China, more so than most countries, cannot afford the political costs associated with corrective economic cycles. During the global financial crisis, the world's largest economies were unable to purchase as many Chinese goods as they once did, and the credit-driven policy response that sustained growth after 2009 appears to be coming to an end. At this point in the financial crisis, we are increasingly concerned about the possibility for more bankruptcies among the country's small- and medium-sized private enterprises. China's core challenge as it manages a slowdown after more than a decade of rapid growth is to redress its economic issues while preserving the foundation its current political system was built on.

Economies have a natural boom and bust cycle. During downturns, a variety of factors force credit to shrink, and unprofitable companies go out of business. As unemployment rises, social anxiety builds. In a short cycle, this is a quick process as weak, uncompetitive companies are culled and efficient companies are able to expand on a less crowded playing field. Long downturns, however, frequently are accompanied by profound changes that countries must make to adapt to new internal and external market conditions. The economic system that emerges from that process may be profoundly different from the pre-crisis system.

For China, the 2009 financial crisis accelerated structural shifts that were already underway. By now, these processes are well understood. Chinese wages had begun to rise in industrialized coastal cities, and low value-added manufacturing was becoming increasingly unlikely to sustain high levels of employment indefinitely as market forces pushed investors to consider alternate markets. China was at the point in its industrial development where moving up the value chain and developing a significant consumer base had become — and remains — a national imperative.

But as Chinese universities were turning out a new generation of educated Chinese graduates eager to participate in a new and evolving China, the country needed to maintain a system that employs hundreds of millions of low-skill, low-education workers. The economic downturn aggravated the labor divide as demand for Chinese goods abroad stagnated. China was forced to expedite an inland development program that it had originally intended to enact over the course of a decade or more. The country plans to continue developing the value-add industry on the coast, while shifting lower cost manufacturing to the interior to maintain employment for both demographics. There is a limited period of time for the country to enact this transformation without suffering social repercussions and without compromising the core political structure of the state. 

The downturn also lowered already thin profit margins for a variety of export-oriented industries, leading investors and state-owned companies alike to take their capital into more speculative markets. As a result, growth in the past several years has been increasingly driven not by the real sector — the trade in goods and services — but by the financial sector, where investors bet on poorly defined financial assets and a highly speculative property market. Thus the monetary decisions coming out of Beijing are vital for the future of the Chinese and global economies.

It is in this context that we are so interested in the recent moves in the Shanghai Interbank Overnight Rate. Borrowing money is expensive, largely available only for the short term and sometimes difficult to obtain on the shadow lending market, which already has shown signs of instability. This instability has exposed the underlying unsustainability of the financial market-led growth strategy. The rise in official interbank lending rates has fallen since spiking earlier this month, but is still higher than the recent norm. The higher rate is likely a demonstration of the central bank's commitment to tighten liquidity throughout an already strained system and ideally to transform a debt-driven economy to a profit-driven economy.

Even if fluctuating lending rates are the result of profound weakness in the financial sector, the effect is the same: bankruptcies, which in turn may further destabilize speculative markets, with the potential to cause chain reactions throughout China's banking system. Inefficient companies operating purely on credit simply will find that credit more expensive. There have been several instances of bankruptcies at periods in China's recent history. The example that drew our attention Wednesday was the closing of a steel company in Jiangxi that shut down because of mounting debt and no sources of additional funding.

The problem for China is that bankruptcy results in unemployment. This is a natural part of the correction cycle in many economies, but the Chinese social contract with its citizenry relies on nearly full employment. Many Chinese dynasties failed because they could not ensure an adequate level of prosperity. As a result, the Chinese government likely will extend liquidity as much as possible to cushion the impact of ongoing financial changes.

But there are constraints on liquidity expansion, as well; inflation is a concern for China, and too much expansion could have deleterious effects. The question facing the Chinese government now is not strictly one of monetary or fiscal policy. These political considerations are ultimately why Chinese policy is cyclical and why major companies will not be allowed to fail as long as Beijing retains a modicum of control.