China’s Shadow Currency
Image Credit: REUTERS/Chance Chan

China’s Shadow Currency


China’s economy is straining to keep up a semblance of its former growth rate. The surest sign is the way a shadow market in bank paper has evolved to substitute the commodity that China is increasingly running short of: cash.

Bankers are passing around their own ersatz currency, stimulating trade with what, in effect, are off-the-books loans. As in the wildcat currency era of the United States, the antebellum period before America had a national currency, this paper trades at a discount from province to province. It is increasingly used for speculative purposes, is potentially inflationary, and is hard to regulate. The People’s Bank of China (PBOC) has been unable or unwilling to crack down, lest it provoke a serious slowdown. But when the world’s second largest economy must resort to passing around IOUs, the financial community should take note.

Bankers acceptance notes (BANs) are nothing more than a post-dated check with a bank guarantee. For example, a buyer in Chongqing might have a hard time passing checks to vendors in Shanghai. But if the purchaser gets his paper signed by, say, Bank of China, his check now has the guarantee of a major financial institution: it is money good. BANs facilitate trade by obviating the need for vendors to assess the creditworthiness of purchasers. But in China, this prosaic instrument of commerce has become a kind of shadow currency that allows under-reserved banks to purchase deposits, fuels speculation, and undermines the central bank’s control over the money supply.

“From the bank’s point of view, Banker’s Acceptance Notes are all about getting deposits,” explains a banker in Zhengzhou. In a typical transaction, a customer with cash in his pocket can put down 100 RMB as a security deposit and walk away with double that amount in BANs. The bank is pleased because it receives hard currency in return for its own funny money. The customer is delighted: he has turned 100 RMB in cash into 200 RMB in something almost as good. In effect, the bank has given the customer a 200 RMB loan without using a cent of cash.

The transaction harkens back to U.S. banking in the era before fiat currency, when banks used their own banknotes to purchase reserves of everything from gold bullion to national bank notes, British pounds, and bushels of wheat. Chinese banks print their own scrip to purchase “reserves” of cash, i.e., deposits. If the bank paper is accepted, it functions as currency and banks get to hold onto their reserves. But if people worry about the bank’s credit, or need cash (perhaps during a crisis) the bank will be forced to redeem its paper, possibly in a hurry.

In theory, all BANs are issued to support trade. When a customer is issued BANs, he must show proof of an underlying transaction. And to the extent the notes truly are backed by trade – by televisions shipments to Chongqing, say, or refrigerator exports to Seattle – there is very little risk. The notes get paid down as transactions are settled, and the bank need not worry about them. But to the extent BANs are not used for trade – to the extent they are merely rolled over and circulate as a secondary currency – they represent a constant, outstanding bank liability to high-risk industries.

“The truth is, most BANs are not used to support real transactions,” says a grinning shadow banker in Shenzhen. His company is one of many Chinese conglomerates whose business tentacles seem to span every industry from mining to tourism. But nearly half of its transactions are unprofitable: they are formalities, conducted solely for the purpose of acquiring BANs. “BANs are supposed to be issued only to support trade. But the rules are very flexible, and there are ways around them,” he continues. For example, trading partners can coordinate so that transactions net out. Party A sells Party B 100 RMB of widgets and Party B sells Party A 100 RMB of widgets. They both walk away with the same widgets they started with, and an extra 100 RMB of BANs each. As if by magic, the transaction has generated 200 RMB of highly liquid, bank-guaranteed financial assets.

BANs without underlying trade are used to finance speculation. Shadow bankers sell the BANs at a discount of about 5 percent – a process known as “discounting” – in return for cash. The seller of the note needs walking-around cash and is willing to dump his paper at a loss. After all, the seller is likely a speculator. He only loses 5 percent on the sale of the BAN, but his cash is invested in trust products or lent into the grey market at yields well in excess of 10 percent. The buyer of the note is likely to be a grey market BAN broker. As far as he’s concerned, he’s earning a risk free 5 percent by purchasing bank-guaranteed paper at a discount. In other words, a piece of paper – an IOU – is being passed around on which first a speculator and then a bank gives a guarantee. In this way, credit flows from the banks through shadow bankers and into property and other high-yield, high-risk industries such as mining or infrastructure. What looks to a banker like a purchase of televisions or washing machines in Shanghai could easily end up financing condominiums in Jiangsu or rolling over coal debt in Inner Mongolia. Most worrisome is that banks account for BANs as guarantees; guarantees are obligations that, a la Fannie-Mae, do not appear on a balance sheet.

The banks find the off-balance sheet accounting treatment of BANs particularly useful. Onerous statutory requirements force Chinese banks to keep a loan to deposit ratio (LDR) of 75 percent or less. BAN issuance simultaneously decreases loan balances while increasing deposits; it relieves LDR pressure on both sides of the vinculum. Of course, the change in LDR is a purely cosmetic change: the risk – and leverage – in the bank is just as high as if it had extended a plain vanilla loan, but the leverage is moved off balance sheet. Hence, to the extent BANs are used for speculation, they represent bank exposure to high-risk activities that is invisible to regulators, investors and even bankers themselves.

January 23, 2014 at 01:45

I want to make sure I understand the mechanism.

Bank A issues an acceptance for 100RMB postdated for 90 days to me. I only need to deposit 50RMB now and then deposit the rest before the acceptance becomes due.

Is that correct?

December 18, 2013 at 07:14

“I’ll gladly pay you Tuesday for a hamburger today.”

This BAN scheme looks like banks in China have developed an industrial-strength payday loan side business in each province.

Moira Gallaga
December 16, 2013 at 23:04

A bit difficult to wrap my head around the financial aspect of the shadow money, but it does seem to hint as a possible problem for China.

December 15, 2013 at 21:07

«Party A sells Party B 100 RMB of widgets and Party B sells Party A 100 RMB of widgets. They both walk away with the same widgets they started with, and an extra 100 RMB of BANs each. As if by magic, the transaction has generated 200 RMB of highly liquid, bank-guaranteed financial assets.»

I don’t get it. Party A sells Party B 100 RMB worth of widgets. Party B pays with a BAN of 100 RMB. Then Party B sells Party A 100 RMB worth of widgets. Party A pays by returning the same, unique, BAN of 100 RMB. Nobody has generated 200 RMB of any kind, and the BAN is back to its initial owneer. It’s like Party A and Party B were using barter, by exchanging directly their widgets, each party’s worth 100 RMB.

Either you clarify your article, or you stop writing nonsense.

December 17, 2013 at 14:02

There’s not much difference between economics and nonsense, I find.

Canyon Bosler
April 11, 2014 at 01:19

You misunderstand. Each company traded 100 widgets now for RMB100 in the future in the form of a bankers’ acceptance. Now the two companies both have a RMB100 BA that they can use for other transactions or discount for a smaller amount of RMB (say, 95) in addition to the same assets they had before (100 widgets). They still owe the bank for the BAs they issued, but they’re going to have to make that money somewhere other than the transaction that is theoretically the foundation for the BA. The BAs are not truly tied to the underlying widget transaction, which was just a scam, so they have to find some other way of paying back the bank — Lowenstein thinks they do so though speculative investment. The whole point is just to demonstrate how BAs, despite ostensibly being tied to transactions and thus fairly low risk, can become plain old loans that could be much riskier.

9 dashes, 4 dishes - 1 soup
December 13, 2013 at 17:20

This is an astonishing article. The BANs are more than checks (cheques). They are more similar to ‘cashier’s checks in the US. They are notes drawn on a specific deposit – with a guarantee of bank acceptance in advance.

However, in paragraph 4, the author points out that unlike cashier’s checks, BANs can exceed the amount on deposit. A depositor of 100 RMB can walk away with 200 RMB in BANs – according to the author – thus doubling his or her money in a single deposit. Only 100 RMB are deposited. But 200 are guaranteed by the bank holding the deposit.

In paragraphs 8 and 9, the author explains that BANs are basically loans that are not counted toward the bank’s statutory loan to deposit ratio of 75% or less.

In a normal case, the bank sells a 100 RMB BAN for a 95 RMB deposit. That 100 RMB is then invested in speculative undertakings that may pay more than 5% or may fail completely. Either way, the bank is on the hook for the 100 RMB it guaranteed. And as paragraph 4 points out, the bank may lose far more than the 100 RMB it guaranteed. And the beauty of the scheme is that it’s all off the books.

Wow! What a sweet deal for depositors. In a normal case, they can pocket 5% off a single transaction – every day – every deposit they make. 5% a day – 365 days a year.

Who couldn’t get rich fast in a scheme like that?

December 14, 2013 at 03:56

What you just describe is called kiting in the banking world. And it is illegal everywhere in the world. LOLz. Oh, BTW, it was used thousands of years ago when our ancestors tried to pass off seashells in exchange for gold.

December 13, 2013 at 08:11

So is the article saying that a BAN guaranteed by the BOC is good all over China but a BAN signed by a provincial bank is only good in that province?

December 13, 2013 at 12:56

People’s Bank of China (PBOC/PBC) is the central bank of PRC, Bank of China (BOC) is just one of big four stated-owned commercial banks in PRC. It seems PBOC does not issue BAN, only BOC issues BAN. But RMB (the PRC’s currency itself) is issued by the PBOC and RMB is good all over China as well as good at a lot of other nations around the world too.

December 13, 2013 at 00:11

Dude, Banker Acceptance Notes is also called a cheque in the world. It is a common mechanism for exchanging money.

December 13, 2013 at 03:51

Let’s turn the tables around a little bit. Let’s say YOU were selling an automobile worth $100,000 and someone you don’t know (or don’t trust) were to come to you and offer to purchase the car from you with a personal check of $100,000. Would YOU accept? If you said yes, you’re either completely naive or lying through your teeth. Problem is you don’t know if that check is worth anything. There’s a reason why the use of “checques” are in decline and slowly being phased out in many places of business.

Fault is entirely yours
December 13, 2013 at 11:56

In a transaction, the buyer has to give money first before seller hands over the merchandize; it seems you are confused cheque with money, cheque is not money, it is only a note saying you have the money on the cheque in the bank. Until the cheque is cashed, usually the merchandize will not be changed hands. Writing a cheque without the money to be cashed is a felony, a punishable crime by law.

In developed nations, people do purchase cars with personal cheques, people even buy houses with personal cheques, but usually you need to provide additional informations for the seller to verify your personal cheque is in good standing.

Unfortunately the verifying process is time consuming and costly, but seller can let you have the merchandize right away by using you credit card as guarantor of your personal cheque (of course your credit card has to be checked first via phone, etc.), getting your personal cheque certified, or providing banker’s draft.

Electronic payment provides the advantages of convenience, speed and lower cost that cheque cannot match; these advantages are the causes of cheque usage in decline.

It seems you are lack of understanding of cheque, then blame the cheque for faults of the human beings. It is common trait of developing nations.

December 14, 2013 at 03:46

Apparently, you have never use a cheque before. You never heard of a crossed cheque or a certified cheque, which is as good as cash to the receiver? Duke, in my company we issue cheques for over US$300,000 at times.

not exactly
December 15, 2013 at 01:43

Except you can get a BAN for 50% off face. A standard bank check is sold at 100% + a small commission.

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