Today you could not tell the Chinese banking system is entering a new phase in its month-long liquidity crisis, at least from the Chinese stock market. Shares ended down 0.4 percent, but the big story is that trading was only “choppy,” not volatile. 

The reason for the last-minute recovery? Government-related entities went on a buying binge, indicating that central government technocrats were supporting the market. This is at least the second time they did this in the last two weeks. On June 13th, Central Huijin Investment Co., a holding company for Beijing’s investments, bought 363 million yuan of stock of the so-called Big Four banks, according to Reuters’s calculations.

Chinese leaders have to be worried. Stocks also fell across the board Monday, with the Shanghai Composite off 5.3 percent. “We are down almost 20 percent in two weeks,” said Hao Hong of Bank of Communications International. “It’s ferocious.”

The ferocious fall is just the latest result of China’s liquidity crunch. On Thursday, overnight rates hit 30 percent, and, as a result, the credit market froze. Banks defaulted on their interbank obligations, and Bank of China, one of the Big Four, had to issue a statement to deny it had failed to meet its obligations.

The virtually universal opinion in the analyst community is that the near-disaster of last week is actually a good sign. Why? Observers believe the People’s Bank of China, the central bank, is heroic, insisting on reform by refusing to inject liquidity in substantial quantities. This is, we are told, designed to force banks to back away from their reckless affliction with dangerous banking practices. “The central bank wants to accelerate reform,” said Zhu Haibin of JPMorgan Chase to the New York Times, in a typical comment. “They want to give the market a lesson: you need to manage your risk and not rely on the central bank.”

This narrative is what everyone wants to hear, but it makes no sense. If this were true, it means the PBOC engineered the month-long credit crunch, but government officials by their nature never set out to start panics. If the events of last Thursday were the result of conscious policy, China’s central bankers are nothing short of reckless. On the contrary, they are, like their counterparts across the world, cautious.

Anne Stevenson-Yang, of J Capital Research in Beijing, has proposed a much more believable storyline. The crisis, she says, began on May 5th when the State Administration of Foreign Exchange issued a rule cracking down on fake export invoices. That caused $40 billion to flow out of the banking system, and this led to a series of crises in June.

This month, for instance, there have been two failed central government bill auctions, two spikes in short-term interest rates, and two waves of defaults in the interbank markets. In the last couple days, banks have suspended lending. Smaller banks are reportedly borrowing from loan sharks and online microfinance sites.

In this crisis, Beijing’s technocrats have no good options. Everything they could do to remedy the situation carries extremely negative consequences. For example, if the central bank injects substantially more liquidity, the fresh funds would end up in imprudent investments, as we have seen with the recent explosive growth of wealth management products. This would make the eventual crisis even bigger than it will already be.

The problem is that China does not really have a liquidity crisis; it has a debt crisis, and the debt crisis is the result of a slowdown in the economy. Despite claims from China’s National Bureau of Statistics that the economy is growing 7.7 percent, growth is more like 3 to 4 percent. And if you strip out economically useless production, the growth rate might even be 0 percent. Slow growth means borrowers will not be able to service their debts, and highly leveraged businesses and government entities will default in domino-like fashion.

What follows the ongoing liquidity crunch? Stevenson-Yang believes there will be a “severe contraction.” That’s probably the best possible scenario, as China could otherwise be facing catastrophic failure. Look for the property market to crash, money to flee stocks, the renminbi to decline in value, and money to leave the country. We could, within six months, see China’s “Lehman moment,” the beginning of a broad-based economic failure.

Almost everything we know about the mighty Chinese economy could become obsolete overnight.