China’s Shadow Banking Challenge

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China’s Shadow Banking Challenge

As the government attempts to rebalance the economy, it will face testing moments in the shadow banking sector.

China’s Shadow Banking Challenge
Credit: Shanghai financial district via Shutterstock.com

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?

To answer this question fully would take more space than is available here, but there are certain logical arguments that can be made.

First, the shadow-banking system, while representing progress and a more market-based way of allocating credit, has developed in a highly distorted credit environment.

In 2010, emergent worries about runaway debt led to tightening measures. Yet the tightening measures resulted in the still-politically influenced state banks lending to state-owned enterprises and other entities they believed to be backed implicitly by government organs, rather than the more productive private sector.

As periodic and sometimes targeted attempts to tighten continued, the shadow banking system grew to fill the gaps. Indeed “shadow financing” has been increasing as a share of total credit for years. In 2013, it reached a record 30 percent of total financing.

Both demand and supply factors have led it to develop in ways that have warped its potential and in some cases increased risks.

The main demand for shadow credit has come from companies and local government entities that were unable to access formal lending. The reasons may have included a lack of connections necessary to obtain bank loans; a lack of profitability so pronounced that banks were unwilling to lend even if connections were decent; restrictions on their sectors (especially for real estate, industries suffering from overcapacity, and dubious local government infrastructure projects) resulting from policy initiatives; or a lack of credit being available after other, better-connected or even government-guaranteed “safe” borrowers had used up lending quotas, particularly those operating in sectors identified as “strategic” in five-year plans.

For borrowers lacking political connections, the shadow banking system, in providing vital credit (even if sometimes at highly inflated interest rates), has sometimes been providing a valuable and helpful service. Many healthy, value-creating companies have been surviving even while paying “shadow” interest rates of over 30 percent.

On the other hand, companies suffering from restrictions on their sectors, or those that were un-creditworthy in general, including many local government financing platforms (LGFPs), have become hooked on shadow credit in order to stay in operation, rather than closing down and defaulting.

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.

Their access to shadow credit represents “leakage” in liquidity tightening that is negating credit-control driven attempts to restructure the economy, cool bubbly conditions in some real-estate markets, and eliminate overcapacity. Of course, their ability to keep rolling over their debts and operating is not all bad for policymakers, who in the past have frequently seemed to backtrack whenever GDP rates began to fall too much.

On the supply side of the equation, banks have been keen to use shadow banking channels, including off-balance sheet and misrepresented interbank lending, to avoid regulatory controls such as deposit ratios, loan quotas and especially capital requirements. Banks can also able to earn fees for this wealth management business, without taking on (explicitly at least) any risk. (If readers are reminded of pre-2008 U.S. mortgage lending, it is not a surprise.)

Corporate and individual investors are attracted by the higher rates that they can earn on their capital in the shadow system, whether or not they understand the higher risks.

Keeping these demand and supply factors in mind, it is easier to understand why we have seen (and will continue to) see apparently contradictory policies emanating from various central government sections with regard to shadow financing. Early 2013’s strict Document 9 from the CBRC was never fully implemented due to pragmatic concerns about the effects on economic growth and stability and the CBRC will continue trying to rein in risk without crushing the system.

It has recently emerged that the state council drew up a new policy in early December 2013 “Document 107”) that is more accommodating to shadow financing than Document 9, even while bringing in increased regulations. Language from the document describes shadow banks as “…a complement to the traditional banking system, shadow banks play a positive role in serving the real economy and enriching investment channels for ordinary citizens…”

Another interesting point: each time the PBOC constrains liquidity and drives up money market (and thus WMP) interest rates, the attractiveness of WMPs over normal deposits increases, drawing in more savers’ money. So far, the PBOC has been careful to prevent the cash crunches from causing a crisis – its return to providing liquidity each time is yet another policy contradiction for China’s financial markets. It is very difficult to sort out “bad” shadow borrowers from the “good” without risking the whole system, and the system does sometimes play its “positive role.”

The debate about shadow financing is sure to continue and influence policy going forward – 2014 will probably see a series of tense moments, but hopefully no crisis. While some see shadow banking as a dangerous Ponzi-like system that is merely keeping credit-addicted, wealth-destroying enterprises afloat while increasing the eventual cost of adjustment, it cannot be denied that depositors’ earning higher rates from WMPs represents a partial end to the financial repression that has contributed so much to distortions in the economy – “liberalization from the bottom” as it were. (Much like the new phenomenon of tech companies offering wealth management services). The truth lies between these two poles: shadow banking is undeniably a form of liberalization, but at the same time, for reasons mentioned above, parts of it now carry big risks.

Chinese policymakers, like many others, seem to have mixed views on utility and risks inherent in the shadow financial system. The fact that it is intimately tied-up with “traditional” finance through the banks and their WMPs, as well as the overall issue of non-performing loans, makes it even more difficult to see clearly. They will need to react quickly yet selectively as they steer China into its reform process. This year will be a key test.