Photo: Reuters
Photo: Reuters

The shadow looming over China

The health of China's financial sector is a cause of concern, what with non-banking financial institutions holding assets that exceed 80% of the country's GDP

Of all the topics sure to come up in the Sino-US economic talks this week—from the problem of excess capacity to currency controls—the health of China’s financial sector will no doubt feature high on the list. Especially worrying are the multiplying links between the country’s commercial and “shadow" banks—a broad range of non-bank financial institutions from peer-to-peer lending platforms to trusts and wealth management companies. All told, the latter now hold assets that exceed 80% of China’s gross domestic product, according to Moody’s—much of them linked to the commercial banking sector in one way or another. That poses a systemic threat, and needs to be treated as such.

There’s nothing inherently wrong with shadow banks, of course. Largely owned by the government, China’s commercial banks focus primarily on directing capital from savers to state-owned enterprises, leaving Chinese households and smaller private enterprises starved for funds. Shadow banks have grown to meet the demand. At their best, they allocate capital more efficiently than state-owned lenders and keep afloat businesses that create jobs and growth.

The line between good shadow banks and dodgy ones is increasingly fuzzy, however, as is the divide between shadow and commercial banking. Traditional banks often assign their sales teams to sell shadow products. This gives an unwarranted sheen of legitimacy to schemes that are risky. Buyers trust that the established bank will make them whole if their investment goes south.

Shadow banks are also selling more and more products directly to commercial banks. Wealth management products held as receivables now account for approximately 3 trillion yuan of interbank holdings, or around $500 billion. According to Autonomous Research, as much as 85% of those products may have been resold to other shadow banks, creating a web of cross-ownership with disturbing parallels to the US mortgage securities market just before the 2008 crash. In total, the big four state-owned banks hold more than $2 trillion in what’s classified as “financial investment", much of it in trusts and wealth-management products.

The potential for disaster is significant. In a country with no credit reporting bureau and many doubts about the enforceability of contracts, wealth-management products aren’t for the faint of heart. Online peer-to-peer lending platforms give little thought to the creditworthiness of borrowers; several have collapsed in the past year. The sector has earned such a bad reputation that one platform felt it necessary to employ the motto, “Honestly, we won’t run away."

Given that most shadow lending is short-term in nature, typically under three months, there’s a risk that a small-scale panic could rapidly turn into a liquidity crisis that sweeps the industry. And liquidity crunches are the drivers of financial crises. The increasing ties between shadow and commercial lenders raise the risk of spillover into the larger financial sector.

What’s needed above all is greater transparency and visibility into the sector. The government can begin by building a sound, up-to-date regulatory framework, one that properly defines the roles and responsibilities of non-bank financial institutions. That means forcing shadow banks to provide more detailed information about their products, in particular the types of assets they hold. It also means defining more clearly who’s liable in case of a default.

Not that long ago, China was handing out suspended death sentences for entrepreneurs who solicited deposits outside the banking system. There’s no need for such draconian measures. But China would be wise to bring its shadow banks into the light before risks to the financial system mount much further. Bloomberg

Christopher Balding is an associate professor of business and economics at the HSBC Business School in Shenzhen.

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