a long adjustment period to deal with such problems,” he says.

Indeed, there are still a number of bears who think the economy is headed for a harsh downturn. James Chanos, founder of New York–based hedge fund firm Kynikos Associates, believes that much of the stimulus borrowing went to finance dubious speculative real estate projects. Chanos says he is shorting Chinese property and banking stocks because both sectors are headed for a crash. “We see a history of horrible lending,” Chanos said at the Delivering Alpha conference in New York, sponsored by Institutional Investor and CNBC in September.

A sharp slowdown in China is the last thing global investors want to see, considering that Europe is flirting with recession because of its debt crisis and the U.S. recovery remains weak and vulnerable to global turmoil. The mainland economy had been the greatest source of strength at a time of troubles in the West, says Shane Oliver, Sydney-based head of investment strategy and chief economist at AMP Capital, which has A$97 billion ($99 billion) in assets under management. “China worries have escalated recently because of anecdotal evidence of slower growth, indications of a credit crunch in some parts of the economy and increasing pressure on property developers,” he says.

According to official figures, about 1 percent of the 53.5 trillion yuan in loans held by the Chinese banking system are currently nonperforming. Most analysts believe the real number is higher—or soon will be. May Yan, a Hong Kong–based banking analyst at Barclays Capital, forecasts that the NPL rate will rise to between 3 and 4 percent in the next year or two. “With any rapid growth there is potential of an asset bubble,” says Yan. She estimates that licensed banks may have made as much as 5 trillion yuan worth of loans—many of dubious quality—in excess of the official stimulus program since 2009. Underground banks such as credit cooperatives and microlenders, many of which borrow at low interest rates from the state banks and lend to private businesses at much higher rates, may have extended an additional 9 billion yuan in questionable loans. The easy money fueled a dramatic rise in property prices and financed countless speculative real estate projects, primarily residential housing in major cities.

The government responded by squeezing liquidity out of both the formal banking system, which is dominated by the Big Four state-controlled banks, and the informal system, which involves everything from unlicensed banks to credit cooperatives to virtual loan-shark operations. The central bank increased its policy lending rate three times in 2011, taking it up to 6.56 percent. Even more important, the central bank raised reserve requirements 11 times since 2009 to a record high of 21.5 percent, effectively limiting the amount of customer deposits that banks can lend out.

The tightening has had a dramatic impact on conditions in Wenzhou, a city of 9 million people in Zhejiang province, south of Shanghai, that is a major hub of private entrepreneurial activity, much of it financed by informal lending. Since April more than 80 major businessmen have disappeared, committed suicide or declared bankruptcy to avoid repaying debts to informal lenders, China’s official Xinhua News Agency has reported.

“Entrepreneurs were hit when export orders dried up,” says Yeo Lin, director of the Industrial Development Research Center at Zhejiang University’s School of Management. “Now the excess funds in China’s underground banks are drying up.”

Premier Wen Jiabao visited Wenzhou in October and pledged to aid small and medium-size enterprises. Also that month, China’s ruling State Council issued a series of measures ordering state banks to shift their lending from state-owned enterprises to private entrepreneurs. In November, Wenzhou officials established a 1 billion-yuan fund to provide bridge loans to small businesses, many of which can’t get loans from state-run banks and often resort to paying interest rates as high as 30 percent from underground lenders.

Those measures are inadequate to meet the needs of the country’s small businesses, says Shen Minggao, Citigroup’s Hong Kong–based chief economist for greater China. Most banks still prefer lending to big state-owned enterprises because those companies have political connections and long-standing relationships with their lenders. To spread the flow of credit, China needs to fully privatize the giant state-controlled banks, give banks the freedom to set interest rates and legalize underground banks, Shen contends. “There is much more to do,” he says.

The central bank eased policy in early December after China’s Purchasing Managers’ Index fell to 49.0 percent in November from 50.4 percent in October. A reading below 50 percent suggests the economy may be slowing below its trend rate of growth. The central bank move, which lowered the reserve requirement by a half point, to 21 percent, should release some 350 billion to 400 billion yuan of fresh lending capacity, analysts estimate. For now, however, the impact of the past year’s tight money policies dominates the economy.

That tightening is helping the government win its war against property speculators. Housing prices are likely to fall by 10 percent by the end of 2011 and another 10 percent in 2012, says Du Jinsong, a Hong Kong–based property analyst with Credit Suisse. “Some small developers—unlisted ones—already defaulted,” he says.

Putting overleveraged property developers out of business would actually be good for China, says Andy Xie, a Shanghai-based independent economist who formerly worked as Morgan Stanley’s chief economist for Asia ex-Japan. He believes property prices will fall as much as 25 percent in 2012 and another 25 percent by 2015.

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