The Economist looks at how much better off China would be if it's banks worked "properly". By properly, they mean banks that allocated capital and credit by risk rather than political factors, and banks that didn't prop up ailing state firms. Below is a chart that shows the difference between China's GDP by sector and China's bank lending by sector. This mismatch is estimated to have cost China a massive 16% of its GDP...or $320 billion. That's one hell of a mismatch.

Full article below the jump.

THE Chinese economy continues to astound. Behind its latest surge lies a renewed acceleration of bank lending. Credit growth at the mainland's financial institutions reached 15% in the year to March, just above the official target of 12-14%. Loan volumes are again nearing the levels of the 2003 credit boom, notes Jonathan Anderson, chief Asia economist at UBS. This week the authorities acted to stem the flood.

But China could sustain an even faster pace if its banks did their job properly. A mountain of bad debts is only the most visible sign of the persistent misallocation of capital. Many more loans do not go bad but yield only negligible returns. In a study* to be published on May 4th the McKinsey Global Institute, the consultancy's economics think-tank, calculates that China's GDP would be a staggering $320 billion, or 16%, higher if its lenders knew how to lend.

Around $60 billion, the think-tank reckons, could be gained from raising the banks' operating efficiency by cutting costs, putting in proper electronic payment systems, and developing bond and equity trading. The rest—some $260 billion—would come from redirecting loans to more productive parts of the economy. The banks should switch funds from poorly run state firms to private enterprises, which contribute 52% of GDP but account for only 27% of outstanding loans (see chart). This would both increase the efficiency of investment and raise returns for China's army of small savers.

Easier said than done. Aided by generous government bail-outs, the banks have worked to restructure themselves over the past several years. But changing old habits takes time: a recent paper by economists at the International Monetary Fund found little evidence that Chinese banks' lending decisions had become more commercial.

Even the industry regulator, which has been leading the reform effort, seems unwilling to break some taboos. Allowing foreign banks to take control of domestic rivals would undoubtedly help to introduce healthy competition and speed modernisation. Yet the long-running attempt of a consortium led by America's Citigroup to purchase 85% of Guangdong Development Bank (GDB), a relatively small institution, seems to have hit a brick wall. On April 25th Lai Xiaomin, director-general of the China Banking Regulatory Commission, said that he believed the “GDB case should not break the current rules”. These rules limit foreign investors to buying a total of 25% of a Chinese bank. No single investor is allowed more than 20%.

The poor state of the banks increases China's reliance on macroeconomic tools. The central bank raised interest rates surprisingly on April 27th, and announced guidelines to control banks' lending. It is expected to raise their reserve requirements next month, after China's spring holidays. Such top-down direction has served the economy fairly well in this cycle, averting the violent swings of earlier decades. Still, there is little doubt that this latest lending boom will produce another batch of bad debts and low-yielding loans. If the leaders in Beijing carried out the reforms needed to create a banking system that allocates capital properly, they would find the economy easier to steer—and their countrymen would be better off.

*“Putting China's Capital to Work: The Value of Financial System Reform.”