Keep calm over China’s surging shadow banking

Keep calm over China’s surging shadow banking

Five years after the 2007-08 financial crisis, the term ‘shadow banking’ can still stir up a sense of fear, at least among investors in China.

In January 2013, Shang Fulin, Chairman of China Banking Regulatory Commission (CBRC), stressed that preventing systemic or regional risks was CBRC’s top priority this year. CBRC, an institution directly under the State Council, is China’s major regulator of banking institutions. Market actors joined the chorus soon afterwards. One estimate puts China’s shadow banking at $4.7 trillion, 55% of China’s 2012 GDP, while another suggests 69% – enough to pose systemic risks.

Given shadow banking’s role during the subprime crisis, the caution expressed by the Chinese government (and the market) is reasonable and timely. But the Chinese shadow banking system is nothing like the over-securitized one in the U.S. around 2007. Rampant development of unregulated securitization and derivatives in the U.S. alternative banking system led to excessive risk taking before the 2008 financial crisis.

Despite a lack of consensus on what counts as shadow banking in China – most cited are underground banking, trust products, wealth management products (WMPs) and other off-balance-sheet commercial bank activities – Chinese banks do not carry the same risk from credit default swaps, U.S. shadow banking’s most notorious product. Chinese instruments work more similarly to bank loans, only with higher promised returns.

Composition of Chinese Trust Assets

China’s shadow banking system has a heavy hand in the infrastructure and real estate markets (Source: WIND, ANZ)

Rather, the real risk in China lies within its fragile capital chain. Despite the less-securitized nature of China’s shadow banking system, default risk is ever looming. Sustaining economic development by flooding the market with credits poses credit risks to the entire system: shadow banking may just be first take the hit.

Specifically, money invested in China’s shadow banking went to risky and barely profitable projects. These were in infrastructure, manufacturing and real estate industries, generating potential default risks. According to a recent report, over 50% of trust companies’ assets were in these industries by 2012. The risky projects, combined with the fiscal pressure on local governments – in 2012 local government debt exceeded 25% of GDP while revenues stood at 23% of GDP – can trigger a series of default cascading all the way to the banks.

The survival of China’s shadow banking system also hinges on the real estate industry. A slumping real estate sector not only directly hurts the investors but also threatens local government revenue and other industries’ capital chain. Heavy exposure to real estate can also be fatal for shadow banks. Zhongrong International, a trust company with RMB 1.6 billion in registered capital, generated a loss of RMB 6.1 billion due to excessive investment in real estate projects. Fully aware of these risks and low returns, trust companies and banks promise high returns to investors to compete for market share.

The good news for investors is that the Chinese government is pushing for more transparency in the shadow banking system. A tacit promise from the central government to bail out the whole system will also help. In March 2013, CBRC announced that banks must clearly link WMPs with specific assets. They must disclose who will ultimately use the funds and for what purpose, and every product must be audited. Trusts and banks can continue selling new investment products as long as they pay back the principal and interest at maturity.

This policy would not trigger severe credit tightening as many expected since its aim is to facilitate healthy expansion of shadow banking in China. More importantly, the belief that the central government would not allow banking failure should sustain investor confidence. The government, however, must clarify what is and is not covered by bank insurance. Beyond that, default risks should not all be transferred to the Chinese government: the shadow banking system should be held accountable for its activities.

Categories: Asia Pacific, Finance

About Author

Roger Yu Du

Roger works for a strategic advisory group that provides services to investors focused on Asia. He holds a master’s in International Political Economy from the London School of Economics and received his BA in International Relations from Fudan University in China, with a focus on East Asian affairs.