The ratio of non-performing loans on the balance sheets of Chinese banks declined in 2012, according to their latest earnings reports, but does that indicate an improving bill of health for the financial sector? A new Reuters report claims that the country’s shadow lending system” blurs the reliability of such figures by enabling banks to shift risky assets off their own books:

Trust companies and brokerages probably aren’t buying many bad loans directly, analysts and industry executives say, but they have become a vital source of credit, allowing banks to arrange off-balance-sheet refinancing for maturing loans that risky borrowers cannot repay from their internal cash flow.

Without these institutions, the amount of NPLs might have been much higher, though no one is quite sure how high.

Trust assets increased 55 percent in 2012 to 7.5 trillion yuan ($1.21 trillion), according to the China Trustee Association, while funds entrusted to brokerages by banks soared more than fivefold to 1.61 trillion yuan.

“There is absolutely an impact on NPL figures from the ability to offload stuff through these channels,” said Charlene Chu, China banks analyst for Fitch Ratings.

China’s informal credit market grew for years under the cover of strong economic growth, but began to attract concern as Beijing tightened funding for state-run banks amid the global financial crisis. The Zhejiang city of Wenzhou in particular served as an example of China’s growing credit woes, as some cash-strapped entrepreneurs who had turned to the shadow lending market went into hiding or even committed suicide.

With on-balance sheet lending shrinking as a piece of the overall liquidity pie, China’s banking regulator has sought ways to limit the scope of the shadow lending market and hold banks more accountable for such arrangements. But Kate Mackenzie of the Financial Times questioned last week whether the most recent regulations would accomplish anything, and Bloomberg reported last month that a pilot program in Wenzhou has clearly not worked:

“We made some efforts and progress, but we didn’t achieve any meaningful breakthroughs,” said Zhou Dewen, chairman of the Wenzhou Small and Medium-Sized Enterprises Development Association, which has more than 1,000 members. “To reform means to take bold moves and not be afraid of making mistakes, but no government officials are willing to put their jobs on the line. If they could feel the pain of small businesses, they may understand that Wenzhou is running out of time.”

Former Premier Wen Jiabao announced the project last year after more than 80 businessmen, unable to make payments on underground loans, committed suicide or declared bankruptcy in Wenzhou over a six-month period. The plan was approved by the State Council on March 28, 2012. At the National People’s Congress in Beijing this month, where Li Keqiang took over the premiership, no top government leader mentioned the program or any measures to curtail shadow banking.

Of 12 measures proposed by Wen, only two — the opening of the registration center and allowing qualified small firms to issue bonds — have gotten off the ground. While officials in other Chinese cities have indicated a desire to copy Wenzhou’s lending center, none has.

Not everyone is as spooked by China’s shadow lending system, however, writes Forbes’ Kenneth Rapoza:

“Is it a problem? Yes and no is the answer,” said Milligan. “And that is because we want sustainable companies in China that we can sell to. The downside is that their financing in some cases is an unknown. A lot of the money invested is going into large holes in the ground. That’s money wasted. There is some evidence that the usual pattern of these loans is they find their way to the central government and the debts get rolled over by the local municipal banking system. I don’t think it is worrisome yet because China is perfectly able to manage the situation,” he said, adding “at the moment.”

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China’s off balance sheet debts could, in theory, implode. Pension funds could have been set up to invest in non-returning assets. Companies could be throwing money into a black hole in peer to peer lending.

But overall, China’s official, and much larger, banking system is relatively sound. Non-performing loans account for less than 1% of the total lending portfolio. In Brazil, it is more like 4.5%.

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“We should use the word ‘shadow’ with a bit of caution,” said Milligan. “This is actually a service of a bunch of concentric circles that are mostly known to the government. There is a lot of data in China. This is not an underground system trying to be hidden from view. The Central Bank is starting to piece things together,” he said.