Few people grasped the full extent of the risks from shadow banking before the global financial crisis exploded almost a decade ago. One reason why is that billions of dollars of sub-prime loans didn’t feature on bank balance sheets. Regulators in China are concerned about making the same mistake as their own shadow banking sector surges in size, growing by just over a fifth last year to $9.3 trillion or 87% of GDP, according to Moody’s, the ratings agency.
A key area of concern is sales of wealth management products (WPMs), which reached more than Rmb26 trillion ($3.8 trillion) at the end of December, up almost a third from a year earlier, the People’s Bank of China (PBoC) admitted. One paradox about shadow banking in China is that so much of it is conducted by the banks, many of which are state-controlled. They sell WMPs for a fee or introduce another issuer, taking a commission. Investors like the high yields but many of the products are little more than leveraged bets on a particular stock or commodity. If the punts don’t pay off, the issuers have to tap the money markets to meet their commitments to investors.
That has worried the banking regulators, which have threatened the financial institutions with “severe penalties” if they continue with the practice, likening sales of the products to “working without bending down” and “sitting there collecting free money”.
Anxious about the risks to financial stability, the PBoC has also been making it more expensive for the banks to meet their repayment commitments by pushing up short-term interest rates and draining liquidity from the financial system.
The authorities have turned their fire on similar behaviour in the insurance sector, which has been rocked by the arrest of Xiang Junbo, the head of the China Insurance Regulatory Commission, on suspicion of corruption (see WiC362).
Anbang is another of the targets for the more hawkish stance, after hoovering up income from WMPs to finance a flurry of bids for overseas assets and high-priced property deals. Last Friday regulators said it was forbidden from issuing new insurance products for three months, because it had been selling short-term deals disguised as longer-term policies in a way that “wreaks havoc on market order”.
The liquidity squeeze is making Chinese banks more cautious about dealing with third parties for so-called entrusted investment, another fiefdom in the shadow-banking sector. In these kinds of loans the banks act as agents between borrowers and lenders. Asset managers then invest the cash in bonds and stocks, hoping to generate enough income to cover the banks’ returns to clients, as well as some extra for themselves. But the pressure on funding has forced the banks to pull capital back from the pool of entrusted loans. Asset managers have had to sell shares and bonds, and one outcome is that the benchmark Shanghai Composite Index has dropped for four straight weeks.
The positive spin for the fiercer focus on financial risk is that the situation is being addressed because China’s economy is doing reasonably well, with better than expected GDP numbers and signs that industrial profits are improving. Certainly it’s a change of mood from January this year when anxiety about capital flight and depleting currency reserves was prompting dire predictions about a devaluing yuan.
All the same, the campaign against shadow banking is hardly novel. Four years ago the central bank engineered another cash crunch, putting pressure on the shadow bankers in a similar way (see WiC199). Another of the targets was loans to the local government financing vehicles (or LGFVs) that had become key providers of capital for investment and spending by provincial and municipal officials. Thousands of these special-purpose platforms had sprouted up. Fearful of the financial exposure (see WiC221), the central government called a halt to the borrowing. It allowed bond issuance from qualified candidates instead (see WiC329) and swapped about Rmb8 trillion of the existing loans into bonds to bring the liabilities back onto local government balance sheets.
These efforts at instilling greater discipline and transparency haven’t dealt with the problem, the Financial Times reported this week. Citing data from a presentation by the World Bank, the newspaper reported that financial exposure on the local government platforms has actually been growing. The World Bank’s view is that they still account for the “vast majority of public expenditures and public investment”, adding that, “government and LGFV finances [are] intertwined in complicated ways, making separation difficult in practice”.
The analogy is a useful one for the campaign against the WMPs, where the interests of the formal lenders and the shadow bankers often overlap. Clamping down too sternly will also spill over into regular lending, putting a dampener on economic growth. The impact is already being felt in the wider markets, erasing more than $450 billion from Chinese stocks and bonds since mid-April. Prices are coming down for copper and iron ore as well because customers from China are having greater difficulties getting finance.
Another lesson from the recent clean-up is to beware the law of unintended consequences. Three years ago the local fiscal authorities were banned from monitoring lending on the platforms because Beijing wanted to make it clear that there was no government guarantee protecting investors. Yet the reduced scrutiny in the sector did little to curtail borrowing. Indeed, the World Bank describes it as giving the “dangerous impression” of ‘free money’ to many of the participants.
This year’s push to prevent capital from leaving China (see WiC351) may also have had unwanted side effects, with cash heading into shadow banking products instead. And while sales of new wealth management products have slowed in the first quarter, according to official data, entrusted loans grew nearly 16% to Rmb635 billion. Issuance of banker’s acceptances – another form of shadow banking activity – has also surged. The tighter credit conditions make it harder to get a regular loan, turning borrowers back to shadow banking as a source of finance.
Xi Jinping has made it clear that lower leverage in the financial system is one of his priorities. But he won’t want the central bank to drain too much cash out of the financial sector in case it prompts a wave of defaults on the eve of this autumn’s Party Congress when he will start his second term as leader. Weaker data from the purchasing managers indices last week highlighted that the economy isn’t as robust as many had hoped either.
Of course, in the longer term the conundrum is even greater – how to deleverage an economy which is dependent on ever-increasing amounts of debt for growth.
Meanwhile for some independent economists like Jonathan Anderson a banking crisis is more a matter of when not if, as he told WiC in an interview just over a year ago citing China’s “debt bubble” (see issue 310).
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