China: Reform spotlight on China's shadow loans

Last Updated: 20 November 2011
Article by David Olsson and Patrick Phua

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.

Conclusion

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.

Footnotes

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions