local government debt) being rolled over, disguised or otherwise hidden; the increasingly frequent spikes of interest rates in China’s interbank lending market; or the questions surrounding “wealth management products” and the “shadow banking system” – it is the Chinese financial system that lies at thetrueheart of much that is being targeted for change in the country. Indeed the financial system has emerged as both one of the main causesandsignificant results of the distortions that have been developing in China’s economy. Compared tohukou reform, or changes to ownership rights affecting rural residents, the financial system reforms are more difficult, potentially more disruptive, and arguably very urgent. The People’s Bank of China(PBOC), led by reformer Zhou Xiaochuan, has taken a leading role in driving the financial reform process in China in recent years. However, the central bank, along with reformers on the State Council, the other financial regulatory institutions, and upper levels of party - government, are constrained by some hard truths that lead to sometimes contradictory - seeming policy decisions. To put the issue simply, the large build - up in debt levels in China – total debt including the central government and its ministries, local governments and corporate debt(both state owned and private) is now over 200 percent of GDP – combined with falling growth rates, mean that the economy is on an unsustainable path. The increasing amounts of credit required to deliver GDP growth suggest that, indeed, investment has been too high for too long, and has been increasingly misallocated as the projects with strong returns have been depleted as targets. Data released January 15shows that China’s credit growth moderated during 2013. Total Social Financing(TSF), which attempts to include elements of the “shadow banking” system, grew by “only” 9.1 percent in 2013 –stillahead of GDP growth. Broad M2 money supply increased 13.6 percent at the end of December compared to the previous year, while the total stock of outstanding loans grew by 14.1 percent. To a certain degree, even with the decreases last year, China has walked(or perhaps run) into a debt trap. How? In short, easy credit and liquidity has become increasingly necessary to keep growth ticking over. Now a serious tightening would force many entities into financial distress, and a “subprime” moment could be reached: If liquidity levels were suddenly restricted, then interest rates would rise, resulting in a spike of debt servicing costs. Growth rates would collapse as corporate distress spreads throughout the economy. Contagion throughout the formal and “shadow” financial systems would be a risk. However, doing nothing and allowing the credit to flow is no solution. This will only increase the total debt load, and with it the total problem. Eventually, the costs(hidden or explicit) of servicing the debt mountain and associated distortions will themselves collapse growth levels(some believe this has already begun). As Anne Stevenson Yang fromJ Capitalrecently noted, “…China is in a spiral: the more money goes into the economy, the more credit will be required to pay off the old. One market - theory method to stop credit being misallocated, and to stop non - profitable ventures receiving it, is to raise interest rates.(Incidentally, higher deposit rates will also end the consumption - suppressing transfers from the household sector to mainly corporate and government - corporate borrowers). It is clear that Zhou, Prime Minister Li Keqiang, Politbureau Member Wang Qishan and other leaders support this theory. Yet they are limited by circumstance, and for reasons explained above, must move gradually. Thus in 2014, we can expect policies, including and especially those coming from the PBOC, to seem erratic and sometimes contradictory, as the government tries to nudge the economy towards a more stable pathwithoutpushing it over a cliff. Throughout 2013, the PBOC has been leading the process(with the implicit authorization of the State Council) to drive de factointerest rates higher. In fact, the PBOC’s actions largely explain the much smaller gain in TSF over 2013 compared to previous years. In 2014, this will continue (absent a dramatic slowdown), and show just how much the reformers have gained the ascendency in China’s policymaking circles In 2013, the PBOC’s pressure on the money markets resulted in “cash crunches” in June and December. Even if the unusually high amount of fiscal deposits at the central bank at the end of the year were partially responsible for the latter, the PBOC remains the prime cause. There will probably be more to come. Why? Unable (or unwilling) to tackle the controls on normal bank deposit rates in the formal banking system yet, the PBOC is first focusing its efforts on the money markets and, by turn, the shadow banking system that relies on them to function. In China the shadow system is a multi-headed beast including trust companies and trust lending, asset management companies, wealth management products (WMPs) issued by formal banks and other entities, corporate-to-corporate lending, pawn-broking, loan sharking, and more. Herein lies one of the main policy debates and source of many of the policy contradictions in China today. The shadow banking system, in part developed as companies, bankers, financial innovators and various other agents sought to avoid the squeeze on runaway credit which began several years ago, is in fact itself a more developed and liberalized system of credit allocation. Interest rates are higher than those in the formal banking system (both for investors and borrowers); the importance of political connections is smaller, (although by no means non-existent). So why, if the PBOC, CBRC, CSRC and State Council want to increase interest rates (and thus the efficient allocation of credit) would they seek to “rein-in,” tighten conditions or punish players in this shadow system?