Chinese regulators are playing a game of hide and seek with the country's lenders, trying to uncover deals struck with the intention of evading official loan restrictions.

Though far from easy, the search for shadow loans -- lending hidden off banks' balance sheets -- is a priority for China's policy hawks, who worry lending limits are not as tight as they used to be, and monetary policy is looser than meets the eye.

Unlike other major economies, China relies not on interest rates but on loan targets as its most potent policy tool. It tells banks how much to lend by lifting or cutting loan quotas.

But China's solid economy, which has buoyed demand for cash, has forced banks to get creative and dream up a bevy of back-up financing in recent months to bypass loan limits.

From designated loans to bank acceptance bills and trust loans, Chinese banks are pushing out a wide variety of off-balance-sheet loans, and weakening Beijing's efforts to contain lending.

Just look at the amount of cash circulating outside the banking system and you will know the true story, said Du Zhengzheng, an economist at Bohai Securities in Beijing.

Firms are turning to non-bank channels to get funds while lenders are rushing into off-balance-sheet products to skirt loan controls.

Indeed, data shows that the proportion of financing accounted for by bank loans in China dropped from 85 percent in 2008 to just over half in the first quarter this year.

The off-balance sheet financing boom belies a recent slowdown in bank lending and -- contrary to the arguments of some investors that weaker credit demand augurs a hard landing for China -- points to a still-robust appetite for loans.

Lower growth in loans is caused by monetary policy tightening as of now, not by demand weakening, said Helen Qiao, an economist at Goldman Sachs.

ECLIPSING BANK LOANS

For China's central bankers, however, ample credit is not entirely good news. Policy makers have made inflation their top goal, and the extra cash from creative lending could help keep inflation -- already at a 34-month high -- elevated.

To better track the explosion of non-traditional lending, the central bank proposed in February that China's true monetary conditions be measured using social financing, a broad group of credit that includes on- and off-balance-sheet loans and bond and equity issuance.

By this measure, China's monetary conditions are only a little tighter than in 2010, despite four interest rate rises and nine increases in reserve requirements over the past year. The central bank's 2011 target for total social financing is 14 trillion yuan, not far off last year's 14.3 trillion yuan.

That figure will stay high despite Beijing's efforts to restrain bank lending, bankers said.

Lenders have strong incentives to cash in on demand for credit by making off-balance sheet loans, including designated loans, bank acceptance bills and trust loans.

In the first quarter, designated loans, or loans lent from one firm to another but facilitated by banks, leapt to 320.4 billion yuan ($49.6 billion), more than doubling from the same period last year. Bank acceptance bills hit 761.1 billion yuan, or a third of all that was issued in 2010.

Most popular are trust loans, which are dressed up by banks as a variety of higher-yielding wealth management products to attract deposits from savers looking for better returns.

Chinese banks sold 8.25 trillion yuan ($1.28 trillion) worth of wealth management products in the first six months, topping last year's total of 7.05 trillion yuan, local media reported.

The sales of such products keep surging in our bank and I cannot see any sign of cooling in months ahead, said a banker at a small city bank in China's southwest Sichuan province, who declined to be named.

HOW RISKY?

China's bank regulator has made plain its dislike for nebulous shadow loans. It has a long-standing order to banks to move trust loans back on their books by the year-end.

It made its latest move this week by telling banks to check all bill financing deals [ID:nL3E7I40A7], just days after tightening control on wealth management products.

But some analysts say shadow loans could help avert a cash crunch if China overtightens policy in its fight against inflation.

Credit created outside the banking system can work as a cushion against excessive monetary tightening, said Goldman's Qiao.

Others are uneasy that so much lending and borrowing is happening out of sight, since it is hard to gauge if the loans were made sensibly and to what end.

Indeed, some economists say some of the off-balance sheet loans are funneled into properties and stocks, fuelling China's asset inflation, a point officials tacitly acknowledge.

The risks of such off-balance-sheet activities outweigh the benefits, because 40-50 percent of the shadow lending goes to the property sector, said Nie Wen, an analyst at Hwabao Trust in Shanghai. ($1 = 6.463 Chinese Renminbi)

(Editing by Don Durfee)

China