RENEE MONTAGNE, HOST:
And last week was a wild one for China's economy. First, interest rates on the loans that banks give each other spiked. As the banks struggled to get money, stock markets dropped - not only in China - but throughout Asia - and briefly in New York.
Things have calmed down since then. But the crisis showed how China's new leaders are just beginning to confront some fundamental problems in the world's second largest economy.
We're going to NPR's Frank Langfitt in Shanghai to tell us what they're doing.
And good morning.
FRANK LANGFITT, BYLINE: Good morning, Renee.
MONTAGNE: Remind us what sparked this panic in the first place?
LANGFITT: Well, the big context really here is this is the first shot by new government in a kind of a battle to fix China's financial system. Banks were getting squeezed for cash, as they usually do towards the end of the second quarter, and usually the government will come in and pour money into the system. This time they didn't do it and credit started to freeze up.
What the government was doing was sending kind of a tough new message to financial firms and banks and saying basically, you've got to get your house in order. There's been a lot of credit growth here in recent years. The government is worried about bad loans, not good projects, and they're particularly concerned about a sector of the finance industry called the shadow banking business.
MONTAGNE: The shadow banking. Frank, what exactly is that?
LANGFITT: Well, shadow banking is really interesting. China's formal financial system is quite inefficient and kind of outdated. The government controls deposit rates, it keeps them low, often get not very good returns to people. The state banks have a monopoly and they only like to usually lend to state companies. So what has happened is people have set up investment trusts that can funnel money to companies and return much higher rates to people. The problem is this has grown really fast - about 300 percent in recent years. The governments worried that a lot of that money has been going into the real estate bubble here. And so the new leadership wants to reduce that growth to avoid a crash.
MONTAGNE: Now here's something one can't help thinking. China is a one-party state. Why can't the Communist Party - which has so much power - just dictate changes?
LANGFITT: Because actually, the political system here in one sense is actually a lot more like the U.S. than you would think. There's lots of money vested interests here - like those state banks I was talking about. So let's say you wanted to introduce a lot more bank competition, the monopoly banks - they've got big profits - they don't want to see that, and so they try to fight it. Now right now, what the government is saying is we're really serious now, we've got to have a lot more efficient system, and we're going to make changes.
I was talking to a guy yesterday named Oliver Rui. He's a finance professor here in Shanghai at China Europe International Business School. And he put it this way, is how kind of a lot of economists are seeing it these days.
OLIVER RUI: Don't underestimate the determinations of the new government. They are very serious because it's a threat to the safety of their power and also the country.
MONTAGNE: Well, then, let's get back to the heart of the matter. China is such a huge global player. How much is at stake here for the government and China as a whole?
LANGFITT: I think really, in the long run and for the future of the country and political leadership, they know that the economic model they have now isn't going to work anymore. Cheap exports are pretty much over, and they need to make a lot of changes. And one is they need a much more efficient banking system - getting money into the parts of the economy that create jobs, that create growth. And so if the economy now continues to slow, people think you're going to see a lot more push for change from the new leadership, and they say frankly, the new leaders don't have any choice.
MONTAGNE: That's NPR's Frank Langfitt speaking to us from Shanghai.
Thanks very much, Frank.
LANGFITT: Happy to do it, Renee. Transcript provided by NPR, Copyright NPR.