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But why is shadow banking still all the rage, despite thehostile regulatory environment?

In the past two to three decades, China has implemented anextremely inflationary monetary policy. Since 1986, for example,its money supply has grown at a compound annual growth rate of 21.1per cent, and its bank loan balance by 18.2 per cent. Of course,Chinese citizens have not become richer as fast, and much of thegrowth is merely a monetary illusion.

Why did credit grow so fast for so long? Apart from a robusteconomy, the reason has been the regulated and negative realinterest rate. Due to financial repression, demand for loans hasbeen artificially boosted, as bad investments become feasible onsubsidised credit. Indeed, it has been a vicious cycle.

First, the fast growth of loans worsens inflation, which weakensthe purchasing power of money. To facilitate the same amount ofbusiness, corporate China needs more credit. And as more credit isreleased into the economy, the purchasing power of money shrinksfurther. I call this an iterative escalation of credit andinflation. There is a constant shortage of credit no matter howfast credit grows. The reason? Bank loans are impossible to refuseas they are heavily subsidised. Homebuyers and speculators knowthis all too well.

The Chinese government frequently talks about prudent monetarypolicy but does not really have the political will to tightencredit for fear of job losses and a recession. Even in April, thebroad money supply (M2) has grown at 16.1 per cent compared to thesame time last year. That is a very high rate on a high base. Chinais still inflating rapidly despite repeated declarations of creditcontrols by government officials.

The results of financial repression are visible everywhere, fromindustrial overcapacity to excess real estate construction, and theunstoppable growth of shadow banking.

Over time, the Chinese statistics (particularly on inflation)have lost credibility among citizens. Despite high inflation thatis widely believed to be somewhere between 5 and 10 per cent ayear, Chinese depositors are paid an average of 2 per centinterest. Naturally, they want better deals. While many have chosento speculate on property, others have embraced shadow banking,including microcredit and wealth management products. Afterconsistently deflating for two consecutive decades, the domesticstock market remains very expensive, with banking stocks being thepossible exception.

Negative real interest rates on bank loans constitute a subsidyfor borrowers. Unfortunately, access to finance is neither equalnor fair. State-affiliated companies and well-connectedprivate-sector borrowers take the bulk of funds for loans, leavingvery little for small businesses. The underprivileged have toresort to the curb market, involving trading outside the officialstock markets, pawnshops, microcredit firms and high-cost fundsarranged by trust companies.

In other words, China's shadow banking is a reflection of thefinancial repression. The high interest rates prevalent in shadowbanking activities are a result of the low rates in the formalbanking sector.

Financial repression has accentuated the uneven playing fieldfor the two types of borrowers. Normal bank loans carry a 6 percent annualised interest rate, while the shadow banks typicallycharge 15-30 per cent per annum.

If Beijing really wants to help small businesses, or deflate theproperty bubble, it should raise interest rates steadily. As aresult, the growth rate of money supply will decline to 7-8 percent within two to three years. Yes, this will risk an economicrecession, but a recession may be exactly what is needed to avoidthe next global financial crisis. This time, unlike in 2008, thecrisis will be made in China.

China's iterative escalation of credit and inflation has severesocial consequences, too. Ordinary savers are punished, and areleft further and further behind by the rising prices of assets suchas property. If President Xi Jinping wants Chinese people torealise their own "China dream", he must tame the credit monster.Shadow banking is only the shadow, not the monster waiting in theshadows.

Joe Zhang was chairman of Wansui Micro Credit Company inGuangzhou from 2011 to 2012, and is author of a new book, InsideChina's Shadow Banking: The Next Subprime Crisis?