Lending at China's four largest state-owned banks declined during the first two weeks of May, China Daily reported May 17. New lending from two of the four banks totaled only 10 billion yuan ($1.6 billion) during the two-week period, and it contracted at the other two banks. Compared with overall lending estimated at 1.1 trillion yuan in March and 681.8 billion yuan in April, the numbers for May represent an unusually large drop-off.

While two weeks are not enough to predict a long-term decline in lending, the sharp drop in new lending among the four largest banks is significant and unexpected. The lending drop in April could be attributed to the general economic slowdown, but because state bank lending typically accounts for 30 percent of all lending in China, a near-total drop in lending so far in May is an indicator of the country's overall lending situation, and a lack of new credit could further slow economic activity.

There are several possible reasons for the decline in lending. These include Beijing's cautious monetary policy and a restriction in lending in response to the greatly expanded lending that was part of China's 2008-2009 stimulus program. The maturation of existing loans from 2009 and rapidly declining demand for new loans due to the slowing economy have also affected Chinese lending.

While Beijing has seemingly abandoned some of the credit restrictions it imposed after the stimulus package, making moves (such as the three reductions in reserve requirement ratio so far in 2012) to prevent a credit crunch, it remains watchful over new credit, concerned about driving inflation and bubbles in real estate and other sectors. Indeed, the Chinese economy is still recovering from the negative consequences of its 2008-2009 credit-fueled stimulus. As a result, the pace of reserve requirement ratio cuts and other forms of monetary easing has been slow.

Declining deposits have also contributed to the liquidity crunch. In the past two weeks, deposits in the four largest banks fell by 200 billion yuan. That decrease is in addition to a 465.6 billion yuan drop in April from deposits of 2.95 trillion yuan in March. The decline in deposits may be a result of the effective negative net interest rate, but if the issue persists — and particularly if it is matched by unexpectedly lower corporate deposits — the risk of monetary contraction leading to economic recession will increase.

The tight control over investing in China's real estate and railway sectors is another contributing factor. These are important sectors for China's domestically oriented economy and major sources for new loan demand.

The general economic situation in China will become an even more serious problem if the economy gets to a point where increases in liquidity do not lead to increases in economic activity. This increased liquidity without growth is particularly concerning right now, as China is experiencing an economic downturn and a declining demand for loans. Economic indicators from April offer a negative outlook: Exports grew by only 4.9 percent, and there was a decline in industrial output and power consumption.

Loans are an important part of the Chinese economic model and one of the most expedient ways in which Beijing sustains economic growth. A continuing decline in lending will pose a serious challenge for Beijing.