China faces two separate but interrelated problems: rapidly increasing levels of debt and the growing complexity of its financial system – specifically of its shadow banking system, which is estimated to account for 70-100 per cent of the country’s GDP (£3.8trn to £5.5trn) and is expanding rapidly. Chinese banks’ share of new lending has fallen to around 50 per cent, from 90 per cent a decade ago, and the economy has become increasingly reliant on shadow banks as an important source of finance, especially for local governments, property companies and small and medium-sized enterprises.
The credit quality of borrowers from shadow banks is uneven. Collateral securing loans is variable. Many trust loans and investments in some wealth management products (WMPs) are secured by real estate. This exposes investors to losses if property values fall sharply. The Golden Elephant No 38 WMP, which offered investors 7.2 per cent a year, was found to be secured by a deserted housing estate in a rice field in Jiangxi province.
Other forms of risky collateral, such as industrial machinery and commodities, have become common. In a few cases, the collateral has been more exotic (tea, spirits, graveyards, etc). Sometimes, lenders seeking to foreclose loans have discovered that the underlying collateral has been pledged more than once or does not actually exist.
The products entail significant asset-liability mismatches, with short-dated investor funds being used to finance long-term assets; these are sometimes non-income producing, for example undeveloped land. The constant repayment or refinance requirement exposes the vehicles and the financial system to the risk of a liquidity crisis. For example, in 2014 around £400bn of trust products alone mature.
The trust companies and financial guarantors frequently lack adequate capital. Trust companies have average leverage of more than 20 times, which is high given the nature of the investments. Many products do not detail the exact use of investor funds. Documentation is vague. Due diligence by the sponsor or investment managers, enforceability of security interests and investor rights are unclear. Controls and oversight are weak.
Interconnections between the shadow banking system and the traditional banking system create additional risk and moral hazards. Banks frequently use the shadow banking system to shift loan assets off their balance sheets and “window dress” financial statements for regulators and investors. Banks also use trust companies and WMPs to arrange high-interest loans to companies such as property developers that they are unable to lend to for regulatory reasons. Banks work closely with trust companies and security brokers to create investment products for depositors seeking higher returns, in effect acting as a conduit between savers and borrowers.
In principle, the risk of these structures and investments rests with the investors. But investors in trusts may believe that they are protected from loss because the trust companies risk losing their operating licence if their products suffer losses. Investors may also assume that banks will guarantee repayment and returns on shadow banking investments.
In recent years, policymakers have taken steps to slow the rapid growth in debt and the expansion of the shadow banking system. Policymakers have used quantitative measures to reduce credit creation, increasing reserve requirements to reduce bank lending. Qualitative measures, primarily loan quotes and specific restrictions on certain types of loans, have been used to control borrowing growth.
In early 2014, the central government announced plans for measures designed to rein in shadow banks. Banks are to be subject to more rigorous enforcement of existing rules and bans on moving certain loans and assets off the balance sheet. They will have to set up separately capitalised and provisioned units for wealth management businesses. Co-operation between banks and trust companies or security brokers would be restricted. Trust companies would be prohibited from pooling deposits from more than one product or investing in non-tradeable assets. Private equity firms would not be allowed to lend to clients.
The government also announced plans for three to five new private banks to increase the capacity of the banking system, outside the dominant state-owned lenders. In mid-2013, and again in early 2014, authorities also intervened in money markets, draining liquidity to restrict excessive credit growth and improve banks’ risk-management practices. The actions resulted in a sharp rise in interest rates (in June 2013 they reached more than 13 per cent) and increased volatility, revealing the instability of the shadow banking system. After both episodes of intervention by the central banks, authorities had to supply significant amounts of liquidity to alleviate concerns about financial problems and a slowdown in growth.
The central problem is China’s reliance on debt-funded economic growth and the need to expand credit to maintain high levels of economic activity. In addition, the increase in the size and complexity of the shadow banking sector reflects structural problems. As a consequence, attempts to slow credit growth, regulate the shadow banks and reduce speculation have been unsuccessful.
What is needed is widespread economic, financial and structural reform, but that is politically unpalatable. Responding to the regulations covering shadow banking in January 2014, Anne Stevenson-Yang at J-Capital wrote: “The hilarious new Document 107 on shadow banking betrays how toothless the government is in the face of the mounting debt, because the only solution presented is more debt.”