SB -shadow dragonShadow banking is not a new phenomenon in China, but recently it has been coming under the spotlight because of the relationship between shadow banking and soaring local government debts.

The term ‘shadow banking’ refers to banks and finance companies who offer high interest loans to companies and local governments. 70% of all trust loans given in 2012 were attributed local governments and companies that struggle to get finance through traditional banks. These loans fall outside of the usual financial system regulation and so can be particularly risky as the finance companies involved are not required to have as much capital backing them up.

Shadow banking has become more in China due to a rising demand from local governments and private companies for finance, as these entities are usually unable to access traditional forms of lending. As shadow banking promises higher interest rates than state-controlled banks, it is also an attractive proposition for investors.SB -ICBC

Shadow banking also plays a major part in encouraging growth in the economy as it offers much-needed finance to new, start-up companies and small, private businesses. A large proportion of shadow loans have been given in support of infrastructure projects which also benefit the economy.

However, the sheer amount of investments handled by the shadow banking industry could cause serious problems for the Chinese economy if people start to lose confidence in it. By the end of 2012, shadow banking amounted to 55% of China’s GDP and, in 2013, shadow financing accounted for 30% of all finance given in the country.

This vast share of the finance market has been growing exponentially over the last few years due to the government restricting interest rates and credit availability in the banking industry; leaving those who are refused bank loans and those who want to see higher returns on their investments, no option but to seek other options. Shadow banking has become a vital resource for small and non-state owned companies to get credit, thus helping the economy to grow.

Nevertheless, ‘shadow finance’ has also contributed to the mountain of local government debt which is quickly becoming unmanageable. If local governments are unable to repay their debts, it could lead to a financial crash in the country, which would also have a powerful impact on economies throughout the world.

Much of the shadow banking industry in China, 6 trillion USD worth in fact, is focused around ‘Wealth Management Products’ (WMPs). These are often marketed to individual savers as a better alternative to savings accounts as they can offer a higher return on investments. As it is the state-controlled banks themselves who are marketing these products, customers think their investments are protected and, if the company running the WMPs gets into financial trouble, they believe the banks will step in to ensure they don’t lose money.

Although this has been the case in previous years, banks are now no longer willing to hold up the shadow banking industry. ‘Credit Equals Gold No.1’, a shadow banking company that sold WMPs through the Industrial and Commercial Bank of China (ICBC), has recently come into difficulties after it financed an insolvent coal mining company. ICBC have, so far, refused to bail the company out although they have said that, in order to protect their reputation as a safe bank, they may step in and help investors in the product. ICBC confirmed they would inform investors of their final decision regarding the product before January 28th. In the case of ICBC refusing to bail out investors, ‘Credit Equals Gold No.1’ will, most likely, have to default on its payments, leaving investors out of pocket.

The shadow banking industry holds many risks for investors as WMPs and similar products are often backed by high-risk projects or projects with a long maturity, whereas most WMPs have a short maturity which creates difficulties for banks when they have to repay investors.SB -shadow money

The problem the Chinese government and the PBOC have is if they don’t bail out the company or protect investors’ money, it may cause other investors to panic and create a run of investors rushing to cash in their investments. However, if they continue to artificially protect investments, investors won’t realise the risks involved in these products, meaning that investments in this unpredictable sector will continue to rise. Allowing ‘Credit Equals Gold No.1’ to default gives investors the warning they need to not put all their trust in these investments.

While the Chinese government and the Peoples’ Bank of China (PBOC) realise that the shadow banking sector greatly benefits the economy and helps growth, they do concede that the industry needs more regulation and that the whole banking sector in general needs to be reformed in order to avoid a possible crash which would devastate the country’s economy and may lead to another worldwide economic crisis.  However, reforms have to be introduced gradually to ensure investments are protected and that the reforms themselves don’t create an economic crisis of their own. There are rumours that the PBOC released guidelines in December on regulations for shadow finance products. These guidelines have been dubbed Document 107.

Document 107 supposedly splits shadow banking into three categories – “completely unregulated credit intermediaries without a license, including Internet finance companies and third-party wealth management institutions; unlicensed credit intermediaries that lack sufficient regulation, including financing guarantee corporations and micro-loan companies; finally, services provided by licensed financial institutions that lack sufficient regulation or avoid regulation, including money market funds, asset-backed securitization and certain wealth management services” (china.org.cn). These categories form the basis for the new guidelines.

HSBC economists, Qu Hongbin and Sun Junwei, believe that the government will use the guidelines set out in Document 107 to try to strike a balance between stabilizing economic growth and reducing risks to investors and institutions. There are rumours that the document proposes the introduction of separate regulatory bodies to watch over shadow banking institutions to make sure these companies follow the guidelines and regulations and protect investors’ assets.

The reforms proposed in Document 107 also include requiring companies offering ‘shadow finance’ to disclose off-balance sheet investment and to register WMPs as well as developing unified regulatory standards across all financial products and businesses. This will create more transparency within a previously very confusing and secretive industry.

At the moment, however, Document 107’s guidelines are all speculation as it hasn’t been officially released. Once PBOC and the State Council have confirmed between themselves the new guidelines and regulations, we will see a more concrete set of regulations which will hopefully go further than those set out in Document 107 and will make a start at reigning in the shadow banking industry.

No matter what regulations are introduced they will be introduced with caution and there may well be several contradictory guidelines created in the process as the PBOC grapples with reigning in the shadow banking system without destabilizing the economy.

References

http://www.bloomberg.com/news/2014-01-17/will-china-s-shadow-banking-craze-slow-down-.html
http://thediplomat.com/2014/01/chinas-shadow-banking-challenge/2/
http://thediplomat.com/2013/05/is-shadow-banking-chinas-subprime-mortgages/
http://www.reuters.com/article/2014/01/06/us-china-economy-shadow-banking-idUSBREA0503T20140106
http://www.china.org.cn/business/2014-01/22/content_31268265.htm
 

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