One of the persistent concerns about China's recent boom is that it has been financed by excessive debt and that this debt burden will trigger a fiscal or financial crisis. The concern is heightened because of the explosion in credit extended by non-bank financial institutions outside the official channels - the so called "shadow" banking market.1
China has a long history of shadow market financing flowing from small, informal and unregulated groups, to all sectors not well covered by banks. A number of formally incorporated entities, including trust companies,2 leasing and guarantee companies, have also emerged, with the scope to provide alternate financing .
The increase in this shadow banking has increased dramatically over the last few years. The People's Bank of China (PBOC) estimates the size of shadow lending at 3.38 trillion yuan or over 20% of total outstanding loans in China. A recent Bloomberg article put that figure at 55% by the end of this year, up from about 4% in 2002.
Whichever figure is right, the sums involved are now too big to ignore.
Shadow banking challenges the government's tight control of credit and interest rates - two of the main policy levers it uses to manage the economy.
Concerns about the systemic risks associated with this massive build up credit have been voiced by market commentators for some time. Earlier this year China's central bank, the People's Bank of China (PBOC), publicly acknowledged the importance of non mainstream financing and, implicitly, the need to regulate it. Dual-pronged measures have since been launched aimed at making more funds available for small and medium sized businesses (SMEs) and at regulating the market.
The call for further reforms to support financial stability is now coming from all quarters. In its first formal evaluation of China's financial sector published earlier this week, the International Monetary Fund (IMF) concluded that while China's financial system is robust overall, it faces a steady build-up in vulnerabilities.
It noted that significant progress has been made towards developing a more commercially-oriented financial sector, and that supervision and regulation are being strengthened, but risks are arising from the growing complexity of the system and shadow banking.
With the next generation of China's leaders to be announced late 2012, the direction and pace of China's financial reform is now being watched carefully.
The need for new credit options
Financing in China has historically been controlled by the state-owned banks, with the government using its control to regulate the country's pace of economic growth, directing it to pump out credit when required and restrict volume of new loans to prevent overheating.
In a rapid and effective response to the global financial crisis in 2009, China's main banks were directed to lend vast sums of money to fund major state-owned enterprises (SOEs) - generally without any real concern for potential credit risk. Today the story is different. The government is seeking to control inflation through the use of tough lending quotas, with banks rationing credit and limiting loans to SOEs that are seen to pose negligible default.
In both cases SMEs have had difficulty in obtaining bank loans and have had little choice but to source private loans and finance in the shadow banking market. With SMEs accounting for about 60% of China's GDP and 80% of the country's jobs, the extent of the practice is far reaching.
Moreover shadow loans' interest rates often range from 14% to 70% or more. With the market slowing there have been a raft of bankruptcies, leading recently to significant social disturbances in China's so-called entrepreneurial capital of Wenzhou, and other cities, in recent times.
Reform agenda for funding SMEs
Wenzhou's events sounded an urgent alarm for China's central government to take swift action.
The government immediately acknowledged that some SMEs have encountered difficulties due to heavy tax burdens and inability to access financing despite accounting for
Premier Wen Jiabao's official statement from a recent State Council executive meeting urged China's financial regulators to address these issues:
"Small firms play an irreplaceable role in fostering economic growth, increasing employment, facilitating scientific and technological innovation and maintaining social stability... We must pay close attention to such problems."
China's State Council last month also raised its concerns about the unstable private lending market and urged local governments to take effective measures to reduce informal lending and crack down on illegal fund-raising.
The banking regulator has already required banks to put back on their balance sheets by the end of 2011 the billions of dollars of loans that are sold to trust companies and repackaged as high yielding products.
The government also pledged strong financial and fiscal support to China's cash-strapped SMEs in times of global economic downturn, with 14 trillion yuan promised as the 2011 total social financing target.
Financial regulator changes
An interesting development in recent weeks has been the quiet reshuffling of the heads of the three main central regulators , China Banking Regulatory Commission (CBRC), China Securities Regulatory Commission (CSRC) and China Insurance Regulatory Commission (CIRC).
Guo Shuqing, the former China Construction Bank Chairman, is the new Chairman of CSRC, replacing Shang Fulin who in turn has become the Chairman of CBRC and Xiang Junbo, the Agricultural Bank of China's former Chairman, is the new head of CIRC.
All of the appointees are known in the market for their reform approaches. The fact that these changes are taking place before the Communist Party of China (CPC) leadership changes in late 2012 is an encouraging sign that China is still pushing its financial regulatory reform agenda in spite of overall global financial troubles and the CPC leadership change.
As noted in the IMF report, China's financial sector is confronting several near-term risks: deterioration in loan quality due to rapid credit expansion; the rapid growth of shadow banks and off-balance sheet exposures; a downturn in real estate prices; and the uncertainties of the global economies.
However, shadow banking, by itself, was not identified as the main problem. Indeed it performs a vital role in promoting an efficient allocation of capital in the market. The current day problems arise primarily from the rapid expansion of the shadow banking system and the fact that it is only lightly regulated.
The steps that the Chinese authorities are taking to reform and regulate the shadow banking market are encouraging and point to a commitment to continue the reform program that has underpinned the development of China's financial market for the last two decades.
There are however a number of significant structural issues still to be addressed. These include:
the need to further widen and diversify the financial markets and services. The creation of a deep and liquid corporate bond market should be a priority in creating alternative funding choices and healthy competition among banks;
the further opening up of the market to foreign competition to provide expanded opportunities to adopt work best practice in the newer financial sectors and emerging growth centres;
a reorientation of the role of government away from using the banking system to carry out broad government policy goals and to allow lending decisions to be based on commercial goals;
a greater use of market-based monetary policy instruments, using interest rates as the main instrument to govern credit expansion, rather than administrative measures. Delay in allowing interest rates to rise above the rate of inflation can only lead to a decline in the efficiency of the market; and
an upgrading of the financial infrastructure and legal frameworks, including strengthening the payments and settlement systems, as well as consumer protection and expansion of financial literacy.
We look forward to witnessing continued and sustained progress on all of these issues over the years ahead. The recent developments provide good reason to believe that this is a priority for the government.
1 There is no official definition of shadow banking but the main types of credit include (i) loans from non-bank financial institutions such as trust companies and micro-finance companies, (ii) credit that is arranged by banks but does not appear on their balance sheets, such as entrusted (company to company) loans, letters of credit and bankers' acceptances, (iii) corporate bonds and (iv) loans from money lenders and individuals.
2 Trust companies are investment vehicles unique to China and have little in common with western-style trust companies. They have enabled banks to stay below their loan quota by repackaging bank loans as investment products which are often repurchased by the banks at a later stage. The CBRC has been seeking to curb this practice.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.