Satyajit Das: Growth of China’s shadow banking sector casts light on fault in system

Das Capital: Beijing’s attempts to rein in runaway credit expansion has also perversely encouraged growth in the sector

Chinese debt concerns are complicated by two structural issues – the rise in borrowing by local governments and the increase in the role of the shadow banking system. Both sectors are testament to Chinese entrepreneurial spirit, but also point to deep problems in the financial system.

Outside of security matters or foreign affairs, China’s provinces, regions and centrally controlled municipalities enjoy a degree of autonomy. After the global financial crisis in 2007/2008, the aggressive stimulus measures to boost economic activity required the central government to relax controls on local government spending programmes.

According to the World Bank, China’s local governments have responsibility for 80 per cent of total spending but receive only about 40 per cent of tax revenue. As local governments are not legally allowed to borrow, they created LGFV (local government financing vehicles), also known as UDICs (urban development and investment companies). These special purpose arm’s-length vehicles, which are separate from but owned or controlled by the local government, can borrow.

The LGFVs generally borrow funds predominantly from banks (as much as 80 per cent or more), with the remainder raised by issuing bonds or other equity-like instruments. In recent times, with pressure on banks to curtail loans, LGFVs have borrowed from the shadow banking system. There are now more than 10,000 LGFVs in China, whose exact level of borrowings remains in dispute.

There is concern about the quality of the underlying projects financed, which are sometimes expensive, politically motivated trophy ones. Many of the LGFVs do not have sufficient cash flow to service debt, being reliant on land sales and high property prices to meet obligations. Probably more than 50 per cent of LGFVs have unsustainable debt levels.

In recent years, China has evolved its own substantial shadow banking system. There is the informal sector that encompasses direct lending between individuals and underground lending, often by illegal loan sharks that provide high interest loans to small businesses.

The larger sector consists of a range on non-banking institutions, which are subject to various degrees of oversight. It involves direct loans of surplus funds by companies to other borrowers or trade credit (often for extended terms). It involves non-bank institutions such as finance companies, leasing companies or financial guarantors. There are also more than 3,000 private equity funds, funded in part by foreign investors. An unknown number of micro-credit providers, consumer credit institutions and pawn shops provide personal credit. The largest portion of the non-banking institution sector is trust companies and wealth management products (WMPs).

Trust companies that control more than  $1.8 trillion (£1 trn) – 20 per cent of GDP – finance riskier borrowers and transactions that banks cannot undertake due to regulations. Trust companies raise money from large investors and companies. The major attraction for investors is the high returns: about 9 to 12 per cent a year compared with bank deposits rates in low single digits. After adjusting for the trust company’s fee of 1 to 2 per cent of loan value, the ultimate borrower must pay about 10 to 15 per cent a year for the funds, well above the 7 to 8 per cent charged by banks.

The funds primarily finance local government infrastructure projects (via LGFVs), real estate and industrial and commercial enterprises. The high interest rates mean that the borrowers are riskier. Problems with assets supporting trust loans are well documented, most notably the “Purple Palace”, a half-built and abandoned luxury development in Ordos.

WMPs are higher-yielding deposit or investment products, with a variety of seductive monikers – Easy Heaven Investments, Quick Profits and Treasure Beautiful Gold Credit. They are sold through banks or securities brokers to a broader investor base than trust company investments.

WMPs invest in a variety of assets, ranging from low-risk inter-bank loans, deposits and discounted bills to higher-risk trust loans, corporate securities and securitised debt.

A central feature of China’s shadow banking sector is its complex structure. Banks may arrange and act as an agent in a loan from one non-financial company to another (known as entrusted loans). Banks can sell assets to trust companies or create WMPs to channel client funds to them. Banks transfer assets to the shadow banking sector. Corporate bonds may be bought by trusts, which are then repackaged into WMP products for bank depositors. The growth of the shadow banking sector is driven by the structure and regulation of China’s financial system.

The credit markets are dominated by the four major state-controlled banks (Bank of China; China Construction Bank; Industrial and Commercial Bank of China; and Agricultural Bank of China) that focus on lending to state-owned enterprises, firms associated with the government and officially sanctioned projects. Other businesses have more limited access to bank credit. The shadow banking sector fills this gap.

For much of recent history, bank deposit rates have been below inflation. Negative returns and have led savers to seek higher rates in the shadow banking systems.

Beijing’s attempts to rein in runaway credit expansion by reducing loan quotas, limiting lending to specific sectors such as local government and property and restricting riskier transactions, has also perversely encouraged growth of the sector. The shadow banking system exemplifies a popular Chinese saying – shang you zhengce, xia you duice –  “policies come from above; countermeasures from below”. 

Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’

Life and Style
life
Voices
The Ukip leader has consistently refused to be drawn on where he would mount an attempt to secure a parliamentary seat
voicesNigel Farage: Those who predicted we would lose momentum heading into the 2015 election are going to have to think again
News
Joan Rivers has reportedly been hospitalised after she stopped breathing during surgery
people81-year-old 'stopped breathing' during vocal chord surgery
Life and Style
Chen Mao recovers in BK Hospital, Seoul
health
PROMOTED VIDEO
Life and Style
One in six drivers cannot identify a single one of the main components found under the bonnet of an average car
motoringOne in six drivers can't carry out basic under-bonnet checks
Environment
environmentCrop pests are 'grave threat to global food security'
News
i100
Voices
Pupils educated at schools like Eton (pictured) are far more likely to succeed in politics and the judiciary, the report found
voices
Arts and Entertainment
Simon Cowell is less than impressed with the Strictly/X Factor scheduling clash
tvSimon Cowell blasts BBC for breaking 'gentlemen's agreement' in scheduling war
Arts and Entertainment
Shady character: Jon Hamm as sports agent JB Bernstein in Million Dollar Arm
filmReview: Jon Hamm finally finds the right role on the big screen in Million Dollar Arm
News
Orson Welles made Citizen Kane at 25, and battled with Hollywood film studios thereafter
people
News
Brad Pitt and Angelina Jolie reportedly married in secret on Saturday
peopleSpokesperson for couple confirms they tied the knot on Saturday after almost a decade together
Sport
footballAnd Liverpool are happy despite drawing European champions
News
i100
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
Arts and Entertainment
tv
News
i100
Arts and Entertainment
Diana from the Great British Bake Off 2014
tvProducers confirm contestant left because of illness
Arts and Entertainment
Lisa Kudrow, Courtney Cox and Jennifer Anniston reunite for a mini Friends sketch on Jimmy Kimmel Live
tv
Life and Style
fashion

Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Database Developer (SSIS, TSQL, Microsoft SQL) London Finance

£35000 - £55000 per annum: Harrington Starr: A Global global asset management ...

Web Developer/UI Developer (HTML5, CSS3,Jquery) London

£55000 - £65000 per annum: Harrington Starr: A Global Financial Service Organi...

JavaScript Developer (C++ / C# / HTML, Java Angular.js) London

£50000 - £60000 per annum: Harrington Starr: A world leading business intellig...

C# Web Developer (C#, MS Dynamics CRM, SQL, SQl Server) London

£40000 - £50000 per annum: Harrington Starr: A Global Financial Service Organi...

Day In a Page

Ukraine crisis: The phoney war is over as Russian troops and armour pour across the border

The phoney war is over

Russian troops and armour pour into Ukraine
Potatoes could be off the menu as crop pests threaten UK

Potatoes could be off the menu as crop pests threaten UK

The world’s entire food system is under attack - and Britain is most at risk, according to a new study
Gangnam smile: why the Chinese are flocking to South Korea to buy a new face

Gangnam smile: why the Chinese are flocking to South Korea to buy a new face

Seoul's plastic surgery industry is booming thanks to the popularity of the K-Pop look
From Mozart to Orson Welles: Creative geniuses who peaked too soon

Creative geniuses who peaked too soon

After the death of Sandy Wilson, 90, who wrote his only hit musical in his twenties, John Walsh wonders what it's like to peak too soon and go on to live a life more ordinary
Caught in the crossfire of a cyber Cold War

Caught in the crossfire of a cyber Cold War

Fears are mounting that Vladimir Putin has instructed hackers to target banks like JP Morgan
Salomé's feminine wiles have inspired writers, painters and musicians for 2,000 years

Salomé: A head for seduction

Salomé's feminine wiles have inspired writers, painters and musicians for 2,000 years. Now audiences can meet the Biblical femme fatale in two new stage and screen projects
From Bram Stoker to Stanley Kubrick, the British Library's latest exhibition celebrates all things Gothic

British Library celebrates all things Gothic

Forthcoming exhibition Terror and Wonder: The Gothic Imagination will be the UK's largest ever celebration of Gothic literature
The Hard Rock Café's owners are embroiled in a bitter legal dispute - but is the restaurant chain worth fighting for?

Is the Hard Rock Café worth fighting for?

The restaurant chain's owners are currently embroiled in a bitter legal dispute
Caribbean cuisine is becoming increasingly popular in the UK ... and there's more to it than jerk chicken at carnival

In search of Caribbean soul food

Caribbean cuisine is becoming increasingly popular in the UK ... and there's more to it than jerk chicken at carnival
11 best face powders

11 best face powders

Sweep away shiny skin with our pick of the best pressed and loose powder bases
England vs Norway: Roy Hodgson's hands tied by exploding top flight

Roy Hodgson's hands tied by exploding top flight

Lack of Englishmen at leading Premier League clubs leaves manager hamstrung
Angel Di Maria and Cristiano Ronaldo: A tale of two Manchester United No 7s

Di Maria and Ronaldo: A tale of two Manchester United No 7s

They both inherited the iconic shirt at Old Trafford, but the £59.7m new boy is joining a club in a very different state
Israel-Gaza conflict: No victory for Israel despite weeks of death and devastation

Robert Fisk: No victory for Israel despite weeks of devastation

Palestinians have won: they are still in Gaza, and Hamas is still there
Mary Beard writes character reference for Twitter troll who called her a 'slut'

Unlikely friends: Mary Beard and the troll who called her a ‘filthy old slut’

The Cambridge University classicist even wrote the student a character reference
America’s new apartheid: Prosperous white districts are choosing to break away from black cities and go it alone

America’s new apartheid

Prosperous white districts are choosing to break away from black cities and go it alone