China’s shadow banking industry is bigger than reported, more dangerous than understood – and probably can’t be stopped anyway.
These are some of the less-than heartening conclusions reached by CLSA’s head of China and Hong Kong strategy, Francis Cheung, the same man who in May said China’s banking sector’s bad debt ratio is really 15% when the big four banks reckon it’s about a tenth of that level.
Cheung estimates shadow financing hit Rmb54 trillion ($8 trillion) in 2015, or 79% of GDP, compared to a commonly cited figure of 26% by the G20’s Financial Stability Board. In itself, this isn’t a problem – financing by institutions outside the regulated banking system accounts for 59% of GDP on average among big jurisdictions, according to the FSB, 147% in the UK and over 1,000% in Ireland – but darker concerns lie behind the scenes.
Getting around
One is that most of this shadow banking ultimately comes, not from rivals to the banks, but the banks themselves: the Brookings Institution estimates that banks are providing 65% of all shadow financing in order to lend off-balance sheet.
“Shadow banking is driven by banks getting round regulations and lending where they shouldn’t be,” says Cheung.
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That, in turn, means that the banking sector is running up considerable debt (about Rmb35.5 trillion) that mostly does not appear in reported numbers on balance sheets and therefore also does not turn up in stated NPL numbers, nor, by extension, in investors’ calculation of bank risk.
Moreover, it’s likely that banks have pushed the riskier stuff, such as loans to over-supplied industries, off the balance sheet, which undermines state efforts to stop lending to those sectors for the very good reason that they are defaults waiting to happen.
On top of the issue of transparency, there is the problem that retail investors no longer have any idea what risk they’re taking in what appear to be mainstream investment products.
Cheung highlights a recent product from China Merchants Bank where the stated allocations are 0% to 50% in bank deposits, 0% to 90% reverse repo into interbank markets, and 10% to 100% asset management plans and trusts.
“They have absolutely no idea what they are buying,” says Cheung.
Another troubling prediction is that the potential bad-debt loss for the shadow-banking system is equivalent to 3.7% of China’s GDP, on top of the banking bad-debt ratio Cheung identified in mainstream banking in May.
And Cheung isn’t just going for the headline worst-case here: he assumes a 40% recovery rate, which is far from guaranteed. Cleaning up both bank and shadow bad debts would cost China 14% of GDP, he says.
Fortunately, China has deep pockets.
“I’m not calling for any systemic risk because of it,” he says, “but that doesn’t mean there won’t be shocks.”
How have we got here? The story starts in 2007 when the China Banking Regulatory Commission started allowing banks to launch wealth management products investing in trust companies. Trusts historically funded vehicles for infrastructure development but instead, under less regulation than the banks themselves, became a method of channelling bank money into higher-risk sectors such as property and mining that were restricted by the government.
Seeing this, the banking regulator began tightening rules on trusts, but unfortunately did so just as the China Securities Regulatory Commission saw an opportunity and decided to let securities companies and mutual funds expand the asset classes they invested in. They promptly began developing asset management plans investing in the same way the trusts had.
Opacity
On top of this, banks have developed various opaque ways of getting around regulations.
Two examples are entrusted loans – a bank lends to company A, which then passes on a further loan to company B for a fee, meaning the bank only appears to be an agent in the transaction – and lending through trusts and asset management plans that in turn lend to a separate company.
“You have to wonder how serious they are about reforming the banks,” Cheung says.
He thinks shadow financing has a lot to answer for and has played a role in four consecutive years’ worth of market problems.
The most obvious was the Shibor crisis in 2013 when interbank liquidity froze thanks largely to a funding mismatch in shadow wealth management products; then the 2014 property correction was made worse by the fact that shadow financiers had been lending to the property sector; the A-share bubble and crash was exacerbated by leverage shadow finance had put into the system, and the slashing of interest rates this year and consequent outflows of capital were in turn a reaction to the property market problems that shadow lenders had helped create in the first place.
So why not just step in and stop it?
In a corner
Well, that’s the other problem. The entire middle class is committed. Cheung estimates that 20% of individual wealth is now in shadow products.
“If the government clamps down and people stop investing in them, essentially you get a run on the banks,” he says. “And the consumer has so much in there the government would have to come in and rescue it. By the very fact that they have allowed it to grow so large, they have painted themselves into a corner if there are any defaults.”
The planned merger of China’s regulators into one will at least stem the regulatory arbitrage where, as Cheung puts it: “CBRC wasn’t talking to CSRC”.
But the situation now appears unfixable. “It [shadow banking]’s so big,” says Cheung, “they actually need it now.”
