Shadow Banking in China

Shadow Banking is a huge problem in China which was closely linked to the stock market crash of 2015. It can potentially destroy China’s financial system.

It’s an alternative, parallel system of banking that does more or less the same things as a regular bank. It has two advantages over a regular bank:

  1. The return to depositors is much higher than the 3% (set by the government) that regular banks offer on savings accounts in China. This 3% return is so low that considering the rate of inflation, depositors get net negative returns. Therefore most of them flock to the shadow banks.
  2. There are no CRR or SLR requirements (amount blocked from being loaned out) so these banks have more to lend and the money multiplier effect gets magnified making everyone happy.

It operates like the regular banking system: Gives out loans at higher rates from the money it collects from depositors who get a lower rate of return. The difference is its profit. But there is a twist. The loans are given to people and entities who don’t get a loan from the regular system because they are high risk investments for the bank. This includes SMEs, and brokers trying to help their customers evade limits on margin trading. These loans are then sold out to investors (depositors aren’t actually depositors, they act like investors) with a promise of a higher return that the regular system (point 1 above). Incentivised by higher returns and not knowing that there funds are being utilised to fund such risky loans, many investors give in to it. These are called Wealth Management Products or WMPs. To an investor, they look like time deposits.

To put it in perspective, 60% of the total lending activity in China is through these shadow banks! The shadow banks have a greater market share than the legitimate banking system itself!

This poses a huge problem: China’s monetary policy by controlling bank interest rates and money supply are de facto rendered moot. It limits China’s control over it’s inflation and money supply. This is a huge macroeconomic problem that can lead to financial instability in the country.

Shadow banks tend to lend to more risky investments. For instance they will ease out the collateral requirements for loans. This might be great to boost the economy but the added risk makes them dangerous. There is no ‘lender of last resort’ safety net for them too.

Moreover, a lot of these WMPs have started acting like Ponzi Schemes. A Ponzi Scheme is one where a financial product is sold to an investor with a promise of a return and to pay that investor more Ponzi Schemes are sold to more investors fraudulently and so on and so forth. Till of course, it stops at some point and the last leg of investors face dire losses. Shadow banks often issue new WMPs to pay off old ones and dodge reporting bad loans. It’s like a big Ponzi scheme.

The worse part is that even China’s local governments have started relying on these shadow banks for money. “China’s audit of local governments exposed an increased reliance on shadow banking, swelling the risk of default on 17.9 trillion yuan ($3 trillion) of debt.” and “As banks tightened their purse strings, local governments had no choice but to resort to shadow banking and incur more expensive borrowing costs,” as per Bloomberg. “China’s local-government debt problem has always been twofold. First, there is the sheer amount of money they owe. That has doubled from less than 20% of GDP in 2007 to nearly 40% today. Second, there is the very peculiar and opaque structure of these liabilities. Because local governments can only borrow with the explicit permission of the finance ministry, which has been miserly in the past, they have been forced to use off-balance-sheet entities to raise funds” as per The Economist.

So why doesn’t China stop it? Because it’s not that simple. By putting an end to shadow banking, 60% of the credit availability in the market will be wiped away leading to a significant slow down in the economy (less borrowing= less spending by consumers= less incomes for sellers and so on).  On June 12 when the Chinese government put a curb on WMPs and umbrella trusts, its stock markets saw one of the sharpest curbs in history.

Read more: Brookings Paper on China’s Shadow Banking

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