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Analysis
China's shadow banking seeks the light

China's shadow banking seeks the light

Reforms reflect efforts to strengthen market economy

by Julia Leung

Wed 2 Apr 2014

To compare China's 'shadow banking' to the US subprime crisis makes catchy headlines. To suggest that China is facing a 'Lehman moment' sounds scary. One shouldn't be surprised that, on China, market commentators are in a state of either euphoria or depression. The truth lies somewhere in between.

Although the growth of shadow banking has undoubtedly brought risks, this is not a problem on a systemic scale. The China Banking Regulatory Commission (CBRC) has taken a series of actions to contain the sector's growth. Further development of the system is likely to be messy, as more trust loans will go bad amid China's slowdown. Non-performing loans will increase. But China's banking sector, long protected by interest rate ceilings, is hugely profitable and adequately capitalised to cope with a serious rise in non-performing loans from the average 1% seen up to now.

Tightening prudential regulation to contain the growth of shadow banking may be necessary. But this is merely a shorter-term expedient. The real solution lies in tackling the root of the distortions caused by the interest rate structure of the domestic financing sector. The best way to encourage banks to bring their lending business in from the shadows would be for the authorities to liberalise remaining controls on deposit rates. Finding remedies for shadow banking is part of a general effort to bring about deep-seated structural reforms across the Chinese economy.

One distinction needs to be made. China's shadow banking, which experienced phenomenal growth in the past four years, is very different from that in the US. In the west, shadow banking normally refers to non-bank financial products such as money market funds (MMFs), asset-securitised products in the wholesale market which has become an important source of short-term liquidity for banks. The 'Lehman moment' came in September 2008 when funds that had invested heavily in Lehman papers 'broke the buck', triggering a run on MMFs and the seizing-up of the wholesale funding market.

In China, a significant part of its shadow banking is de facto bank financing off balance sheet. This credit comes in three main forms. First come trust loans, which are lending extended by trust companies, often with the latter acting as a conduit for bank lending. Then we have entrusted loans, a kind of peer-to-peer lending mechanism among companies, with banks acting as middleman. Third come corporate bonds and riskier commercial bills, known as undiscounted bankers' acceptances.

The amount of credits generated in this new form is staggering. According to data from the International Monetary Fund (IMF) and the People's Bank of China, these three categories at end-2013 stood at just over Rmb30tn ($4.8tn) or roughly 25% of total financing in China, up 30% from a year earlier.

By comparison, bank loans make up 70% of the total stock of financing. But in flow terms, shadow banking is much more significant, accounting for 40% of new total financing last year, while banks took up 50%. Rapid growth in this sector has been the main reason driving total financing to 200% of GDP in the fourth quarter of 2013, from 129% of GDP in 2008, according to IMF data.

China's shadow banking is a by-product of the massive fiscal and monetary stimulus announced in late 2008 to offset the shortfall in external demand following the near-meltdown of global finance. This gave the green light for provincial governments to step on the gas pedal. Using land as collateral, local governments used their own financial platforms and trust companies to borrow from banks to finance infrastructural projects and real estates. Such financing needs are insatiable, limited only by the supply of credits.

In China, credit quotas and loan-to-deposit (LTD) ratios (75%) used to be an effective tool to rein in credit expansion. Commercial banks wishing to expand lending traditionally have to expand their deposit base, but regulated deposit rates prevented them from competing through price. This is where the banks, particularly those with smaller deposit bases, became innovative. Collaborating with trust companies, banks started the practice of selling trusts' investment products and wealth management products (WMP) to high net worth individuals at 8-10% returns, more than double the rates they receive on term deposit accounts.

The banks used such WMP proceeds to purchase assets in areas like real estate, coal mines etc. When bank regulators issued decrees limiting such activities, they kept a step ahead by burying such financing deeper off balance sheet.

Banks have been trying to play a much-needed role to help bring flexibility into a partially liberalised interest rate system. But such off balance sheet financing is opaque and under-regulated. In addition to taking on riskier credits, banks face serious liquidity risk in tapping WMP proceeds to fund illiquid long-term projects. Disclosure and standards for investor protection are often inadequate.

There are no simple answers to the question of who bears the losses if borrowers default. I am told that the legal documents would say it's not the trust company or the bank which sells them. When China Credit Trust's loan to a Shanxi coal mine went sour, investors were bailed out with full repayment of principal, but not the promised 10% interest rate. Moral hazard is high. Partly because of this, the authorities have allowed the first corporate bond default without a bail-out. The market is guessing that the same would apply to shadow banking. That might unsettle markets in the short-term. Yet over the longer-term such steps form part of progress towards China becoming a more market-oriented and efficient economy.

Julia Leung is former Undersecretary for Financial Services and the Treasury in Hong Kong and Senior Adviser to OMFIF.

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