THE country's financial rise has been vertiginous. Until 1990 China had no stockmarket at all, and until 1993 no Chinese company was listed abroad. Today, the Shanghai stockmarket and its smaller counterpart in Shenzhen between them have 1,200 listings and a market capitalisation of around $500 billion, second in Asia only to Japan. So much for communism: officially, some 66m individuals—more than the population of Britain or France—invest in the stockmarket, with 100-odd brokers and 15 fund-management companies to cater for them. Over the next three years, under China's commitments as a new member of the World Trade Organisation, rules prohibiting the foreign ownership of brokers and fund managers are to be eased. Approved foreign investors will gradually be allowed into the domestic markets, drawing on the example of Taiwan's earlier financial liberalisation. All this, it is hoped, will mark the coming-of-age of mainland China's capital markets.

Meanwhile, Hong Kong has gained a new lease of life as a financial centre by helping to raise foreign capital for the modernisation of state-owned enterprises in mainland China—and, increasingly, investment for China's growing private sector. Chinese companies now make up 35% of Hong Kong's stockmarket capitalisation, against only 7% in 1995. With stockmarket listings in Hong Kong of giants such as China Mobile, China National Offshore Oil Corporation and Bank of China, the mainland accounted for the biggest chunk of the world's international share offers in 2001-02—a welcome boost to global investment banks facing a dearth of new issues in America and Europe.

Yet all is not what it seems in China's capital markets. For a start, growth in the domestic stockmarket has outstripped the efforts—game as they are—of the regulators and the legal system to police it. The authorities say that computer-matching of share transactions has allowed them pretty much to stop powerful syndicates ramping up share prices. They have even sent the biggest manipulators to jail, yet insider trading is still rife on a heroic scale. Stock-exchange executives reckon that the real number of investors is around half the official number: investors use multiple accounts for dodgy share-dealings.

The real issue is the quality of the listed companies themselves, says one financial official. Even some of the better-regarded ones indulge in all sorts of market abuses, such as lending money raised on the stockmarket to the parent company rather than investing it, or speculating in the stockmarket on their own account. Almost all companies allowed a listing are the beneficiaries of government favouritism. Their profitability is usually abysmal, their levels of disclosure poor, and—with the state holding roughly two-thirds of the shares of companies listed in Shanghai and Shenzhen—their treatment of minority shareholders appalling. Most private firms have hitherto been denied access to the stockmarket. Standard & Poor's, a credit-rating agency, counts 35 “private” listed companies in China, but points out that a good number are in fact controlled by local governments and even the military.

The China Securities Regulatory Commission (CSRC), a body of refreshingly modern-minded officials, is only too aware of the shortcomings. It has raised standards and even delisted companies whose performance is not up to scratch. It has introduced quarterly audited financial statements, and a requirement for independent directors on company boards.

Cleaning up the stockmarket may have done much to take the steam out of rising share prices, but therein lies the commission's dilemma. It is alarmed by the inflated valuations of domestic shares, a consequence of the small proportion of a company's shares that are actually tradable, and of investors' enduring belief that share prices are dictated by political signals, not by the laws of supply and demand. At the same time, the Communist Party has a much broader concern: that middle-class dissatisfaction with stockmarket losses, coupled with working-class anger at the continuing wave of lay-offs at state enterprises, could threaten the legitimacy of the party's rule.

Over the past couple of years, the CSRC has been forced to abandon plans to plug the state's $100 billion-200 billion unfunded pension liability by selling government-owned shares. On paper, the scheme was brilliant. By offering a way out of the urban pensions mess, it gave reformists in government a reason to persuade dogged conservatives to let go of state control of industry. In practice, investors took fright at the prospect of the shares of thousands of companies (and not very good ones at that) being dumped on the market. Share prices in Shanghai, until 2001 among the world's best-performing, have slumped. The CSRC has put tight restrictions on new listings—new share offerings halved in 2001 and again in 2002—which has disproportionately hurt the country's private companies, desperate for capital. Last year the commission officially abandoned the share-sale plan for the time being. Having set out to ensure the unfettered working of China's financial markets, the CSRC has ended up as the country's chief allocator of equity capital. No wonder that China's equity markets, for all their impressive size, financed less than 2% of total investment in China last year.

“The equity market”, says a senior financial official, “is dysfunctional. Nor do I think a proper corporate-bond market will develop for a very long time. For instance, there's never been a proper default on corporate bonds in China, and if you had one there'd be a riot. That's why the banks will continue to play a very important role.”

It is the banking system that collects up the bulk of China's great pool of domestic savings, equivalent to nearly 40% of GDP. Sadly, the banks misallocate the savings on an even grander scale than the stockmarkets. The four big state-owned banks that dominate the system direct four-fifths of their lending to state-owned enterprises which destroy value more often than they create it. The vibrant private and export sectors—which have created perhaps 40m new jobs in the past five years, as many as the state sector has shed—are left largely to fend for themselves. They rely on retained earnings and foreign direct investment, or else on informal sources of credit. “Until recently, at least, there has been a big disconnect between those earning money and those borrowing it,” says Paul Coughlin of Standard & Poor's in Hong Kong.

Considerable strides have been made in getting the banking system into better shape. Five years ago the central bank, the People's Bank of China, was given a federal structure that brought decision-making back to the centre and cut across powerful provincial lines. The big four state banks were also recentralised. They have sacked huge numbers of staff: the Industrial & Commercial Bank of China has laid off one-fifth of its employees, a staggering 110,000 people. The banks have hired western consultants to teach them about risk-management systems, credit-scoring and tackling bad loans. Last year, the former head of the Bank of China—intolerably corrupt, it seems, even by Chinese standards—was put under house arrest.

More changes are likely to be pushed through by the new, reformist generation of political leaders. For instance, there is talk about the establishment of an independent bank regulator. But potentially the most interesting development took place late last year when the central authorities gave Newbridge Capital the go-ahead to take a controlling stake in Shenzhen Development Bank. This bank, until now owned by the Shenzhen local government, has 200 branches in the most capitalist city in China, with deposits growing by 50% a year. And, because it is fairly young, it has a much smaller legacy of bad loans than the big state banks.

“In policy terms”, says Weijian Shan, head of Newbridge in Hong Kong, “the significance goes way beyond the deal itself. It says a lot about what's going to happen to the whole industry.” In theory, only foreign banks with assets of over $20 billion may set up in China or take a minority stake in a domestic bank, and even then are not allowed to do local-currency business. Newbridge is not even a bank. What is more, foreigners are not supposed to be able to buy the non-tradable shares—so-called legal-person shares—with which the state keeps control of enterprises. The deal is an indication of how reformists in central government intend to use foreign capital and management skills as a way to shake up China's banks.

Meanwhile, though, under guidance from central and local political barons, the big banks continue to lend to weak state enterprises—perhaps not as much as they used to, but still far too much. The bad loans this generates are the system's Achilles heel. For several years, the government denied the scale of the problem and pooh-poohed unofficial estimates that put bad loans at 40% or more of the total. But recently a franker assessment by the banks themselves, using international standards of measurement, has brought official figures closer and closer to those earlier unofficial estimates. A best guess by Nicholas Lardy of the Brookings Institution, one of the earliest to draw attention to the problems of China's banks, now puts bad loans in the system at around $500 billion, or over 50% of the total.

In 1999 the finance ministry decided to set up four asset-management companies, one for each bank, to deal with the bad loans. Over the following couple of years the government transferred, at face value, roughly $170 billion of bad loans from the four big banks to their respective AMCs, equivalent to more than one-fifth of the banks' loan books. The loans were almost all made before 1996, and most of them were state-directed “policy” loans. The central-bank governor, Dai Xianglong, said it was the banks' “last supper”. Since then, another $40 billion of bad loans appear to have been transferred to the AMCs. And now, the finance ministry suggests, a further supper might be needed to take a fresh batch of NPLs off the banks' books. After all, even after the relief provided by the first batch, the banks' bad-loan ratio still stands at 22%, according to Guonan Ma and Ben Fung in a recent paper for the Bank for International Settlements.

The two authors point to a curious accounting sleight-of-hand that raises questions about where the buck for China's bad loans ultimately stops. In order to buy the $170 billion of banks' bad loans, the AMCs needed to be capitalised. At the outset, the finance ministry injected capital of $1.2 billion into each new AMC—a tiny amount, accounting for just 3% of assets acquired. The People's Bank of China put in quite a bit more cash, say Mr Ma and Mr Fung: up to $50 billion. But in return for that cash, a big chunk of state banks' liabilities to the central bank appears to have been transferred to the AMCs: that is, state banks' debts were forgiven, while new ones owed by the AMCs were created. Lastly, the AMCs themselves issued $140 billion-worth of ten-year interest-bearing bonds. These were given to the banks, along with $40 billion-odd in cash, in return for the bad loans. The AMCs, in other words, have a lot of debt resting on a tiny sliver of capital.

In the long run, the AMCs will be lucky to recover one-third of the value of the bad loans from selling off the underlying assets. So far only 25% of loans, by face value, have been sold. It will come as no surprise if the AMCs are unable to pay the interest, let alone repay the principal, on the bonds to the state banks and on their borrowings from the People's Bank of China. Messrs Ma and Fung argue that the central bank's claim on the AMCs is larger than its own capital base.

This raises the question of systemic risk. If China's insolvent state banks are to be nursed back to health—and any suggestion that they might not be would lead to a run on deposits and a full-blown banking crisis that would send China into turmoil—the government will have to pick up the tab. The cost of cleaning up the banking system needs to be added to the government's already considerable pile of liabilities. But instead of facing up to this, says Mr Lardy, the government shuffles debt around as though it were constructing a Ponzi scheme.