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.Enjoying this article? Click here to subscribe for full access. Just $5 a month.
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.