June 2014 Issue
Shadow banks provide a vital service across a number of different business sectors – dispensing services within the parameters of the law but predominantly away from the glare of regulators. Shadow banking networks are comprised of financial institutions operating outside of traditional banking facilities, generally comprising trusts, leasing and insurance companies and other non-bank financial institutions which perform banking functions without a formal banking licence. As a result they are able to offer credit where traditional lenders cannot or will not.
Although every country has unofficial lenders and shadow networks, the size and penetration of the Chinese system is second to none. As a result of the Chinese network’s size it is able to provide lines of credit not only to individuals and companies, but also local governments which might otherwise be unable to access, or are forbidden from accessing, traditional forms of credit. Within the Chinese network, investors pay money into trusts and wealth management products which aim to tackle the perceived lack of investment avenues in the country from official channels. The money pooled from the sale of these trust products is used to fund local government projects and various other industries. The system has developed and grown as a direct response to a void in the Chinese financial system, both from the borrower’s and the investor’s point of view. As a result, the shadow network has quickly become an important source of finance for many diverse sectors including real estate and manufacturing.
In recent years the level of unofficial lending in China has reached tremendous proportions. According to some estimates, approximately $6 trillion of all Chinese funds lie outside of banks’ traditional loan portfolios. Lending by shadow banks now totals approximately 84 percent of the country’s GDP. In many respects China’s economic rise in the last 10 to 15 years has been built upon a foundation of shadow banking. Over the past decade alone the Chinese economy has become increasingly reliant on financing outside of its formal banking system. Having previously accounted for more than 90 percent of total credit, formal bank loans fell to just over half of all new financing agreed in 2013. By offering better returns than bank deposits, trusts have grown exponentially in popularity among China’s wealthy investors. Accordingly, trusts have surpassed insurance firms to become the country’s second biggest institution within the financial sector.
“In recent years the level of unofficial lending in China has
reached tremendous proportions.”
Although the advantages of such a network are obvious, the reliance of almost all strata of Chinese society on shadow banking could have a catastrophic effect on both the national and international economies should the system break down. At a time when other emerging markets have begun to falter and fail, China has been regarded as the last bastion of economic development. Free from the economic, social and political upheavals that have so impaired other emerging markets, China has marched onward. Of late Turkey has experienced a steep and dangerous currency slide; in South Africa the central bank has been forced to raise interest rates; India has been maligned by stubbornly high interest rates; and Argentina has seen its currency spectacularly collapse. By comparison, China’s recent economic development has been tranquil despite the relative slowdown of the national economy. Although growth in China has been slowing in the last few years, it is still expected to reach approximately 7 percent in 2014. The renminbi remains steady against the dollar and inflation is largely under control. China is also protected by robust capital controls which should insulate it against the removal of any US quantitative easing in the years ahead.
Furthermore, some analysts believe that the dangers associated with a shadow banking system as large as China’s have been overstated. Although corporate debt is high, the average profitability of Chinese companies appears to be sound. There is a belief that problems of overcapacity and financial stress among corporations have been overblown, particularly by Western media looking for a ‘Lehman moment’ in China. Yet should the country’s economic situation worsen, some believe that the government has the capacity to absorb any major financial losses which may develop. Total government debt is a mere 57 percent of GDP. China also has national savings of around 50 percent of national output, should the government need to issue more debt.
Despite the relative strength of the overall Chinese economy there are very real concerns emerging about the volatility of the shadow banking system. The fear that Chinese trust products may default has worried China’s State Council and the International Monetary Fund (IMF). Among the concerns is that the country’s rapid economic development has been built on a mountain of debt that may prove very difficult to service. It is unknown how many companies in China are taking out loans to cover their existing repayments, yet some estimates state that only around 30 percent of corporate borrowers could repay their loans without new credit. Furthermore, China’s total debt is estimated to have risen from 125 percent of GDP in 2008 to more than 215 percent in 2014.
If the Chinese economy were to destabilise, the shockwaves would be felt across the financial landscape. A faltering Chinese economy would dampen global growth and result in countless job losses. So, with the financial wellbeing of China woven so deeply into the fabric of the global economy, how likely is the collapse of the country’s shadow banking network? Nicholas Borst, research associate and China program manager with the Peterson Institute for International Economics, believes that many of the significant debts which have been amassed in recent years will go bad. In order to safeguard the Chinese economy, attempts must be made to regulate the system, bringing it more in line with traditional banking. “The key to regulating shadow banking is removing the opportunities for regulatory arbitrage,” says Mr Borst. “If nonbank or quasi-bank entities are offering bank-like financial services, they need to be regulated to the same level as traditional banks.”
Previous attempts have been made to bring the shadow banking sector to heel. According to Ren Gulong, a partner at Anjie Law Firm in Beijing, the government has been concerned by the rise of shadow banking for some time. “The Chinese government has a great deal of concern regarding the systemic risks of shadow banking and has issued rules from time to time to regulate shadow banking. However, the shadow banking business grows robustly as it can always find new ways to evade regulation. Taking trust company loans as an example, it is heavily regulated by the China Banking Regulatory Commission (CBRC), but its volume has grown continuously, reaching over ¥10 trillion by end of 2013.”
Despite the sector’s adaptability, China’s banking regulators will soon be redoubling their efforts to crack down on the shadow banking network. The CBRC has warned the country’s many trust companies to either restrict their businesses and reduce their net assets, or have shareholders replenish capital when the firms suffer losses. In the second half of 2014 the regulator will also move to impose a stringent approval process on trust firms’ entry into new businesses and products. The Commission is bolstering regulation of the network after China narrowly avoided what would have been its first trust default in at least a decade in early 2014. Investors in a ¥3bn trust product issued by China Credit Trust Co and distributed by Industrial & Commercial Bank of China Ltd to fund a coal mine, had to be bailed out by an unidentified party just days before the trust was due to mature. In March, Jilin Province Trust Co missed a number of payments related to a ¥973m product as Shanxi Liansheng Energy Co, the borrower drawing on the trust’s funds, underwent a local government led plan to restore it to profitability.
According to Mr Borst, in order to better insulate the wider Chinese economy from the potential collapse of the network, regulators should not look too far into the future. “The key is to take short-term steps to head off potential risks, such as reducing the exposure of traditional banks to shadow lenders. Over the long term, regulators should continue to develop more sustainable forms of direct financing, including the corporate bond and stock market. Financial diversification is healthy for China, but there are less risky options available.”
The task of controlling the shadow network should be left to the Chinese government as, in many respects, it is responsible for its impressive and perilous rise. Chinese credit markets are dominated by the four major state controlled banks which focus predominantly on lending to state-owned enterprises. As a result, other businesses have limited access to bank credit and the shadow banking system fills this gap. Government regulation of deposit interest rates has also empowered the shadow banks. As bank deposit rates in China have been below inflation, negative returns and the loss of purchasing power has pushed Chinese savers to seek higher rates from the legion of shadow banks. Furthermore, the central government has attempted to curtail credit expansion by reducing loan quotas, limiting lending to specific sectors and restricting riskier transactions. This too has encouraged growth in the shadow banking sector. According to Mr Borst, if the Chinese government hopes to rebalance the national economy and curtail the influence of the shadow banks, the authorities must go about “reducing the distortions to the cost of capital in China”. By doing so, this will serve to “reduce the incentives for regulatory arbitrage and slow the growth of shadow banking. From a longer-term perspective, it will also help China move away from its current investment-dependent growth model,” he says.
The tight regulations the Chinese government has installed around its financial services sector have given rise to the situation we see today, agrees Mr Ren. “Shadow banking in China grew quickly mainly because of the strict control placed by the government on the financial sector,” he says. “The Chinese government is now loosening that control and encouraging private funding in the sector. CBRC has recently approved the incorporation of five new private banks in China. The loosening of finance control will help to reduce trust company loans and other shadow banking business.”
Despite the relative strength displayed by the wider Chinese economy, should the shadow banking network falter China’s economic health would be heavily impacted. To this end the government is making moves to reduce the industry’s grip on the economy. Whether the introduction of regulation and relaxing formal capital controls will make a difference to China’s economic strength is up for debate. As Mr Ren notes, “shadow banking and the official banking system are complementary in China. The government would not remove shadow banking completely”. It will, however, attempt to clip its wings.
© Financier Worldwide
BY
Richard Summerfield