Shadow Banking in China

An Opportunity for Financial Reform

Andrew Sheng, Ng Chow Soon

• Publisher: Wiley
• Year: 2016
• Print ISBN: 9781119266327
• eBook ISBN: 9781119266341
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An authoritative guide to the rise of Chinese shadow banking and its systemic implications

Shadow Banking in China examines this rapidly growing sector in the Chinese economy, and what it means for your investments. Written by two world-class experts in Chinese banking, including the Chief Advisor to the China Banking Regulatory Commission and former Chairman of the Securities and Futures Commission in Hong Kong, this book is unique in providing true, first-hand perspectives from authorities within the world's largest economy. There is little widely-available information on China's shadow banking developments, and much of it is rife with disparate data, inaccuracies and overblown risks due to definitional and measurement differences. This book clears the confusion by supplying accurate information, on-the-ground context and invaluable national balance sheet analysis you won't find anywhere else.

Shadow banking has grown to be a key source of credit in China, and a major component of the economy. This book serves as a primer for analysts and investors seeking real, useful information about the sector to better inform investment decisions.

• Discover what's driving the growth of shadow banking in China
• Learn the truth about both real and inflated risks
• Dig into popular rhetoric and clarify common misconceptions
• Access valuable data previously not published in English

Despite shadow banking's critical influence on the Chinese economy, there have been very few official studies and even fewer books written on the subject. Understanding China's present-day economy and forecasting its future requires an in-depth understanding of shadow banking and its inter-relationship with the banking system and other sectors. Shadow Banking in China provides authoritative reference that will prove valuable to anyone with financial interests in China.

1
Introduction

AndrewSheng

Before the stock market turmoil of June–September 2015, China appeared relatively unscathed from the global financial crisis of 2007–8 (GFC). Supported by ample liquidity and credit growth, the Chinese economy continued to grow. RMB internationalization increased, with its growing acceptance as a global trade and payment transaction currency. Such advances have also faced new headwinds in the form of a slowing global growth and trade environment. The World Bank (2015) has downgraded its global economic projections and cautioned that the global outlook is clouded by weak commodity prices, divergent monetary policies across key economies, volatile financial markets and a decrease in world trade.

Of particular concern is the structural decline in world trade, which is becoming less responsive to changes in global income. The IMF (2015a) also lowered its global growth forecasts, noting that positive factors such as lower oil prices will be more than offset by persistent negative forces, including lower investment and slower potential growth in many countries. A key concern of the IMF (2015b) is the risk of a “new mediocre” – a prolonged period of low growth. As the Chinese economy adjusts to a new normal of slower growth, questions are being raised about the sustainability of the Chinese model and its dependence on ongoing credit “fuelling.” Some commentators have suggested that China's “Lehman moment” is imminent and that the Chinese shadow banking sector could become the cause of the next systemic global financial crisis.

However, a GFC-type crisis is unlikely, given China's still favorable fundamentals and policy space. At this juncture, Chinese shadow banking is also relatively small by global standards and essentially a domestic debt problem without any direct global implications. Prompt policy action is, however, urgently needed to deal with potential shadow bank failures and preempt any escalation of contagion risks. The problem should not be underestimated, as the nexus of shadow banks, the formal banking system and inter-enterprise credit could be highly vulnerable to further slowdown and property price adjustments. While China's shadow banking risks are unlikely to trigger a worldwide systemic crisis, any further slowdown could affect market confidence and have indirect, contagion effects on foreign holdings of China's bonds and securities. Corporate loan defaults (which include foreign currency debt), such as the recent default of a Chinese property developer's bonds, suggested that a domestic problem can spill over to foreign banks and investors, as China becomes increasingly integrated with the global financial system. The fact that global financial markets reacted negatively to the announcement of a devaluation of 1.9 percent of the RMB in August 2015 indicated that global investors recognize the contagion risks of China's role in global growth, trade and investments. If not properly managed, a series of defaults by shadow banks or their clients can affect foreign banks and investors, as well as domestic confidence.

Furthermore, closer regulatory supervision is needed to tackle the moral hazard implications of shadow banking financialization, Ponzi and get-rich-quick schemes, and usurious lending that exploits the poor.

Overall, barring any sudden shocks, we envisage that China's shadow banking problem is still manageable, although the central government may need to step in to restructure some of the local government debts and return them to stability and productive growth. While most local government debt is manageable, since the local governments have a fairly high level of assets, local government finances need to be reformed through greater transparency, appropriate sharing of fiscal revenue between central and local government and also clarity of rules on issuance of local government debt. The other area of concern is the rapid growth in corporate leverage, particularly in inter-enterprise debt, which requires comprehensive financial reform to enhance private sector (especially SME) access to bank credit and equity finance.

There is much misunderstanding of the role of shadow banks in an economy, including in China. They are not stand-alone, high-risk entities that should be regulated out of existence. Historically, entities such as microcredit companies, money lenders and pawn shops, for example, form an intrinsic part of the financial system that integrates finance with the real economy, notably in providing access to credit to marginalized sectors that may not qualify for loans from the formal banking industry due to lack of credit history or collateral, onerous regulations, lending requirements and gaps and overlaps in regulatory coverage. Shadow banks do fulfill market needs for longer-term financing that is not provided by the formal banking sector, which is biased towards short-term lending as longer-term loans attract higher capital and other regulatory requirements. Unfortunately, some shadow banking activities involve Ponzi or get-rich-quick schemes, while others exploit SMEs and the poor by charging usurious interest rates, and these require closer supervision.

Since 2007, the Group of 20 (G-20) has tasked the Financial Stability Board (FSB) to focus on too-big-to-fail (TBTF) financial institutions and on shadow banks in order to curb the systemic and institutional risks that precipitated the GFC.

The FSB recognized that there were gaps in financial regulation in advanced economies (AEs) that underestimated the role of shadow banks in the run-up to the GFC. While the international experience in dealing with shadow banks offers a useful guide to China, there is no one-size-fits-all solution to regulate banks and shadow banks “on a global level playing field.” In particular, China's approach to shadow banking will need to “fit” domestic conditions and address risks that are peculiar to China.

In August 2014, the FSB Regional Consultative Group for Asia took the view that not only is there no uniform definition of shadow banks in Asia, but also their non-bank financial institutions (NBFIs) do not present systemic risks like those in AEs and are subject to adequate regulation, based on country-specific circumstances.

In a globalized, complex and highly interconnected financial system, diversity is a source of strength and resilience. Shadow banks exploit information, regulatory, price and tax arbitrage opportunities that fall beyond the purview of national financial regulators. The result is a global network of financial institutions, interconnected through complex and sometimes toxic financial derivatives and highly leveraged products that are not transparent to investors, operators and regulators alike.

Similarly, at the national level, the segmentation (and therefore fragmentation) of supervision of different financial products and institutions results in regulatory gaps and overlaps that enable new and unregulated institutions to emerge to meet market needs that were underserved because of obsolete policies and regulatory processes. This is true of moneylenders and microcredit providers as well as Internet finance platforms that provide financial services to market segments not served by the formal banking system.

Bringing shadow banks into the light by understanding their mode of operations, appreciating their systemic risks and putting them within the context of the whole ecosystem of real sector economic demand and supply of financial services would suggest that policy makers should look at the opportunity of inculcating the right environment for stable, efficient and inclusive growth between banks and NBFIs (notably e-finance) in supporting the real economy. This calls for a comprehensive policy approach that goes beyond the introduction of more regulations to control shadow banking risks.

The purpose of this book is to bring the explosive growth in China's shadow banking credit into the light and explore the potential implications for financial stability in China, and also for fundamental structural reforms in the Chinese financial sector that have key implications for the real economy.

The study takes a broader view of shadow banks to include Internet finance providers, identifying both groups not just as potential sources of chaos due to quick-profit and high-risk activities, but also as areas of profound change in the real economy that must be met by structural changes in the financial sector.

China is undergoing profound change, as the economy and society moves into middle income, urbanized consumption and production that is not only more broad-based, but also technologically driven, mobile Internet-friendly and more inclusive and ecologically green. The present financial system was designed to serve largely a state-owned production environment, based on investment and exports. The financial system needs to reform to meet China's changing needs as it rapidly shifts to a mass consumption-driven and market-led economy that is closely integrated with the world economy.

Just as the explosive growth in Internet finance and e-commerce reflects fundamental changes in Chinese supply chain production, distribution and consumption patterns, so do microfinance, moneylending and wealth management products reflect the growing complex, diverse and specialized needs of different segments of the Chinese market and society.

Of course, such explosive growth in new, opaque products gives rise to regulatory concerns of personal privacy, cybersecurity, usury, greed, moral hazard and system failure, which warrant prompt and careful management to curb the negative aspects of shadow banking and e-finance. But they are also opportunities to address the genuine needs of the real sector and to reform the present antiquated financial structure and processes.

This book argues that to understand Chinese shadow banks, we must understand the current financial system with Chinese characteristics and look into how a better system can be evolved, through rigorous and fundamental financial reforms.

This is because more regulation per se will not resolve China's shadow banking problem, given its complicated interlinkages and opaque bundling of risks with the formal banking system and the real sector. Indeed, there is much confusion on the measurement of shadow banking risks, which has been constrained by the problems of double counting (and underreporting) of assets as liabilities in wealth management products (WMPs).

A comprehensive assessment of the scale of risks of Chinese shadow banking must consider the quality of assets or net assets at risk (non-guaranteed assets). At the same time, the rapid growth in inter-enterprise credit (a characteristic quite unique to China in terms of its size and complexity) represents another source of risk, which needs to be monitored and managed carefully. The solution lies in taking a holistic assessment of the way the shadow and formal banking sector interacts and provides funding for the real economy. This calls for a comprehensive financial sector blueprint to improve transparency, promote financial diversification, and strengthen corporate governance, the credit culture and financial discipline as the basis for a modern, sound and stable financial system. The financial services industry, both incumbents and foreign players, will also need to change to meet the challenges posed by advances in technology and the rise of e-finance.

This book is organized as follows:

1. Chapter 2. Shadow Banking in the Global Context. This chapter reviews the evolution of shadow banking in the global context, including a survey of developments across selected countries. The attendant challenges in measuring shadow banking (given the lack of a common definition) are discussed, as well as the factors underpinning the industry's recent growth. This chapter also highlights the complex interconnections and feedback loops between shadow and commercial banks as a potential source of fragility in the financial system. The chapter highlights that there is a divergence of views over the role of shadow banks in the emerging markets vis-à-vis the advanced countries and therefore the issue of risks and supervisory oversight will be different from those in the advanced markets.
2. Chapter 3. Shadow Banking within the National Balance Sheet. This chapter analyzes the interconnectivity and relationships between the different components of shadow banking and formal banking through a stock-flow approach. Financial stability in a large economy suffers from risk concentration at the product level, the institutional level and also the geographical/regional level. Traditional economic analyses through flow accounts (national income, trade, investments) do not reveal these vulnerabilities. Recently published Chinese national balance sheet and flow of funds accounts, based on the China National Balance Sheet Report 2013 and its latest update in 2015 published by the Chinese Academy of Social Sciences (CASS), offer revealing insights on the interconnectivities and vulnerabilities by sector.

Whilst useful from a systemic perspective, national balance sheet data represents a top-down, snapshot view of the situation in China and a review of current conditions. This study does not attempt to forecast dynamic changes in the Chinese economy and its interactions with changing global conditions. Conditions could well change dramatically for the worse if growth falters or property prices collapse due to some unforeseen shock. While a bottom-up approach and modeling of the dynamics between shadow banks, the real economy and China's risks as a whole could well offer additional insights and predictive value, such analysis is constrained by data limitations. Hence, the rapid growth in shadow banking credit warrants closer monitoring and management to preempt any escalation of risks and contagion effects.

By comparing leverage and where it is located within the national balance sheet, it would be possible to detect an economy's state of robustness or its fragilities, particularly at the sectoral level. Based on the national balance sheet approach, we conclude that a systemic crisis is unlikely in China, as its sovereign balance sheet shows a net asset position of RMB 103 trillion at the end of 2013 (162 percent of GDP) even after accounting for all gross liabilities, with ample net assets at the national, household and central government levels. Even if we were to exclude all its natural resource assets, the sovereign government's financial position remains solvent to avoid any potential liquidity problems. As China is a net lender to the rest of the world, any emerging debt problem will therefore be a domestic one without any direct global systemic implications. However, indirect contagion effects cannot be discounted, if market confidence in foreign holdings of China's bonds and securities is affected. We conclude that China's shadow banking problem is manageable under current conditions.

Time is of the essence in implementing remedial policies, as the national balance sheet analysis represents a snapshot or static view of the shadow banking situation at a point in time. The situation may change at short notice, due to some unexpected shock, as the shadow banks interact dynamically with the real sector and China's risks as a whole. The sooner the shadow banking risks are properly managed, the lower will be the risks of systemic vulnerability to changes in domestic confidence and contagion.

Some c...

Table of contents

• Cover
• Title Page
• Copyright
• Foreword by Victor Fung
• Foreword by Liu Mingkang
• Acknowledgments
• About the Editors
• Executive Summary
• Chapter 1: Introduction
• Chapter 2: Shadow Banking in the Global Context
• Chapter 3: Shadow Banking within the National Balance Sheet
• Chapter 4: Shadow Banking with Chinese Characteristics
• Chapter 5: Inherent Risks in Chinese Shadow Banking
• Chapter 6: Impact of Technology on China's Financial System
• Chapter 7: Implications for Reform Agenda
• Chapter 8: Conclusion
• Appendix A: Evolution of International Financial Crises – Lessons for ChinaLi Sai Yau
• Index
• End User License Agreement