On Tuesday, the Shanghai Securities News reported that a Chinese official at the State Information Office hinted that the country's central bank, in order to stem deflation, will lower bank interest rates.

Consumer and producer prices have been declining in China in the last several months, but most analysts think inflation will return by the end of the year when the economy picks up speed due to Premier Wen Jiabao's stimulus program. In short, no one actually believes deflation is a problem.

Then why is Beijing talking about dropping rates to engineer price increases? Here's a theory and a prediction: The Chinese government will, in reality, mount an effort to increase the profitability of the largest state lenders by reducing rates paid to depositors, thereby lowering the banks' cost of funds. Yet these gigantic financial institutions--one of them dethroned Citigroup last year to become the world's largest commercial bank ranked by market value--have been reporting handsome profits lately.

So why do profitable banks need help increasing profitability? There is only one explanation that makes sense: Beijing thinks its financial institutions will soon suffer loan-quality problems. After all, Liu Mingkang, the head of the China Banking Regulatory Commission, has been issuing warnings, beginning last month, that recent lending practices could endanger the health of China's banks. According to Liu, banks are lending too much and concentrating their lending into too few sectors.

Most observers believe Beijing solved the bad-debt problem of the state banks long ago. According to the banking commission's figures, these institutions have a nonperforming loan ratio of just 2.04%. The banks, according to just about everyone, reformed their lending practices and became modern institutions, quickly moving away from their role as funnels for government cash to state enterprises and state projects. The global business community bought the story, and many foreign investors purchased large stakes in Chinese banks. Three of the so-called Big Four state banks sold stock in international public offerings that rank among the largest in history. The fourth bank--Agricultural Bank of China--is about to go public too.

This happy story, unfortunately, proved to be illusory. Last November, China's State Council announced a $586 billion stimulus plan to restart growth. To conserve its own resources, Beijing decided to rely on state instrumentalities, and especially its banks, to provide much of the cash.

In the first quarter of this year, loans soared. New lending totaled an astonishing $670 billion, as Chinese banks managed to use up 92% of the quota Beijing set for the entire year for new loans. Total loans during this period increased 15%.

Beijing demanded that the state banks make loans and that state enterprises borrow, and that's exactly what happened. As Ma Jun, Deutsche Bank's ( DB - news - people ) chief China economist, said, "There are a lot of companies that borrowed not for the need of business expansion, but rather were talked into borrowing by banks." Take China Aviation Industry Corp. for example. AVIC, the country's largest aerospace business, borrowed 236 billion yuan--about $34.6 billion--from 11 banks in the first quarter of this year. That sum is in addition to an additional 100 billion yuan from the Export-Import Bank of China.

Lin Zuoming, AVIC's general manager, says his biggest concern of the moment is how to use all the cash that was shoveled onto his doorstep. Inevitably, borrowers will use loan proceeds for unviable projects, thereby imperiling repayment to the banks. Already, we know that a substantial amount of bank lending has found its way into the Shanghai stock market, thereby fueling the astonishing 40% rally that began at the beginning of this year.

Lending in April is down from March--how could it be otherwise?--but the banks are still on a tear funding government "beauty show" projects that were turned down in a more prudent era. In the current banks-gone-wild environment, it is virtually impossible for these state institutions to maintain lending standards. So, we all know what will happen next. There will be mountains of bad loans weighing down the balance sheets of state banks when uneconomic projects go bust.

So will there be a new banking crisis? Many argue that the state banks will never default because the central government will use its foreign exchange reserves to shore them up. Although Beijing has taken cash from its reserves to partially recapitalize these institutions and could do so again, foreign currency is not much use, as a practical matter, in the midst of a local currency crisis. China can't satisfy local currency obligations with dollars, euros or yen. Moreover, a massive purchase of renminbi with foreign currency--to pay off depositors, for instance--would send the value of China's currency skyward and therefore would make the country's exports uncompetitive. That, inevitably, would wound the broader Chinese economy.

And there is one more point: The state banks do not have to actually trigger a crisis to cause great damage to China's economy. Beijing will undoubtedly try to repair bank balance sheets by dropping both deposit and lending rates to abnormally low levels. This will create imbalances in the economy and, as Peking University's Michael Pettis argues, undermine efforts to stimulate consumption. Stimulating consumption is job one for Premier Wen, especially if the country cannot export its way out of the global downturn because the crisis is deeper and longer than expected.

Beijing's technocrats, by engineering one of the greatest lending surges in history, are creating the condition for China's next banking crisis. So stay tuned.

Gordon G. Chang is the author of The Coming Collapse of China. Starting today, his column will run weekly, on Fridays.