GUEST CONTRIBUTOR AT HOPKINS-NANJING CENTER
China’s economy has become increasingly over-leveraged, especially its real estate and fixed asset investment sectors. To ameliorate this over-leverage, China has sought to restrict credit by reducing bank’s lending limits. Although official bank lending growth has been tamed, these regulations have expanded rapidly to another form of banking: non-bank lending, also known as shadow banking.
Because shadow banking contributed to the global financial crisis, many observers are concerned that the growth of China’s shadow banking activities may trigger financial turmoil. Analysts have shown that although China’s structural debt risk is real, the role that shadow banking plays in creating debt risk is secondary. China’s debt risk problems stem primarily from on-balance-sheet bank lending, which is a political result of China’s interest rate regime and credit restrictions. As such, unless China reforms this system of credit allocation simultaneously, restricting shadow banking would provide few benefits.
Different types of shadow banking co-exist in China. The small underground, curbside and independently established non-bank lenders influence credit on too small of a scale to be considered systemic problems. Rather, this smaller sector simply provides credit lifelines to borrowers that are politically unconnected and cut off by China’s distorted banking system. As the former head of UBS Asia research and later “micro-financier” Joe Zhang points out, this sub sector is the most incentivized to consider risk and can earn real profits, often through lending at 20 percent interest or more. Therefore, this credit seems to be based on economics rather than speculation. Furthermore, this sector may even be realizing excess profit by serving an urgent credit market need.
Mainline banks and the wealth management products they broker have truly expanded shadow credit most in China. Chinese banks introduce their depositors to other entities that will pay depositors a higher interest rate and then lend forward these funds as loans to other, often undisclosed, borrowers. These loans are not official bank loans, but most depositors consider their bank’s introduction as an implicit guarantee on their money. These deals are essentially bank loans by another name, as banks recognize they would likely have to make good on any defaulted wealth management products. When, on the rare occasion, smaller banks have shirked this understood obligation, mass protests have ensued.
Nevertheless, it is in these bank-sponsored products that we can observe most clearly how credit rationing has failed, quite spectacularly, to hinder risky credit growth. Because they feel compelled to feed credit to politically important companies and local governments, China’s banks respond differently to government-imposed credit controls than they would in a normal market context. That is, they fail to channel official lending to those who can use credit most effectively. Instead, state-owned enterprises (SOEs) and local governments retain enormous influence, if not direct authority, over bankers. When borrowers access artificially cheap credit, the fundamental economics underlying their debt deteriorate while their levels of debt remain untenably high. These forces have created highly complex and hard-to-regulate bad debt that is independent of shadow banking.
China’s four big banks report that less than one percent of their loans are non-performing, yet this is not credible because these same banks have restructured hundreds of billions of RMB in existing loans to the benefit of favored borrowers. Further, although China has “liberalized” interest rates for borrowers, interest rates on deposits remain artificially low. These low deposit rates act as a veiled subsidy for, and a tacit acknowledgement of, the losses associated with the preferential loans made to SOEs and local government-related entities.
So while there is abuse and some speculative froth in Chinese shadow banking, shadow banking has actually removed a substantial portion of these captured funds by partially liberalizing deposit rates through the back door. This is unlike the US situation before the financial crisis, where shadow banking allowed many banks to park loans in external entities so that they could lend to the next most marginal borrower, while still enjoying the subsidy of deposit insurance. Shadow banking in China has actually allowed banks to maintain their more economically profitable clients. It is the official lending that enjoys this inefficient, controlled deposit rate subsidy.
The primary risk of shadow banking lies in its ability to distract from questionable official sector lending. In fact, China’s shadow banking sector has relieved pressure on the more unintentional targets of the central government’s generalized policy to rein in credit. Its excesses are therefore a secondary focal point tangent to the central problem of the bad bank debt that politically-charged credit decisions have engendered. China’s central government must focus its policy decisions on this official bad debt. Continuing to turn away from this type of borrowing will only serve to slow China’s economic growth further.