How shadow banking became the catch-all for riskier finance.
The conditions that gave rise to shadow banking in China before the bursting of the real estate bubble were unique; a finance-fueled stimulus package, coupled with moral hazard, under changing financial regulations, produced a shadow banking system that fomented institutional risk and threatened to bring about systemic risk. This was tightly managed by the Chinese government, which monitored developments, allowing some freedom while reining in the shadow banking sector when its costs outstripped its benefits.
Shadow banking, which rose after the global crisis hit, appeared to be a matter of political expediency rather than careful planning, and its decline was absorbed into the greater concept of the “New Normal.” Shadow banking lost its luster and converted from a lending boom into a debt debacle that was absorbed under the umbrella of restructuring.
As a brief summary, in China, shadow banking refers to non-bank financing, encompassing trust and wealth management products, entrusted loans, and bankers’ acceptance bills. Trust products were products that could include a trust loan, potentially bundled with securities, equity investments, and trust or entrusted loans. Entrusted loans were loans agreed upon between two companies, and were at first carried out between two related parties, such as between a parent and a subsidiary company, but during the shadow banking boom were increasingly carried out between non-related parties. Bundled assets sold to bank customers were called wealth management products. Bankers’ acceptance bills were normally used to finance trade and were traded on the interbank market, but during the shadow banking boom they were used in place of cash to pay bills by riskier borrowers. This occurred especially around mid-2013, as a liquidity crunch set in.
Inevitability of Shadow Banking in China
In its heyday, shadow banking in China was often viewed by China analysts as inevitable, arising from global and domestic economic conditions. Shadow banking itself grew to play a role that the government could not fulfill: providing loans to new sources of demand in the economy. The process started with the global crisis.
The global crisis that hit the United States and Europe in 2008 presented a negative shock to countries around the world, impacting global stock markets and exports from other countries to these developed nations. China experienced a sharp contraction in foreign direct investment through 2008 and in exports at the beginning of 2009. In response, the government unleashed an ambitious $586 billion stimulus package to bolster economic growth. The package channeled funds to upgrading and reconstructing infrastructure and other programs, fomenting a boom in fixed asset investment.
Infrastructure accounted for 72 percent of the stimulus package, and most of the spending was carried out by local governments. The central government financed 30 percent of the package, while the rest was funded through local government borrowing. As local governments could not borrow funds themselves, local government financing vehicles took on debt from banks and shadow banking institutions. Implementation of the stimulus package kick-started the rapid growth in fixed asset investment that accompanied the growth of shadow banking.
Fixed asset investment growth was reinforced by the growth of shadow banking, which provided funding to riskier borrowers. Shadow banking acted as an alternative source of funding to real estate developers and local government financing vehicles, which built up properties and infrastructure, effectively generating GDP. Shadow banking has been acknowledged by China’s leadership as risky. President Xi Jingping stated in October 2013, “…we are soberly aware of potential problems and challenges from falling demand, overcapacity, local debts and shadow banking, and we are paying close attention to possible impacts coming from the outside.”
In response to this increase in perceived risk, government officials chose not to eradicate the shadow banking sector completely, but instead increased monitoring and regulation. As Zhou Xiaochuan, Governor of the People’s Bank of China, said in November 2012, “Shadow banking is inevitable when banks are developing their business…” Shadow banking was recognized as a potential source of systemic risk, and the way it was addressed was to comply with the Financial Stability Board monitoring framework. The CBRC closely watched both the bank and shadow banking sectors for potential sources of risk but allowed shadow banking activity to carry on.
Banks had the incentive to profit from wealth management products, since other asset channels, including the extension of lower interest loans to state owned enterprises and returns on central bank bills, yielded scant returns. If the practice of selling wealth management products had proven unpalatable to China’s leadership, as the practice of banks rolling loans off balance sheet was later found to be, the entire wealth management business could easily have been banned. In fact, there was precedent for this. The trust industry had first originated in the eighties to channel foreign funds into China. Guangdong International Trust and Investment Corporation (GITIC) defaulted on its payments due to risky investment in the real estate sector, and trust and investment companies were thereafter suspended and ordered to recertify in 2000.
China’s leadership was therefore supportive of the shadow banking sector, as it satisfied liquidity supply and demand needs and fuelled economic growth. What is more, local governments, which could not obtain financing from banks after some time due to their excessive perceived risks, were able to obtain shadow bank financing, mainly from trust companies. Local governments were compelled to maintain growth by building up fixed investment, even if the projects delivered low returns. Local government financing vehicles, the corporate arms of local governments, secured many loans in order to finance projects in the name of generating growth, but this process was rife with moral hazard. Local government financing vehicles obtained loans based on the creditworthiness of local governments (rather than the local government financing vehicles themselves), who were technically not themselves the loan borrowers. Funds were used to construct entire cities that were never populated, as well as roads, bridges, and other infrastructure projects, some more viable than others.
Shadow banking products satisfied not only financing demands but also investment demands, as retail and institutional investors obtained higher yields from shadow banking products than from banking deposits. Wealth management products frequently offered considerably higher returns compared to deposits. Individuals and corporations with excess liquidity were becoming increasingly savvy and interested in profiting from financial investment.
Shadow banking had grown to an estimated 20-41 percent of on-balance sheet bank lending, according to Thomson Reuters. Without shadow banking, total lending would have declined by 16-29 percent, impacting GDP creation in turn. China might have missed its target growth rates.
Around 2012, risks within the shadow banking sector became apparent, as trust and wealth management products threatened default. Huaxia Bank allowed a wealth management product to default in December 2012. A number of trust loans were also on the brink, particularly in the property sector. Coal trust loans began to deteriorate from December 2013 and 2014, as the coal mining industry lost profitability. In the most visible case of threatened trust loan default, “Credit Equals Gold #1,”a 3 billion RMB ($470 million) wealth management product based on a trust loan to a collapsed coal miner, Huarong Asset Management, a state-owned enterprise, secretly bailed out the product by lending the funds to the Industrial and Commercial Bank of China, the trust product seller. When “Credit Equals Gold #1” was packaged as a trust product and sold by the branches of ICBC in 2010, it promised investors a yield of 10 percent. However, in 2012 the coal industry was hit hard by the country’s efforts to reduce pollution levels. The borrower, Zhenfu Energy, which was struggling in a declining industry, was caught in management and cash troubles. When the day of repayment came, it was unable to come up with the funds and was bailed out by the trust company. Ultimately, trust loans were frequently bailed out by the trust companies or other parties, which prevented systemic disruption.
The Political Economy of Financial Fallout and the New Normal
China’s economic climate changed dramatically in 2014 as the real estate sector set the gloomy tone for both the financial and real sectors. This slowdown in growth would later be embraced under the “New Normal.”
The downturn of China’s real estate industry grew serious as the oversupply of housing, combined with increased difficulty for developers in finding finance, led to deterioration in the property sector. China Real Estate Index System showed that property sales in China by volume in the 44 cities it tracked fell by 9 percent in April from the prior month and 19 percent compared with a year earlier. Average home prices, meanwhile, rose 0.1 percent in April from March and 9.1 percent from a year earlier. These sequential gains were the lowest since mid-2012, when the housing market ticked upward after the last downturn. The amount of property investment also sent a negative message. Investment of the real estate industry turned negative in four of China’s 26 provinces in the first quarter of 2014, and in two of them, Heilongjiang and Jilin, the fall was greater than 25 percent.
While the real estate sector deteriorated through 2013 and 2014, analysts feared the worst. However, though the environment reeked of financial fragility, the economy was sustained through government intervention, as trusts were ordered to absorb any losses, monetary policy was loosened to encourage spending, often in targeted sectors, and real estate purchase policies were eased.
Trust companies were told by the CBRC in 2014 that they must be prepared to provide funding for defaulting companies. Trust companies were required to restrict business and reduce assets, or get shareholders to provide additional capital. This curtailed rapid expansion of the trust industry and put trust companies on notice that they were to proceed with caution.
Dwindling confidence in the real estate industry was shored up by central bank policies in September 2014 that allowed home buyers who had paid off a mortgage to be reclassified as first-time home buyers, provided discounted mortgages to second-time home buyers, and made mortgages accessible for third-time home buyers. Still, while China had previously experienced bursting real estate bubbles, this time the falling property market was intricately tied up with the shadow banking sector, resulting in more extensive fallout. As shadow banking loans were scaled back in 2014, financing to smaller developers was either cut off entirely or became more expensive. A reduction in pre-sales as a source of financing also curtailed the funding pool for smaller developers.
A draft document suggesting that local governments be allowed to roll over their debt into municipal bonds, in order to maintain government operations, was circulated in an announcement put forward by the National Development and Reform Commission in May 2014. Ten wealthy cities were allowed to issue municipal bonds as part of a pilot program ending the ban on issuing municipal bonds.
The decline in shadow banking also signaled a permanent shift. The political atmosphere changed as officials emphasized that a permanent slowdown in growth was setting in. At this point, the leadership recognized that the heady growth enjoyed for decades, under the growth of manufacturing, and later under expansion of fixed asset investment and shadow banking, could not be sustained.
GDP growth was projected to decline, dipping below 7 percent in Q3 2015, and it was widely recognized that China’s economy needed to restructure in order to maintain growth. While fixed asset investment had, for a short time, buoyed growth, China’s leadership was aware this could not last. Emphasis on reforming the services and high-tech manufacturing sectors was made.
The decline in shadow banking was wrapped into a larger political economic stance warning that an economic slowdown was a natural part of restructuring. It was not as if sentiment was high and dropped off due to the problems associated with shadow banking.
The slowdown was viewed as rational, even inevitable, and not caused solely by the drop off in shadow banking activity, which allowed the leadership plenty of room to maneuver. The international community accepted this explanation; although there was some negative response toward China for allowing the build-up of bad debt, international responses generally viewed the decline in shadow banking and the overall economy as an acceptable component of structural change.
- “Simple logic shows that it is nearly impossible for China’s GDP to grow at current rates while rebalancing away from its dangerous over-reliance on exports and debt-fuelled investment.” –Michael Pettis, Peking University Professor in the Financial Times, July 28, 2013
- “[China’s slower economic growth] is a good thing, and it will ensure steadier growth of the Chinese economy in the future,” Zhu Min, Deputy Managing Director of the International Monetary Fund at the IMF/World Bank Annual Meeting, October 14, 2014 (China Daily 2014).
- “… analysts suggest markets shouldn’t worry too much about the slowdown, which may be largely due to an economic restructuring on China’s path toward more sustainable growth.” Laura He, Market-watch, April 1, 2014.
The slowdown was viewed as justifiable, preventing markets from reacting irrationally. China’s stock markets remained generally stable through mid-2014 and even rallied at year-end 2014. The size of trading inflated quickly in December and there were several days when trading volume exceeded one trillion RMB yuan; previously, the daily average trading volume was less than 300 billion RMB yuan.
What is more, the shadow banking system acted as a key source of funds for the stock market. Some WMPs were reoriented toward the stock market or redeemed; since housing prices were going down slowly, and investors put money into the stock market. As the Hugangtong (Trading channel between Shanghai and Hong Kong stock exchanges) was carried out, investors created a bull market, building up another asset price bubble, this time in the stock market.
The channeling of shadow banking funds toward the stock market was far less visible than the movement of funds into the real estate industry, since investment in the stock market resulted in asset price changes without the accompanying construction boom. Loans for equity purchases from online peer-to-peer (P2P) lending platforms were banned in July 2015. The government also cracked down on margin lending by banks and grey market institutions, and wealth management product leverage for equity investment declined somewhat in step. As in the real estate market bust, the stock market bust was shored up by government funds, preventing a run on the regular banking and shadow banking sectors that had financed the equity boom.
The Death of Shadow Banking?
Since shadow banking was generally not viewed as a cause of China’s economic decline per se, and especially since it was barely visible during the stock market boom, additional regulation imposed on shadow banking has been insufficient. While a couple of regulations were introduced, including a notice issued in the end of 2013, which clarified the scope of shadow banking, as well as some initial shadow banking provisions, a draft rule that encouraged banks to directly invest funds from wealth management products in December 2014, Circular 127, which restricted loans to enterprises disguised as interbank lending in May 2014, and 10 principles produced by the China Securities Regulatory Commission in September 2014 to regulate P2P, there were no regulations imposed that truly quashed the spirit of the shadow banking business. In fact, shadow banking entities expanded in some directions despite the slowing economy; insurance and securities companies increased their holdings of trust products, while crowdfunding, a new type of financing that allowed smaller investors to purchase shares in risky property developments, has become increasingly popular.
As a result, the sector was neither eradicated nor scapegoated. This is quite the opposite of what occurred in the United States during the global crisis, when the financial sector was blamed for the economic slowdown. The story was different, since the slowdown in the U.S. was the result of financial failure and was not engineered. In China, the story was that the economic slowdown was necessary, and from a radical standpoint even intentional. While focus shifted to overall economic growth, the nature of shadow banking changed but the sector did not disappear. As a result of tight money and distress in the real estate sector, new financing from trust loans and bankers’ acceptance bills declined in the second half of 2014, but additional flows to entrusted loans (as well as flows to corporate bonds and equity) were positive. Later, funds also flowed to umbrella trusts and P2P lending companies for investment in the stock market.
What is clear is that China’s shadow banking system has been associated with government control and political will, far more so than in the U.S. and Europe. If the Chinese government had wished to fully eradicate shadow banking at any point, it could have easily done so through regulation and directives. Yet the sector was and has been allowed to survive, taking on different forms that reflect existing economic and political conditions. This situation runs parallel to the more explicit relationship between banks and the government. Banks continue to reflect, to some degree, government objectives and the overall economic climate, focusing lending on particular sectors or entities. In fact, stimulus measures were carried out by directly injecting funds into large banks for loans to earmarked sectors. Therefore China’s shadow banking sector is unique to its political economy.
Still, shadow banking has become the catch-all for non-mainstream, more market-based, and riskier finance in China. While China’s shadow banking system was only lightly chastened by the most recent downturn, it should not be taken for granted that shadow banking has effectively considered risk. This is an area that needs constant attention if the nation’s financial system is to compliment, rather than curse, China’s growing economy.