The pathology of the western financial crisis is all too familiar: misallocation of capital fuelled by cheap credit and lax regulation, a proliferation of investment vehicles with limited credit assessment, and systemic biases predicated on ever-rising real estate prices. We should worry, then, that Chinese banks may be facilitating a home-grown version, especially as they plan to raise $30bn-$50bn in capital over the coming year.

The particular concern is the estimated Rmb3,000bn ($450bn) of local infrastructure loans extended in 2009, representing 30 per cent of the record new bank lending last year. Many were non-recourse loans to provinces, municipalities and counties through shell companies, known as Urban Development Investment Corporations (UDICs). Some went to fund projects backed by assets, such as commercial real estate, others to projects with future cash flows such as subways and toll roads. Still others are social in nature and backed only by an implicit guarantee of the City/Provincial Investment Holding Corporation (CIHC). Most UDIC loans have sparse local equity and limited cash flow prospects for repayment. For the time being, local governments and CIHCs can plug interest payment gaps with healthy land sales, which totalled Rmb1,600bn in 2009, as well as central government transfers. The UDIC liability is estimated at close to RMB6,000bn or 14 per cent of the outstanding loan base. A 30 per cent default rate would in effect wipe out the paid-in capital of top banks such as China Construction Bank and Bank of China.

Chinese state entities have a poor record in preventing faulty provincial lending practices and low quality asset formation. During the 1990s Asian financial crisis, the Guangdong International Trust went bust, in spite of an implicit Guangdong state government guarantee. Today's robust balance sheets of the listed, state-controlled banks are the result of an $800bn carve-out of non-performing assets by four state-backed asset management companies, which are reportedly recovering about 20 cents on the dollar.

China - namely the Ministry of Finance (MoF), the Chinese Banking and Regulatory Commission (CBRC) and the banks themselves - has two options in dealing with potential bad loans. The first is to do nothing. After all, lending rates, averaging less than 6 per cent, are low and most infrastructure loans have no principal due for several years, well beyond the tenure of most local officials. Furthermore, banks can cover up outstanding problems with additional credit; municipalities may issue bonds to banks, creating a circular reference; and banks can raise capital from a captive domestic market and a liquid international market to fund future growth, if ultimately to cover future losses. The second option is to address the issue now. The CBRC and MoF should work with banks to establish a multi-tier classification of existing UDIC loans, separating social from commercial loans. Non-commercial loans need to be ring-fenced and accounted for on bank balance sheets. If they are to remain in the system, they should receive an explicit local guarantee. China also needs to create a central agency separate from the banks to work towards appropriate funding for local projects. Finally, regulators should encourage banks to move towards risk-based pricing - 60 per cent of loans last year were at or below the policy rate.

China's massive counter-cyclical monetary and fiscal stimulus in early 2009 was appropriate given the threat of a severe downturn. Moreover, in this phase of China's development it would be normal for the bulk of bank lending to go into infrastructure and fixed asset investment. Even bridges to nowhere will eventually lead somewhere as 15m new cars come on the road every year.