Shadow banking in China: boon or threat?

May 2016  |  FEATURE |  BANKING & FINANCE

Financier Worldwide Magazine

Having been viewed in a less than positive light during the darkest days of the financial crisis, shadow banking, though still perceived as risky, is now very much viewed as a niche trade providing substantial benefits (as well as challenges), especially for flagging economies such as China’s.

Indeed, in China, shadow banking – also known as secondary banking or non-banking financing – is part and parcel of the Chinese economic landscape. Although the exact reach of the shadow banking sector is largely unknown, Moody’s Investor Service, in its ‘Quarterly China Shadow Banking Monitor’ released January 2016, has estimated that its size is approximately 65 percent of the nation’s GDP, nearly RMB 45 trillion through 1H2015.

Providing meat on the bones as to the extent of the expansion of informal financing in the jurisdiction is the 2015 ‘Bring Light Upon the Shadow: a review of the Chinese shadow banking sector’ report by the Fung Global Institute and Oliver Wyman, which confirms that the shadow banking market in China over the past few years has been thriving.

Intriguingly, in comparison to Moody’s data, the Fung/Wyman report puts China’s shadow banking risk assets at RMB 30.1 trillion or 53 percent of GDP and 27 percent of formal banking system credit assets. The report also takes a different view to those who consider shadow banking to be risky, stating that “the Chinese financial system in general and the shadow banking sector in particular remain misunderstood”.

Another report covering similar ground, the 2015 ‘Future of Shadow Banking in China’ by the Jerome A. Chazen Institute of International Business at Columbia Business School, is somewhat more critical of shadow banking in the People’s Republic than the Fung/Wyman review, stating that it is non-transparent, has few formal safety backstops and can lead to financing being overextended in some industries. In addition, claims the report, investor interest can switch off as suddenly as it is turned on, leaving financiers with no capital to lend.

“Because many activities in shadow banking are not transparent, and because regulatory oversight is non-existent or significantly less stringent than that applied to banks, the sector naturally arouses suspicions,” says Wei Jiang, director of the Jerome A. Chazen Institute. However, she does observe that “global bodies, including the International Monetary Fund (IMF) and Financial Stability Board (FSB), as well as local regulators, have called for increasing light to be thrown onto the shadows”.

Yet Ms Jiang is well-aware that the acceptance and prevalence of shadow banking has led to substantial results and may also assist China in regaining its growth momentum as it finances new business models that the government cannot. “By providing retail investors with a place to park their funds and by loaning to borrowers smaller than the official state policy allows, shadow banking is paving the way to market liberalisation as the economy transitions from strict state ownership and control to a broader focus,” she attests.

More recently, Moody’s 2016 China Shadow Banking Monitor characterised the Chinese shadow banking environment as fluctuating considerably between its core and broad forms, noting that although there has been a slowdown in core shadow banking activities – such as entrusted loans, trust loans, and undiscounted bankers’ acceptances – reflecting the impact of regulations to curb financial risks, broad shadow banking has been expanding concurrently, including assets funded by wealth management products (WMPs), banks’ off-balance sheets and securities companies.

Of course, the expansion of a less-regulated lending regime in China is likely to result in authorities struggling to limit the level of debt that is accumulating throughout the country – a significant concern given that economic growth levels in the region are currently the lowest they have been in 25 years.

Shadow banking in China: friend or foe

In addition to the multitude of concerns surrounding shadow banking, what then are the overriding challenges and issues currently pervading this space? Pointedly, do Chinese businesses consider the shadow banking sector to be a friend or foe?

“Shadow banking in China thrives mainly because banks – especially the big five state-owned banks – are unwilling to lend to small and midsize businesses (SMBs) and prefer to lend to State Owned Enterprises (SOEs),” explains James Lee, ICAEW’s former regional director for Greater China. “As a result, SMEs have to look for funds from other sources, paying higher interest rates in line with higher risks demanded by unofficial lenders. Shadow banking includes loans accumulated by local government finance vehicles. Some of these shadow banking funds are channelled via the big five banks as intermediaries to businesses in need, in the form of WMPs at higher interest than regulated normal bank deposits. Investors in such WMPs assume that the banking intermediaries will guarantee their deposits if the borrower defaults. This however does not happen, and as a result, money is lost.”

Rosemary Coates, president of Blue Silk Consulting, points out that access to the shadow banking sector is critical for most small manufacturers in China. “This is because most of the manufacturers are unable to obtain loans for working capital from China’s major banks, where lending is reserved for only the very largest customers,” she explains. “This creates a dilemma for the hundreds of thousands of small suppliers and manufacturers that make up the backbone of Chinese production. To operate and grow, these small manufacturers are forced to borrow from shadow bankers at annual rates as high as 25 to 30 percent. This situation is simply a way of life for small manufacturers. To continue to do business, the must have working capital and that comes from shadow bankers. To make matters worse, US buyers often negotiate extended payment terms of 60 days or more after receipt of goods. This extended payment period forces the requirement for even more working capital and more shadow banking borrowing.”

Increasing regulatory scrutiny

With the Chinese government on record as having described the shadow banking sector as risky, its plan of action involved substantially increasing the regulatory activity surrounding the sector – an uptick in scrutiny which, in turn, has forced the shadow banking fraternity to evolve.

“In approximately the last 24 months, there were reported cases of borrowers defaulting but each time, the intermediaries stepped in, under government pressure, to assume full liability in order to prevent social unrest,” recalls Mr Lee. “The government has now realised the gravity of the ballooning shadow banking debt, and has started to introduce regulations to keep track of them and prevent new ones. It also coerces intermediaries to convert – or roll over – shadow banking debts into regulated ones or issue commercial papers, especially by local governments. The government hopes that over a period of time, shadow banking will become ‘normalised’.”

As far as small manufacturers are concerned, Ms Coates does not see much changing any time soon. “Even with the Bank of China loosening its credit policies for smaller manufacturers, they still won’t be able to serve the thousands of SMBs in need of funds,” she reasons. “More monitoring and regulation isn’t likely to help either, as this will simply make it more difficult to obtain a loan.”

Shadow banking in absentia

Although perhaps tempting accusations of irrelevance, it is worth speculating as to how China would have coped should the country have been without recourse to the shadow banking sector in the years following the global financial crisis, particularly in view of the impact the sector has had on total lending, GDP creation and overall growth.

“Shadow banking can be considered part of the central government’s financial stimulus introduced immediately after the 2008 global financial crisis,” says Mr Lee. “Investors were attracted to the higher interest in the shadow banking market compared to dismal bank deposit interest. A part of shadow banking funds have gone into property-related investments, with many smaller cities in China now having unsold inventory of apartment blocks, alongside local government investing in sub-optimum local infrastructure projects without expectations of proportionate future returns. The choice was either continuing GDP growth without regard for quality GDP or a lower quality GDP growth.”

According to Professor Ann Lee, an adjunct professor of economics and finance at New York University, it is very difficult to say exactly how much China’s shadow banking system contributed to overall GDP creation and growth due to the opaqueness of many of the credit intermediaries, as well as the unknown multiplier effect of the vehicles concerned.

“It’s fair to say that the sector, broadly speaking, definitely added to the growth, but no one can measure the true impact with any certainty,” suggests Professor Lee. “If the market didn’t exist, I would bet that the Chinese officials would have forced the large banks to lend even more money than they did in order to get the economy going. Thus, I think China would have been fine either way.”

Future trends and developments

“When official avenues of financing are blocked, companies turn to shadow lenders,” opines the Jerome A. Chazen Institute report – a simple but persuasive statement as to why shadow banking is so important, as well as rapidly growing, within the Chinese financial firmament.

“We expect to see the government hoping for some kind of ‘gradual soft landing’ within the shadow banking market,” says Mr Lee. “In reality, the government has realised that it has to create a more conducive environment to resolve the issue of industrial capacity and ‘zombie’ SOEs. It is planning to do it by encouraging greater transparency in local government financing and risk-reward consideration for investments.”

Other potential measures include establishing an insolvency regulatory regime to allow stronger market players to take over failing competitors, establishing specialised banks to target SMBs, channelling high savings by private individuals into regulated investment products, and furnishing a maturing stock market with reliable and sustainable performance measures or corporate governance without the price volatility.

For Ms Coates, the future of shadow banking in China is very much a matter of more of the same. “I don’t expect to see much change,” she says. “Small manufacturers will still need working capital, and in general, they don’t have any alternatives other than shadow bankers.”

Conclusion

The shadow banking sector in China is a fluctuating behemoth. A system of lending which, although often appearing to proffer financial risks and societal benefits in equal measure, is undergoing a significant upheaval with a number of trends and developments likely to come to the forefront in this important component of the Chinese financial system in the months and years to come.

On balance, whichever way one chooses to judge the rights and wrongs and the risks and benefits of the current environment, it is clearly not yet time for the sun to set on China’s shadow banking sector.

© Financier Worldwide

BY

Fraser Tennant