An introduction to Shadow Banking in China

In the chaos that defined the period following 2008, China stood, as it appeared, unscathed and emerged as perhaps the only significant economy with growth in a world where growth was in short supply. How did China do this? The answer lies in credit. The Chinese financial system in 2008 was as different as you can imagine from the one in the US. Unlike in the US, disintermediation of risk from the banking system was almost non-existent in China. Even within the banking system, it was the big four policy banks (ICBC, CCB, BOC and ABC) that warehoused the bulk of the country’s credit (this is true even today). Monetary policy in China has many faucets to control the flow of credit with loan quotas from the big four banks representing the most crude lever and the one used most often. It is quite an irony that pre-2008, China looked up to Western financial institutions as a role model of sort for its big four policy banks. 2008, to say the least, altered that perception.

With demand shrinking as a result of the global financial crisis, the Party (Chinese Communist Party or CCP) ordered its banks to lend, injecting an RMB4tln (US$600bn) stimulus to the economy. The banks lent to whomever they could – a good chunk of this credit flowed to the property sector. Other big borrowers were LGFVs (Local government financing vehicles – these are financing conduits for local authorities. Unlike the US, China does not have any municipal bond market and tax revenues are not shared equitably with the local governments), construction companies, SMEs and the mining/basic materials sector plagued with overcapacity (such as steel). When the property market overheated, the Party tightened policy significantly in 2011 and almost waged a war on the property sector. Credit starved borrowers needed the money and repressed households needed higher returns. The Chinese shadow banking system sprang up to serve these equal and opposite market needs.

The October 2014 version of Global Financial Stability Report defines shadow banking as “financial intermediaries or activities involved in credit intermediation outside the regular banking system, and therefore lacking a formal safety net”. It constitutes about one-fourth of total financial intermediation worldwide and has been growing rapidly in China especially since 2011. However, it is helpful to remember that the US is the only country where shadow-banking assets exceed those of the conventional banking system.
In China, outstanding RMB loans of the banking system are RMB85tln (US$13tln) compared with its GDP of RMB64tln (~US$10tln or in other words loans are close to 130% of GDP). Shadow banking assets are roughly RMB50tln (US$8tln or close to 80% of GDP). Within the shadow banking system:

1) Trust products are around RMB8-10tln (~US$1.5tln) representing around two-thirds of the trust industry’s total Assets under Management (AuM).

2) Security firms and Asset Management companies have shadow investments of around RMB5tln (~US$750bn), which is about three quarters of their total AuM.

3) Wealth Management Products (WMPs) have around around RMB4-5tln (~US$750bn) invested in shadow products, which is about a third of the outstanding WMP assets.

4) Corporate capital represents another RMB8-10tln (~US$1.5tln)

5) Underground lending adds up a further RMB8-12tln (~US$2tln)

Other less important sources include interbank lending, private equity, microcredit etc. The central government has been trying to clamp down on shadow banking since 2013 – for instance banks can now invest only 4% of their total assets in ‘non-standard’ products (these are products not traded on exchanges or interbank markets and include trust loans and entrusted loans).

Below is a short summary of individual shadow finance components:

1) Trusts companies offer investment products (generally yielding more than 10%) to wealthy retail investors (who get meager returns on bank deposits) and to corporates/institutional investors. While many trust products are marketed through banks, in effect trusts move risky bank lending away towards capital markets and over-the counter markets (and therefore act like Chinese version of hedge funds or lightly regulated mutual funds). Most trust assets are invested in property, infrastructure and SMEs and are typically less than 2 years in maturity. Trusts were the fastest growing component of Chinese shadow finance in the past decade but are now facing a sharp slowdown in their AuM growth as a result of recent government clampdown on non-standard credit and the growth of security/asset management firms. With most trust products being short-term, upcoming maturities this year and next may lead to defaults unless the end borrower is able to refinance. 2014 saw quite a few trust products default but the local government generally stepped in to cover the loss (increasing moral hazard).

2) Security firms were allowed to open asset management subsidiaries in 2008 and rules about their investments in shadow assets were further relaxed in 2012. They are the new kids on the shadow-financing block and regulators have been tolerant of this expansion. Regulators may have reasoned that end-investors with dedicated asset managers are aware of inherent risks in high yielding products and will therefore not assume that such products carry an implicit guarantee from the banking sector / government.

3) Both banks and other financial intermediaries offer wealth management products (WMPs), which together with trusts have historically been regarded as poster boys of shadow finance in China. Around three quarters of WMPs are less than three months in duration and they typically yield close to 5% annualized return. Classifying WMPs within the shadow universe is not entirely correct because these products are as risky as their underlying assets, which can be bonds, bank loans, trust loans, discounted / undiscounted bills etc. After a high profile default in December 2012 on a WMP issued by Huaxia bank (a guarantee company apparitated at the last minute and investors got back the principal but no interest), regulatory clampdown has resulted in the proportion of bank WMPs invested in shadow assets to fall below 30%.

4) Corporate lending refers to loans made between companies usually in the form of entrusted loans that carry guarantee from a bank. Cash rich SOEs, which can borrow cheap from banks, typically, use this channel to fund cash-starved SMEs although private sector entities are also involved in this business.

5) Underground lending is a catch-all category that covers everything which falls outside regulators’ scrutiny including but not limited to private loans, bridging loans to SMEs, pawn shop credit, financial leasing etc. The entrepreneurial city of Wenzhou, south of Shanghai, in the coastal province Zhejiang is famous for the business acumen of its people as well as for its elaborate informal lending network. Interest rates in Wenzhou’s private lending market are typically around 20% but can be as high as 5-6% a month. Being outside regulators scrutiny, this category carries a very high risk of escalating defaults in a slowing economy.

The rapid growth of China’s shadow financing in recent years has created risks of a spiraling systemic crisis if defaults escalate as a result of the slowing property sector. This is because property developers, construction companies and LGFVs are the big borrowers from this source and they are all linked to China’s real estate market. The government has so far taken many steps to curb such activities or make them more transparent. Time will tell whether regulators can successfully mitigate this emerging risk; the upcoming interest rate liberalization will probably deliver the verdict one way or the other.