While the Chinese Dream is ideal and serene, the Chinese Reality has the potential to be a nightmare. Recently, China experienced the embarrassment of its first junk bond default, which came on the heels of its first corporate bond default. In the coming months, a slew of Chinese bank trust products will reach maturity, a sizable number of which will be unable to make their interest payments, much less payments on principal. Recent data shows falling industrial material prices, indicating increasing overcapacity. This could lead to lower profits for some of China’s most highly leveraged industries, and potentially lower GDP growth numbers in the future. None of this bodes well for the country’s financial stability, especially considering the increasing importance of the country’s burgeoning shadow banking system. Unless the government and financial sector can work in tandem to remedy this situation, shadow banking could potentially set off the country’s first major financial crisis.
“Shadow banking” is a catchall term referring to non-bank financial institutions, covering everything from bank trusts to bond markets to pawn shops. In recent years, shadow-banking operations have exploded in China. Growing domestic demand for capital and high-yield investment products, restrictive capital controls and banking regulations, as well as poor capital allocation by domestic banks, have all spurred a variety of private-sector financial innovations—the shadow banks. These innovations have in turn provided China’s expanding middle class with alternative investment opportunities outside of real estate and low-yield bank deposits. Shadow banking has supplied many cash-strapped SMEs with much-needed capital, which is denied them by traditional banks. In addition, the shadow banking system has worked to deepen China’s stunted capital markets, and to a certain extent, has also stemmed international capital flight.
While the positive contributions of China’s shadow banking system are indeed laudable, it has also led to a number of troubling developments within the domestic economy. Because traditional banks have refused to lend to them, many high-risk investment projects have in recent years relied heavily on capital infusions from shadow banks to stay afloat. The shadow banks themselves raise capital for these projects via high-yield financial products, such as those sold by bank trusts and wealth management funds. Often, the extent of risk contained within these investment products is unclear or even intentionally obfuscated by the shadow banks selling them. Now, the riskiness of this system is finally coming to a head. The questionable profitability of many of these projects is gradually becoming more apparent, causing some to claim that China’s shadow banking sector is headed for collapse.
Chinese government and banking officials, as well as some foreign financial analysts, have stated that the problems within China’s shadow banking sector are manageable. Reasons include the sector’s relatively small size in relation to other countries’ shadow banking systems, certain comparative debt ratios, and allegedly better underlying collateral stocks. However, a sudden shock in asset prices could easily make all of these arguments moot. Of growing concern is the astonishing growth within the shadow banking sector over the past few years (its ratio to GDP has risen 70 percentage points over the last five years), lower aggregate return on debt (it takes $4 of debt to make $1 of GDP growth), and predictions that more trusts and corporate bonds will end in default. All of these issues have led some to speculate that China is approaching a Minksy Moment. In other words, the amount of speculative and Ponzi financing within the economy is reaching unsustainable levels.
As for the numerous questionable shadow banking products that are fast approaching maturity, they will need to receive either refinancing or some sort of bailout from the government or traditional banking sector. Otherwise, these products will ultimately default, potentially shaking investor confidence in the whole shadow banking system. This would then lead to capital flight from the system to safer traditional bank deposits. A contraction of the shadow banking sector would likely cause a countrywide credit crunch, thus creating greater pressure on other investment projects reliant on shadow bank funding, ultimately leading to even more defaults.
That outcome would be particularly damaging for the country’s real estate and mining industries, as well as local government investments, which receive an estimated 43 percent of their funding from shadow banks. Also, despite relatively low levels of integration with foreign financial markets, the international economy would not necessarily be left unscathed. Decreased Chinese domestic productivity could reduce demand for imports from resource-rich countries. Additionally, the world could expect cuts in global GDP growth, as well as diminished performance in foreign debt and equity markets.
Even if preventative measures were to be taken, it is no guarantee against negative investor sentiment towards the shadow banking system and capital flight. Additionally, any bailout plan would just lead to systematic support of unprofitable “zombie” enterprises, depriving potentially productive investments of capital.
Systemic financial collapse is by no means a foregone conclusion, and a successful government or bank-led bailout program is indeed possible. This, though, would only represent a temporary reprieve for the financial system, and would not solve the underlying issues that face China’s shadow banks. The good news is that in recent months, the central government has undertaken preliminary steps to address some of these underlying problems.
In an attempt to bolster confidence, the government has publicly recognized the important role shadow banking plays within the Chinese economy. This may improve investor expectations that the government will back the shadow banking system in a crisis. Additionally, it should alleviate some concerns of shadow bankers themselves, making them less likely to withhold capital liquidity if market projections were to deteriorate. New rules have finally begun to permit local governments to rollover debt via government bonds issuances. Additionally, the State Council has formulated a series of guidelines, instructing government regulators to create new rules to increase transparency and restrict certain lending activities within the shadow banking system.
While increased regulation is indeed needed, the government should be wary of creating too much restriction within the system. Excessive regulation could negatively impact innocent institutions, such as foreign banks and shadow banks that have thus far been prudent in their lending practices. Also, it is likely that if the government restricts the credit creation activities of one part of the shadow banking system, capital demand will lead to innovation that is ultimately able to circumvent regulations. The government should concentrate more on improving transparency in the shadow banking system, developing institutions and protocols to better assist in risk pricing, and liberalizing the overall financial system. In short, to fix its looming financial woes for once and for all, China needs to shine more light on its shadow banking system.
Daniel Kollar is a masters student at the Johns Hopkins University-Nanjing University Center for Chinese and American Studies in Nanjing.