Shadow banking system in China — Explosion of Risk

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China is now facing issues from its “Shadow Banking System”; a term refers to a diverse set of financial institutions that are performing banking functions outside of regulated depository institutions. There is a ton of talks these days among economists about whether this expansion of risky and complicated financial practices might trigger a major economic crisis in China and thus sending shockwaves around the world. But before addressing this critical issue, let’s look at how it came into being.

It is widely believed that regulated financial system in China gave rise to shadow banking industry. In China, the credit markets are dominated by some major state-controlled banks that focus on lending to State Owned Enterprises or those firms in officially sanctioned industries, while other businesses have limited access to bank credit.

The flip side of the story is that Chinese government also intentionally keeps deposit interest rate extremely low so that it can channel cheap loans to those State-Owned Enterprises. In that case, the low interest rate generated motivation for investors to seek some higher yield investment products. When the demand side for capital (those firms that are not stated owned and are not in favored industries) met the supply side (those investors seeking for higher yield financial products) this is when Shadow Banking market in China came to fill this gap, namely it finances risker borrowers and transactions that banks cannot undertake due to regulation. This practice demonstrates a Chinese old saying: 上有政策下有对策 – meaning when policies come from above, those at the lower levels will find ways to get around them.

According to a report from JP Morgan, Shadow Banking in China nearly doubled between 2010 and 2012 to nearly $ 6 trillion, which is roughly 70% of the nation’s GDP. The pace in recent months remains brisk. Since most of this money is going into risky real-estate developments and other construction projects, there are fears in the market that some attributes of Shadow Banking resemble the toxic subprime mortgage assets that tanked the U.S. in 2008. However, the high government officials in Beijing have no one to blame but themselves, since they have been too slow in reforming the formal banking sector, excessive regulations and bureaucratic interference, they simply don’t let banks operate on a truly market-base, therefore creating grey area for unregulated financial vehicle to jump in.

However difficulty faced by regulators is dilemmatic: since Shadow banking has become an integral part of China’s economy –source of funds for companies who cannot get support from banks, if the government cracks down on shadow banking too hard and too quickly it could cause a major panic. On the other hand, if the government does not move forcefully enough to curb this unregulated market, bad debts issue will escalate which might become harder to resolve later on.

Therefore, in order to solve the Shadow Banking problem, Chinese government should offer somewhat “gentle” policies to squeeze this unregulated market. Here are three possible policy recommendations:

  1.     Since Shadow banking institutions innovate many new products every day, but these products are not necessarily monitored by regulatory sectors, a new financial regulatory body should be established to adapt to the development of the shadow banking system. Its regulatory focus should not only be placed on institutional regulation but also be put on business and financial products monitoring.
  2.     It is also important to push forward reform of interest rate marketization of the banking system and build a multi-level capital market. This would provide investors with more opportunity to receive returns on their money, so that they refrain from seeking out shadowy investments. But there is no doubt that it will take years to reform the Chinese banking system and put it on more stable footing.
  3.     Usually a bond market is the best channel to price those risky corporate debt, since price change reflected market risk would help investors in the shadow banking system to monitor their own risk levels. As China’s corporate bond market (especially for high yield bonds) is still relatively small and undeveloped, an effective bond market should be established.

Finally, in terms of whether the Shadow Banking issue in China will hurt its economy growth or its target GDP growth target of 7.5 percent for the year, I will use a direct quote to answer it:

“The Chinese government not really willing to sacrifice growth, and there’s still a strong desire to keep this job machine running, to keep this economy growing. I think the right question to ask is how long can you go without it hitting a wall and I think the answer is I don’t know.”

——  Bruce Kasman (Chief Economist for Global Research at JPMorgan)

 

 

Relevant articles: http://qz.com/175590/five-charts-to-explain-chinas-shadow-banking-system-and-how-it-could-make-a-slowdown-even-uglier/#/ http://www.economist.com/news/finance-and-economics/21595483-big-default-averted-credit-paroled http://www.marketwatch.com/story/how-china-plays-high-stakes-game-with-its-money-2014-02-26 http://www.businessinsider.com/china-shadow-banks-2014-1 http://www.nytimes.com/2014/01/08/opinion/chinas-shadow-banking-problem.html?_r=0 http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_301-350/WP334.pdf

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