Shadow banking in China needs restraint

September 1, 2011

By John Foley
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

China’s banks have been lending freely since the financial crisis. They’re not the only ones. Companies, ill-understood trusts and even individuals have joined in the frenzy, pushing China’s estimated credit growth this year to more than twice the official target. Reining in this so-called “shadow banking” system will be painful -– but letting it run rampant would be worse.

Lending numbers are, as the name suggests, shadowy. The central bank’s best stab is “total social financing”, a new measure of bank loans plus some other non-bank credit. Fitch Ratings has developed its own broader measure. It predicts total lending in 2011 of 18 trillion yuan, compared to an official 7 trillion target. But even that, Fitch warns, is probably too low.

Understanding why the shadow sector exists is easier: credit supply in short and demand is strong. Lending quotas for mainstream banks fail to satisfy borrowers’ appetites. Depositors –- and other providers of capital -– also want more interest than is allowed under rules that cap rates paid by conventional banks.

Like the numbers, definitions of shadow lending vary. But chief among the thriving alternative lenders are trust companies, which don’t take deposits but package loans and other securities and offer slices to investors. Some say trust companies don’t count, since they are regulated by the banking watchdog. The practice of banks selling loans to trusts has also been curtailed recently. But they remain shadowy: increasing complexity of these trusts means not even regulators really know what’s in them.

As well as trusts, there are three other common sources. Hong Kong banks have made foreign-currency loans to Chinese companies that need to pay overseas suppliers. Fitch reckons that kind of lending could total around 1 trillion in 2011. Often those loans are guaranteed by mainland banks, so they don’t show up on the Hong Kong banks’ books as corporate loans. Instead, they are recorded as interbank loans.

Second, there’s the creative use of trade finance. When an exporter gets a bank bill guaranteeing payment from a customer, its bank will often swap it for cash at a discount and record it as a loan. Yet increasingly, these bills are repackaged as wealth management products. Sometimes banks offer a new bill instead of cash. Either way, it stays off the balance sheet and some 3 trillion yuan of bills remain officially unaccounted for.

Finally there is peer-to-peer borrowing. State-owned enterprises with access to cheap credit are re-lending it, at higher rates, to less-well connected enterprises. Cash-rich small businesses also lend. Meanwhile, peer-to-peer loan matchmakers have sprung up. Deals between individual lenders and borrowers arranged by these outfits aren’t regulated or counted since most claim to be providing information rather than intermediation.

So where is the money going? No one, including the regulators or the ratings agencies, really knows. Worryingly, however, there’s little sign that the lending is meeting truly productive demands. In 2009, when China’s official sources of credit were lending freely, some 10 trillion yuan of new loans helped fire GDP growth of under 9 percent. Yet despite the estimates of perhaps 18 trillion of lending yuan this year, GDP is on course to grow just 9.3 percent.

One likely explanation is that the new money is going to pay off debts that would otherwise have to be recorded by banks as “bad”. The banks dispute this but some borrowers, surely, will have got into trouble, and sought inventive solutions.

That is problematic in itself. But shadow banking is worrying in two other ways. First, it invalidates monetary policy, since the central bank’s credit-tightening instructions are circumvented. A bigger worry is that shadow loans could rebound onto bank balance sheets. Hong Kong’s minibond scandal, where banks who had sold products backed by defunct Lehman Brothers ended up on the hook for many of the products they sold, is a warning.

Defenders say that shadow banking has its purpose, providing important market testing official Chinese interest rates. Rapid action to curtail shadowy banking would also see credit whipped out of the economy. That might mean debts going suddenly bad, and far exceeding the clearly insufficient 2.5 percent of loans banks have laid aside in provisions. It might mean that productive borrowers are deprived of capital, which could suffocate growth.

Neither a credit crunch, nor a bad-debt explosion, is appealing, which explains why regulators privately suggest that it might be best tolerate the status quo. But the rapid expansion of the system -– and the fact that lenders are consistently one step ahead of the regulator –- suggests that policy action is required. Shadow banking, by definition, is hard to see. If left untamed, it could create problems that are all too visible.

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The crisis economy has opened the door to the shadow market and by sound estimate at any day there is more shadowy financial transactions taking place than the regulated legitimate ones.

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