China’s Shadow Banking Challenge


It is becoming clear that, as in 2013, the defining word for China this year will be “reform.” Yet if 2013 was a year for much talk and less actual implementation, 2014 is already shaping up differently. For the financial system, in particular its shadow sectors, this year will be a tough one. Inherent risks from slower growth and restructuring policies combined will test the system and its leaders.

Whether through the story of a dramatic rise in local government debt; several bubbly local real estate markets; the problem of non-performing assets (including local government debt) being rolled over, disguised or otherwise hidden; the increasingly frequent spikes of interest rates in China’s interbank lending market; or the questions surrounding “wealth management products” and the “shadow banking system” – it is the Chinese financial system that lies at the true heart of much that is being targeted for change in the country.

Indeed the financial system has emerged as both one of the main causes and significant results of the distortions that have been developing in China’s economy. Compared to hukou reform, or changes to ownership rights affecting rural residents, the financial system reforms are more difficult, potentially more disruptive, and arguably very urgent.

The People’s Bank of China (PBOC), led by reformer Zhou Xiaochuan, has taken a leading role in driving the financial reform process in China in recent years. However, the central bank, along with reformers on the State Council, the other financial regulatory institutions, and upper levels of party-government, are constrained by some hard truths that lead to sometimes contradictory-seeming policy decisions.

To put the issue simply, the large build-up in debt levels in China – total debt including the central government and its ministries, local governments and corporate debt (both state owned and private) is now over 200 percent of GDP – combined with falling growth rates, mean that the economy is on an unsustainable path. The increasing amounts of credit required to deliver GDP growth suggest that, indeed, investment has been too high for too long, and has been increasingly misallocated as the projects with strong returns have been depleted as targets.

Data released January 15shows that China’s credit growth moderated during 2013. Total Social Financing (TSF), which attempts to include elements of the “shadow banking” system, grew by “only” 9.1 percent in 2013 – still ahead of GDP growth. Broad M2 money supply increased 13.6 percent at the end of December compared to the previous year, while the total stock of outstanding loans grew by 14.1 percent.

To a certain degree, even with the decreases last year, China has walked (or perhaps run) into a debt trap. How? In short, easy credit and liquidity has become increasingly necessary to keep growth ticking over. Now a serious tightening would force many entities into financial distress, and a “subprime” moment could be reached: If liquidity levels were suddenly restricted, then interest rates would rise, resulting in a spike of debt servicing costs. Growth rates would collapse as corporate distress spreads throughout the economy. Contagion throughout the formal and “shadow” financial systems would be a risk.

However, doing nothing and allowing the credit to flow is no solution. This will only increase the total debt load, and with it the total problem. Eventually, the costs (hidden or explicit) of servicing the debt mountain and associated distortions will themselves collapse growth levels (some believe this has already begun). As Anne Stevenson Yang from J Capital recently noted, “…China is in a spiral: the more money goes into the economy, the more credit will be required to pay off the old.

One market-theory method to stop credit being misallocated, and to stop non-profitable ventures receiving it, is to raise interest rates. (Incidentally, higher deposit rates will also end the consumption-suppressing transfers from the household sector to mainly corporate and government-corporate borrowers). It is clear that Zhou, Prime Minister Li Keqiang, Politbureau Member Wang Qishan and other leaders support this theory. Yet they are limited by circumstance, and for reasons explained above, must move gradually.

Thus in 2014, we can expect policies, including and especially those coming from the PBOC, to seem erratic and sometimes contradictory, as the government tries to nudge the economy towards a more stable path without pushing it over a cliff. Throughout 2013, the PBOC has been leading the process (with the implicit authorization of the State Council) to drive de facto interest rates higher. In fact, the PBOC’s actions largely explain the much smaller gain in TSF over 2013 compared to previous years. In 2014, this will continue (absent a dramatic slowdown), and show just how much the reformers have gained the ascendency in China’s policymaking circles

In 2013, the PBOC’s pressure on the money markets resulted in “cash crunches” in June and December. Even if the unusually high amount of fiscal deposits at the central bank at the end of the year were partially responsible for the latter, the PBOC remains the prime cause. There will probably be more to come.

Why? Unable (or unwilling) to tackle the controls on normal bank deposit rates in the formal banking system yet, the PBOC is first focusing its efforts on the money markets and, by turn, the shadow banking system that relies on them to function. In China the shadow system is a multi-headed beast including trust companies and trust lending, asset management companies, wealth management products (WMPs) issued by formal banks and other entities, corporate-to-corporate lending, pawn-broking, loan sharking, and more.

Herein lies one of the main policy debates and source of many of the policy contradictions in China today. The shadow banking system, in part developed as companies, bankers, financial innovators and various other agents sought to avoid the squeeze on runaway credit which began several years ago, is in fact itself a more developed and liberalized system of credit allocation. Interest rates are higher than those in the formal banking system (both for investors and borrowers); the importance of political connections is smaller, (although by no means non-existent). So why, if the PBOC, CBRC, CSRC and State Council want to increase interest rates (and thus the efficient allocation of credit) would they seek to “rein-in,” tighten conditions or punish players in this shadow system?

Oro Invictus
January 22, 2014 at 05:19

What I’m still waiting on is for someone to offer a convincing explanation for how, if the CPC wants to reverse the current positions of fixed investment and services in the PRC economy within ten years, they can do this and maintain GDP growth levels above (at most) 4.5% when such a thing is an arithmetic impossibility.

This is one of the reasons why I take issue with capital economics: It too often feels like something the Learn’d Astronomer would concoct if he worked for the Ministry of Truth.

Oro Invictus
January 22, 2014 at 05:23

Ah, yes, here’s a link to my post where I first brought up this issue upon being made aware of it, in case anyone wants more background on what I’m talking about:

January 22, 2014 at 11:50

I think you are right and that it will be very hard to do so (unless they find a way to do a lot of rolling over without adding to the servicing costs).

January 22, 2014 at 04:48

The article mentioned the coal sector as being in distress. It is said that the government is reluctant to bail out the coal sector. But the fundamental question is not whether to bail out the coal sector or not. The question is why the coal sector is in trouble in the first place. I suspect the coal sector is in trouble because it is using obsolete technologies so that its production is not cost effective enough and so it cannot generate enough coal output to repay the loan. The solution is, as I point out, to use more advanced technologies so that the coal sector as a whole can be more productive using more efficient tools and machies and with more mechanization, automation and robotization. This means with the same per unit of yuan investment the output of coal will be doubled or more. Then the coal sector as a whole can generate more incomes per unit of loan which means they will have no problem repaying their loans. This is why technological advancement must come first. Screwing around with arrangements for loans and interests rates and restricting and controlling “shadow banking” will ultimately not solve the fundamental problem of technological backwardness and lack of productivity and will ultimately lead to total collapse of Chinese economy.

One such company in the coal sector is now facing bankruptcy and is unable to service a loan. Its loan was repackaged as a RMB 495million WMP by China Credit Trust Company and distributed by the Industrial and Commercial Bank of China (ICBC). At the time of writing, ICBC is refusing to stand behind the product – perhaps wishing to avoid setting a precedent. For authorities the dilemma is clear. Bailing out or arranging support for the product will prevent a possible self-fulfilling panic in the WMP sector, but doing so will deliver the potentially unhealthy message to market participants that the government will rescue investors when necessary. Even if this company’s distress is resolved, unknown numbers of similar unprofitable companies and projects underlie other WMPs and other shadow finance.

January 22, 2014 at 11:51

It seems to mention just one company in the sector, not the whole sector itself as being in distress.

January 22, 2014 at 03:05

What are the chances that the government will go to far and create a panic while it tries to sort out the risky parts of the shadow financial system? The way I see it, there government has an almost impossible task. If they don’t act fast enough, debt is going to keep piling on, and the system strain more and more. If they act too fast, then financial distress, debt deflation, minsky moments etc will all make their return (as they always do!)

January 21, 2014 at 15:14

Good points! I agree. This article is addressing how to deal with the existing debt overhang and how to actually go about switching the model without killing the whole economy. If there is an implosion or explosion, then there will be no way even to invest in productivity, it will be a complete grinddown

January 21, 2014 at 06:01

If China is to develop an economy of some 300 trillion yuan within the next 30 years then it must increase its GDP by some 240 trillion yuan. Assuming 4 yuan of investment is required to produce 1 yuan of GDP, China will need to invest some 960 trillion yuan. Therefore, it makes no sense for the government to deliberately suppress investment. What is obviously necessary is to direct the investment in the right direction. This means instead of investment to increase exports China must invest in services such as education, health, financial, water and electricity, communication and transportation, culture-sports-entertainment, and many other services that will raise the standard of living of the Chinese people while allowing them to learn high incomes sufficient to allow them to consume all the high quality services they produce. Ultimately, China’s servives sector will account for some 75% of China’s GDP. Or some 225 trillion yuan out of the 300 trillion yuan total GDP.

The Chinese government should understand that expanding the economy means increasing productivity of the people. Therefore, before China can expand its economy it must first advance its technologies so that the Chinese people can increase their productivity by using more efficient tools and machines to mechanize, automate and robotize their production. Merely screwing around with fiscal and monetary policies without understanding the role of productivity and technologies will be ultiately counterproductive. And always trying to make money instead of trying to raise the standard living of the people will ultimately mire China in a low income trap as the Chinese leaders run around in a circle trying to squeeze more money out of exports and FDI while selling out China’s domestic economy to its enemies.

January 21, 2014 at 15:08

Agreed! They need to focus on productivity. This article is more about the existing problems (massive debt overhand). If the debt situation implodes or explodes, then there will be no way to invest even in productivity gains

January 22, 2014 at 04:23

jaques666 @ Liang1a:
January 21, 2014 at 15:08
Agreed! They need to focus on productivity. This article is more about the existing problems (massive debt overhand). If the debt situation implodes or explodes, then there will be no way to invest even in productivity gains
I see you don’t understand the problem as well. Trying to make money first and then do R&D for technological advancement is putting the cart in front of the horse. The horse is the motive force. This means technologies is the horse or the motive force in developing the economy which is the cart. Therefore, to say that the cart (economy) must go ahead first in front of the horse (technologies) is not understanding the problem. The Chinese government has been increasing taxes in the form of exports tax by devaluing the yuan. For example, if the exchange rate is 3 yuan per dollar then $2 trillion is worth 6 trillion yuan. If the government levies 20% of export tax then it can collect 1.2 trillion yuan of revenue. At 8.27 yuan per dollar, the same $2 trillion is equal to 16.54 trillion yuan and the goverment can collect 3.3 trillion yuan of revenue. Or almost 3 times more. This is why the Chinese government is so eager to keep the exchange with the yuan as high against the dollar as possible. This is also why the Chinese government finds it miraculous to collect so much revenue from exports. But China cannot export more than $2 trillion of products because the rest of the world cannot buy more than $2 trillion of products from China. Even now mor than half of “made IN China” products are the so-called processing trade products which are goods made by foreign factories from imported parts and components. Therefore, processing trade products are not “made BY China” products and confer little benefit to China other than the cheap wages and maybe some export tax. Even simple arithmetic is compelling to show that China cannot develop a $100 trillion economy based on $2 trillion of exports especially if more than half of them are the processing trade products.

This is why the Chinese government should forget about exports and begin thinking of ways to develop the domestic economy through technological advancement, the urbanization of the rural residents and energy self-sufficiency. These will require huge amounts of investment. Probably some 900 to 1,000 trillion yuan over the next 30 years. But these investments will produce a huge amount of domestic goods and services for the consumption of the Chinese people to raise their standard of living. And with a 300 trillion yuan economy, the government can collect 60 trillion yuan of taxes and not just a few trillion yuan of export tax. Therefore, the Chinese government should rise above the current situation so that they can see the forest and not be blinded by the trees. Forget the massive debt and start over. Ultimately, even 100 trillion yuan of debt is very little compared to 300 trillion of GDP. And if the Chinese government cannot expand Chinese economy based on technological advancement, the urbanization of the rural residents and energy self-sufficiency, then the problems will only get worse and there will be no solution. The Chinese economy will even crash with a return to the conditions prevailing in the Qing China when China over-relied on the export of silk which ultimately led to the grinding poverty of the Chinese people and the crash of the Chinese nation.

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