China is moving to stem a surge in credit that could produce a wave of bad debts and financial failures, but it risks slowing the world’s second-largest economy

Updated June 9, 2013, 8:15 p.m. ET

Slower China Credit Is Risk to Growth

Government’s Measures to Stem a Previous Surge in Borrowing Could Hamper Economic Expansion

By BOB DAVIS

BEIJING—China is moving to stem a surge in credit that could produce a wave of bad debts and financial failures, but it risks slowing the world’s second-largest economy.

Total social financing, China’s widest measure of credit, fell by about one-third to 1.19 trillion yuan ($194 billion) in May from April, the second month of substantial decline, the People’s Bank of China said Sunday. And new bank loans, a subset of total social financing, also have fallen substantially in the past two months.

Total social financing consists of all manner of financing including banks, trusts, financing companies, trade credit, corporate bonds, certain kinds of interbank lending and informal lending by individuals, among other kinds of credit.Regulators, however, have a way to go to curb overall lending. In the first five months of 2013, total social financing was up 52% from 2012.

But putting the brakes on lending risks a further slowing of China’s growth, as companies, government infrastructure projects and real-estate developers find it tougher to find financing.

A raft of data for the month of May suggests the current quarter could be a second consecutive period of disappointing growth, and many economists have been downgrading their forecasts for this year’s economic expansion.

A lending-fueled spending binge following the 2008 financial crisis rekindled China’s growth but saddled local governments and other borrowers with heavy debt, raising concerns about the health of the Chinese financial system. Now China’s officials are faced with a dilemma: slowing the pace of lending to avoid deepening financial problems is likely to reduce the rate of growth as well.

For the past decade, at least, China has counted on lending from its big state-owned banks and other financial institutions to fuel growth, especially loans to real-estate developers and to local governments building subways, highways, airports and other infrastructure.

But since the global financial crisis, the payoff from such lending has fallen and concern has grown that lending now is going to many projects that won’t be able to meet their financial obligations, forcing the central government either to intervene or allow a wave of bankruptcies.

Since 2010, financial regulators have pressed big state-owned banks to curtail lending to such borrowers, but a host of nontraditional lenders has emerged to meet finance needs. T

They include what are known as trust companies, which channel money from wealthy investors to real-estate and infrastructure projects. And while trust companies are supposed to be independent from banks, the two are often interlocked, with banks sending clients to trusts for financing and selling trust products in bank offices.

On Friday, the central bank warned that unconventional lending known as shadow banking was creating increased risks for the financial system.

In May, both traditional bank loans and nontraditional lending fell. New trust loans, for instance, fell by about half to 99.2 billion yuan from April, as regulators tightened lending rules and clamped down on wealth-management products that channel funds to trusts. A crackdown on abuse of export invoicing to bring funds into the country also may have dented flows into shadow banking.

The effects of a slowing Chinese economy would ripple across the globe, hurting foreign commodity producers, farmers and machinery makers, among others, who count on China for exports and places to invest.

Chinese President Xi Jinping told U.S. President Barack Obama at their meeting over the weekend in California that he was comfortable with China’s first-quarter growth in gross domestic product of 7.7%, compared with a year earlier, according to the Chinese central government’s website Sunday.

The first quarter was one of China’s slowest periods since the global financial crisis of 2009. But Mr. Xi said such growth was “good for restructuring the economy and good for improving the quality and efficiency of the economy,” according to the government website.

Beijing is trying to restructure its economy so it depends less on exports and investment in infrastructure and capital-intensive industries and more on domestic demand. But making such a change is hard. Consumers are unlikely to spend more if they feel the rest of the economy is heading into the doldrums.

Over the weekend, China released statistics suggesting a slowdown in domestic demand, including a 0.3% decline in May imports on the year and a 2.9% fall in the producer price index. Producer prices have fallen for 15 consecutive months, reflecting vast overcapacity—or insufficient demand—in steel, aluminum, glass, solar panels, cement and construction equipment and other industries.

China’s industrial output was up 9.2% year-to-year in May, off fractionally from April’s growth rate, and much slower than the rates of expansion routinely recorded in 2010 and 2011.

Electricity output, a barometer of industrial activity, rose 4.1% year-to-year in May versus 6.2% in April. Construction starts by area, a key measure of the health of the property market, were up just 1% in the January-to-May period, versus the same five months last year.

“Leading indicators slowed across the board,” said Nomura economist Zhiwei Zhang, who forecasts second-quarter GDP growth will fall to 7.5% year-to-year and continue to decline the rest of the year. Ting Lu, an analyst at Bank of America, BAC +1.36%said he expected second-quarter growth to come in at either 7.6% or 7.7%.

President Xi said Beijing was using targeted measures to tackle economic problems, the government website said, though he didn’t enumerate any.

Still, loans extended in the first five months of this year could help support growth going forward, even if new lending continues to slow. But a number of analysts said the continuing poor results were bound to put pressure on Chinese leaders to launch another round of stimulus, even if that means boosting credit the government is now trying to get under control.

RBS analyst Louis Kuijs, a former World Bank China economist, said China’s leaders aren’t likely to move unless they see evidence of rising unemployment, and there are scant indications of joblessness.

In the past, he said, Chinese officials thought 8% growth was necessary to avoid employment problems. Growth may slowed to 7%, in part because China’s workforce has begun to shrink, demographers say.

“The government may not deviate from concerns about reform until then,” Mr. Kuijs said.