The Australian sharemarket lost 10 per cent over January and commodities markets took a drubbing as it became clear that Chinese authorities were taking steps to end what they euphemistically call "moderately loose monetary policy".
Markets later stabilised, as those whose outlook extended beyond the next trading day realised Chinese policymakers were reducing the risk of a harder, inflation-induced landing later in the year.
"On balance, it is plausible to argue that the recent tightening in credit conditions is a favourable development in that it increases the likelihood that the Chinese economy is on a sustainable path," was last week's cautious assessment from Phil Lowe, deputy governor at the Reserve Bank.
Says Gerard Minack, an economist and strategist at Morgan Stanley: ''It ultimately is a market dip to buy.''
The biggest risk to China's economic outlook is not that policymakers are taking steps to end the country's unprecedented lending boom, but that they are not yet serious enough about doing so.
In a country with no central-bank independence and an insecure and short-term-focused political leadership, the politics of easy money seem all-too comforting. Indeed, there is hardly an official in the country who isn't warmed by the sight of extra cash flowing down their corridor, aside from China's embattled corruption watchdogs and banking regulators.
Since mid last year, both Zhou Xiaochuan at the People's Bank of China and Liu Mingkang at the China Banking Regulatory Commission have shown their concern about the amount of money pouring out of China's "commercial" banking vaults.
Regulators signalled their alarm when 600 billion yuan ($97.5 billion) of new lending was shovelled out the door in the first 10 days of January.
They watched with horror when the figure rose to 800 billion yuan in the second 10 days, before finally reversing this trend with draconian administrative edicts (which were only vaguely publicly acknowledged).
Barry Naughton, who "wrote the book" on the Chinese economy, shows in the latest China Leadership Monitor (www.Hoover.org ) that the costs of the Chinese state's successful response to the financial crisis could be deeper than many had feared.
The problem is not just that money flowed to inefficient state-backed projects. Rather, the sudden expansion of administrative power ''profoundly disrupted'' China's steady evolution towards a more market-oriented incentive system.
''Once the scope of the state sector is indeterminate, and administrative interventions are repeatedly redrawing the boundary between state and private, then individuals must devote a great deal of their attention to anticipating and manipulating those administrative acts,'' writes Naughton.
In short, it became rational for state and non-state actors to spend much more effort on politics and much less effort calculating market risks and rewards. The most obvious damage was to the integrity of China's banking system.
''With the government and the Communist Party strongly behind a raft of investment projects, banks have little reason to worry about risk,'' says Naughton. ''Since these are government projects, the government implicitly guarantees the risk if they go bad. After a decade of progress in the other direction, bank budget constraints are now 'softening'.''
China's loss of banking discipline has translated into a loss of monetary policy control, as Zhou's central bank and Liu's banking commission shuffled responsibility between them without any strong backing from the Communist Party leadership.
''The result was something like trying to compress a balloon: while the regulators tried to squeeze, spurts of new lending kept coming out in unexpected places,'' says Naughton.
And that's why, when regulators last month signalled their unease at infinite cheap credit, bank chiefs were racing each other to secure a greater share of a shrinking pie. (The only prominent exception was Guo Shuqing, head of China Construction Bank, who has the credentials and ambition to replace Zhou or Liu as a top banking regulator).
"It is an incentive system, and a system dynamic, that is familiar from the planned economy," says Naughton.
In the short term, Chinese officials are getting rich, projects are getting done and political leaders are basking in the fealty that comes from handing out expensive public favours with infinite personal discretion.
Maybe only an outbreak of inflation will prompt the politicians who control China's economy to seriously tighten monetary policy.
Naughton notes Chinese premiers tend to lose their job security when inflation hits 5 per cent, a threshold that could easily be breached mid-year. That might trigger a meaningful revaluation of the yuan. Beyond belatedly containing an inflation break-out, however, Naughton is pessimistic that the Chinese economy will be firmly placed back on the path of marketisation and reform.
"The Chinese economy will have to encounter some kind of short-term crisis before the government will contemplate taking the steps necessary to adjust its policies," he says.
"It is very difficult to get change out of a political system that seems to be succeeding so brilliantly on its own terms."
Still, the cadres who have steered the Chinese economy since 1978 have shown an uncanny knack of swerving before hitting the tree.
''The next 20 years … on average is going to be a very good 20 years for China ,'' said Reserve deputy governor Phil Lowe on Thursday, in answer to a question about wasteful Chinese investment. ''I'm quite optimistic that the story has got some decades to run and that's underlying my general optimism of our prospects with the Australian economy.''
