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THIRD WORLD RESURGENCE

China's shadow banking system poses grave risks

Zhang Monan throws light on a little-known aspect of the Chinese economy. While the recent rapid growth of unofficial financial agencies ('shadow banking system') is a challenge to its economic stability, China's financial regulators (see box) appear to be confident that they can contain the threat.

THE recent disastrous debt crisis that hit Wenzhou city, Zhejiang province (see box), revealed a problem that is deeply rooted in China's financial market and which challenges its stability. Shadow banking, being outside state supervision, challenges the stability of China's financial market, because its inverted-pyramid financial structure could collapse at any time if there is a problem with its supporting funds.

Shadow banking has existed for a long time, but it has grown rapidly since the beginning of this year when the state tightened control of financial supply. As the tightening did not change demand, space was left for underground financing to expand. According to Japan-based Nomura Securities, the size of China's shadow financing could amount to 8.5 trillion yuan ($1.33 trillion). Liu Jigang, a researcher from ANZ bank, estimates it could even be as high as 10 trillion yuan. These estimates may not be accurate, but they nonetheless highlight the problem of shadow banking in China.

Shadow banking originated in the United States, with practitioners indefinitely expanding their credit loans by putting loans into the financial market. But it took a different form in China, where practitioners usually get loans from unofficial financial agencies like private lenders or underground banks. Both are unofficial and unsupervised.

Today shadow banking is already deeply intertwined with the US financial system, and it is now one of the main causes of risks. Credit default swaps (CDS) are a typical example; by changing the form of raising funds for mortgages they lowered the costs for house buyers, but introduced more bubbles into the US realty market.

In 1997, the CDS market totalled $180 billion, but it had soared to $6.2 trillion within nine years, accumulating enormous risks in the process, exemplified by the over-trading of CDS. Finally in 2008, with a fall in realty prices, the financial crisis was kindled and swept like wildfire through the US and the whole world.

Despite different practices, China's shadow banking is nonetheless also potentially dangerous and destructive. For the past 30 years, China has generally maintained a typical indirect bank-led financing system, which owes 80 to 90% of funds to banks in the form of loans. Within this relatively stable system, the central bank can estimate the supply of broad money (M2) and decide the size of each year's new loans from the GDP growth rate, so as to control the amount of money loaned.

But the situation has changed with deeper financialisation of the economy. Various emerging financial tools, such as agencies that raise funds through securities and insurance, have increasingly taken a larger share of the banks' role in the financial market.

Non-bank loans were only 8.7% of the total yuan loans in 2002, but had grown to 79.7% in 2010. This growth in finance means the loan size is no longer an index of money supply-demand relations.

As shadow banking is not controlled by the state, many banks turn their loans into financial products through trust companies, which invest them in sectors with high returns but also with high risk.

The high returns attract more economic participants and even state-owned enterprises (SOEs) have joined the game. According to the Financial Times, several jumbo SOEs have financial platforms, while 90% of all loan-lending enterprises are SOEs.

The shadow banking system now has an estimated annual fund flow of 2 trillion yuan, or 5% of China's GDP. If it continues to grow without control and supervision, China's financing market will become increasingly unstable in the near future, with possibly serious economic and social effects.

To limit the growth of shadow banking, China needs to properly deal with its relations with the official financing system. The urgent mission today is to keep a free flow of social funds within the official financing system, and to implement stricter supervision upon shadow banking, so as to solve the problem without causing grave shocks to the economy.       

Zhang Monan is an economic researcher with China's State Information Centre. This article is reproduced from China Daily (24 October 2011).


Chinese regulators step in to control shadow banking risks

Chee Yoke Heong

IN a move to stem concerns about the negative effects from excessive lending in the informal sector, China's banking regulator assured that the government has put in place controls over the potential risks and is addressing the lending squeeze that led to the growth of informal financing.

The risks associated with this growing recourse to the shadow banking system were thrown into stark relief recently in the city of Wenzhou in southeastern Zhejiang province. According to a 12 October report by the official Xinhua news agency, over 80 Wenzhou businessmen had disappeared, committed suicide or declared bankruptcy in order to avoid repaying debts to informal lenders.

According to Liu Mingkang, the former Chairman of the China Banking Regulatory Commission (CBRC), regulators are aware that in the past two years, the overall liquidity in the Chinese economy has tightened and this has resulted in an imbalance between supply and demand that induced diversion into so-called 'innovative' shadow banking activities.

The CBRC has continuously paid attention to this, said Liu in a transcript of a speech made in October and posted on the organisation's website, adding that such moves have shown effects. 

Among the measures taken are direct monitoring and supervision, the elimination of incentives for engaging in shadow banking activities that involved stemming the root causes, and greater transparency in the activities of the banking sector.

Steps are also made to ensure that risks are 'isolated' through a combination of 'mitigation and blocking', by requiring that financial institutions and informal lending institutions establish a strict 'firewall' to prevent risk transfer. There has been concern about the direct impact on the formal banking sector and the economy from the risk posed by the informal lending market.

Liu said that the CBRC is determined to crack down on high-interest-rate loans, illegal fundraising, and financial fraud activities, among others, and to strictly prevent the informal financing market from becoming a hotbed for illegal activities such as fraud, money laundering, foreign exchange speculation and so forth.

There also seems to be recognition that direct assistance needs to be extended to small enterprises and the agriculture community which, according to reports, have been suffering from a credit squeeze that has driven many businesses to the shadow banking system to obtain loans. Liu said strong support will be given to small and micro enterprises and the agriculture, rural and peasant sector as well as to help them to counter inflation. These moves include encouraging financial institutions to promote and strengthen financial services for small enterprises through means such as establishing specialised agencies to meet their needs.

According to Liu, as of the end of June 2011, small enterprises' loan balance is almost 1 billion yuan, accounting for 29% of the total loan balance of all enterprises. Meanwhile, loans by the banking industry to the agriculture-related sector stood at 13.40 trillion yuan, accounting for 24.5% of total loans of the financial institutions.

Premier Wen Jiabao has also pledged more support for small companies.

According to media reports, Liu also cited the debts of local government financing vehicles and real-estate developers as concerns, but he downplayed their risks, saying the latest stress test results show that China's banking industry is in general control of real-estate risk while local governments were in a strong financial position and would be able to service their commitments.

Banks' overall bad debt ratio on real-estate lending is lower than 2% and recent stress tests show that they can withstand a 40% decline in property prices, Bloomberg news agency reported Liu as saying. Property lending accounted for 19.8% of total outstanding loans at the end of August 2011.                           

Chee Yoke Heong is a researcher with the Third World Network.

*Third World Resurgence No. 254, October 2011, pp 4-5
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