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Is Shadow Banking China’s Subprime Mortgages?

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China Power

Is Shadow Banking China’s Subprime Mortgages?

The volume of shadow banking reached a staggering 55 percent of China’s GDP in 2012.

China’s banking system is reaching high highs, but has the potential to see very low lows. On a high note, last month, China’s Industrial and Commercial Bank of China (ICBC) took the top spot on the Forbes Global 2000 list, which weights sales, profits, assets, and market value to determine the world’s biggest public companies.  In 2012, ICBC had US$37.8 billion in profits and $2.8 trillion in assets. Additionally, in the first quarter of 2013, China’s banks made excellent profits: ICBC’s profits were just over US$11 billion, up 12 percent from 2012’s first quarter, but slower than that period’s 14 percent increase.  Agricultural Bank of China had a net profit for the first quarter that was $7.58 billion, up 8.2%, but down from 2012’s 28% first quarter rise.

However, as Xinhua reported this month, there are dangers lurking: non-performing loans reached nearly $85 billion in the first quarter of 2013, creating an NPL ratio of 0.96 percent, slightly up from the previous quarter, and the sixth straight quarter of increases since the end of 2011.  Bad debt rose in all lender categories, such as regional and state-owned banks. Additionally, overdue loans, a precursor to non-performing loans, are also increasing; by mid-2012, the top 10 lenders had 489 billion yuan (nearly $80 billion) in outstanding overdue loans, up from 112.9 billion yuan ($18.4 billion) in the beginning of 2012. In April, the China Banking Regulatory Commission said that non-performing loans and “increased risk in some areas and industries” means that the banking industry “still faces severe risks.”

One of the most salient features of the Chinese banking system moving forward is the prevalence of shadow banking.  Shadow banking plays an important role in the future health of China’s banking system, and falls loosely into two categories: non-banks offering financial services, such as trust entities, and banks that offer off-balance sheet products (to avoid regulation and underwriting requirements), such as wealth management products (WMPs). A new report by Moody’s notes that the volume of shadow banking has increased 67 percent over the past two years, reaching US$4.7 trillion by the end of 2012, a staggering 55 percent of China’s gross domestic product. Shadow banking has blossomed in a period of restricted credit and artificially low interest rates as an option for those that cannot get loans through regular channels and for those that want a higher return on investments, thus becoming a very useful tool for the Chinese economy by giving small, new and non-state owned entities access to credit.  Loans from shadow banking sources have kept the economy going by allowing projects to continue and helping entities service existing debt. In the case of WMPs, Reuters notes that the central government has allowed them to continue growing because it provides a channel for investors to get higher returns, sparking consumption, and is a “backdoor way to liberalize interest rates.” 

However, shadow banking can also inflate the asset bubble and exacerbate unbalanced investment in overheated sectors such as the real estate market. WMPs are one such tool that has exploded on the scene:  in 2012, the top 10 commercial banks issued US$1.24 trillion in wealth management products, a rise of 68 percent from the year before. WMPs are sometimes backed by high-risk projects that can go belly-up or projects with a long maturity, creating a mismatch with short maturity WMPs and making it difficult for banks to pay investors.

According to Bloomberg, shadow banking played a role in Moody’s recent decision to lower China’s credit rating to stable from positive. As for the impact of shadow banking on the banking system as a whole, the Moody’s report noted, “Given the substantial scale and growth of shadow banking activities in China, we are doubtful of the banks’ ability to isolate themselves from a significant increase in defaults in the shadow banking domain.”  However, the company notes that while shadow banking creates “excessive financial leverage,” the real impact on banks will “depend on the amount and timing of losses and how they are allocated,” information that is difficult to know because of “the lack of transparency and fast-evolving nature of shadow banking in China.”

Banks are vulnerable because of their own shadow banking products and by the products they back that are issued by other entities.  In December, several WMPs failed to make payments to investors, sparking small protests and bringing the faults of WMPs into the spotlight.  WMPs can be akin to Ponzi schemes, in that sales of new products allow the banks to pay returns on existing products. Many WMPs also involve fund pooling, which helps banks hide risks and provide the promised payouts for WMPs, but carries significant risks in that it is backed by bonds that may not be mature or may have declined in value, creating a liquidity risk.

The government has taken some steps to address the issue of shadow banking and the stability of the banking system as a whole.  Last October, Xiao Gang, then-Chairman of the Board of Directors, Bank of China and now (significantly) head of the China Securities Regulatory Commission, discussed shadow banking in China Daily editorial. He said, “In order to prevent China's financial systemic or regional risks from happening, it is imperative to pay more attention to shadow banking and to enhance supervision over shadow banking activities…. It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless.”

There is subtlety in the government’s handling of shadow banking, representing an understanding of the delicate balancing act needed to allow shadow banking to fulfill its necessary role in the economy while minimizing its risks. Potential and imminent reforms include: required disclosures about off-balance sheet investment products, required registration of wealth management products, and a potential hard cap on the quantity of investment products.

At the April Boao Forum, George Soros noted: "The rapid growth of shadow banking has some disturbing similarities with the subprime-mortgage market in the US that caused the financial crisis of 2007-2008," and cautioned “if the American experience is any guide, the authorities have a couple of years to bring shadow banking under control…'s of utmost importance that the authorities should succeed. Not only for China, but also for the world."

As for other problem areas in banking, the China Banking Regulatory Commission (CBRC) said that they would move to reduce the volume of non-performing loans and deal with outstanding bad loans by debt restructuring.  In May, the China Foreign Exchange Trade System (CFETS) closed a loophole in banks’ use of fund pooling for wealth management products, requiring more stringent checks on underlying assets.  As a result of a CBRC directive to cap wealth management investment and slower growth, Moody’s expects that the growth rate of assets in shadow banking will fall to 20 percent from last year’s 30 percent.

As for the overall future health of the banking system, Forbes has noted: "Most analysts don't expect a banking crisis in China, but rising defaults and shrinking loan profitability are serious threats to the country's banking system.” 

The latent risks in the Chinese banking system (including growing liabilities) and the emergence of “black market” solutions for economic issues suggests the need for banking reform. Indeed, it is an oft-discussed oft-argued topic among China watchers and Chinese officials alike. On a very general note, a recent report by the Chinese Academy of Social Sciences (CASS) had a number of suggestions for reforming the banking system, including liberalizing the interest rate regime and creating a unified bond market to provide more investment opportunities.