'Shadow Banking' In China

Xiao Gang, Chairman of the Bank of China (one of the “big 4” banks the Chinese government controlls), published an interesting op-ed in China Daily on October 12th. Although some may consider the China Daily the English-language mouth piece of the Chinese government, its op-ed columns often hold some genuinely interesting discussions and analysis of events and affairs in China.

In this op-ed, Xiao Gang takes on the issue of “shadow banking,” that hazy and complicated area of finance that in the developed economies is often associated with hedge funds. As discussed in greater detail below, things are slightly different in China itself.

Chinese finance is undergoing dramatic changes which are not yet widely understood. Historically (mainly before 2008), the vast majority of lending in China was done by the normal banking sector in the form of loans. The process was a cornerstone of the government’s control over the economy. The vast majority of banks in China are controlled by the government, so the “who and when” of lending was firmly in the hands of China’s leaders.

The years 2008/9 will be remembered as watershed years for Chinese finance. The financial crisis rippling out from the United States caused a dramatic reaction by China’s policymakers as exports collapsed. Two key trends developed.

The first is fairly obvious; a wave of credit was unleashed and has continued since that time as China’s growth became more and more reliant on investment and the lending needed to support it. This exacerbated the fears that an unbalanced Chinese economy is undergoing an unsustainable build-up of debt, much like Japan’s did during its boom years.

The second trend came later and is much harder to pin down. In late 2009 and 2010, as policymakers began to worry about the credit boom, inflation, a property bubble, and overcapacity, they attempted to put a brake on lending activities. The reduction in formal lending forced an economy addicted to credit to increasingly turn to less usual financing channels – some of them in the “shadow banking” sector. This trend really began taking off near the end of 2009 and has generally increased ever since. The latest data (September 2012) shows that these non-normal bank credit channels now account for a substantial amount of the financing going on in the economy.

Taking these two trends together – an economy relying increasingly on debt creation for growth, and that debt creation becoming more and more complicated and obscure, it is easy to see why so many officials and analysts are worried.

Formal banks are key players in the “shadow banking” system, helping to create, fund and market wealth management products to their customers – products which are riskier than deposits but which potentially pay a healthier return to investors. Their goals are obvious, if credit taps are shut off, many borrowers who are not able to repay loans will default, hitting the banks’ formal loan books hard. Hence the shadow and formal banking systems have become intertwined, and the transmission of problems from one to another, or a negative feedback loop between the two, are not hard to imagine.

As Mr. Xiao bravely states in his column, it is paramount that the government increases its regulation of the “shadow banking” sector. The difficulty is that shadow banking is just one of the main economic dilemmas facing China at present: Is an economic rebalancing necessary? Is pushing through an economic rebalancing worth than pain of slower growth?

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