Understanding China's Shadow Banking and Its Economic Consequences

China's shadow banking system is a complex network of informal lending and investment activities that operate outside of traditional banking channels. It's estimated that China's shadow banking sector has grown to over $6 trillion in size.

The majority of China's shadow banking activities are conducted through trust companies, which are allowed to engage in a wide range of investments, including real estate and corporate lending. These trust companies often act as intermediaries between investors and borrowers, providing financing to companies and individuals that may not have access to traditional bank loans.

Shadow banking activities are often characterized by a lack of transparency and regulatory oversight, which can lead to a high risk of default and financial instability. In 2013, a major trust company in China, China Credit Trust, issued a $2.5 billion bond that was backed by a loan to a coal mining company, which ultimately defaulted on the loan.

Shadow banking in China refers to non-bank financial activities that operate outside of the traditional banking system. These activities have grown rapidly since 2010, causing concern among analysts who wonder if China might be headed for a similar meltdown to the US financial crisis in 2008.

The rapid development of China's shadow banking sector has been fueled by the country's very rapid rate of credit creation since 2010. This has led to a lack of transparency in much off-balance-sheet or non-bank activity.

Before the rise of shadow banking, China's credit system was largely controlled by the state. The government played a significant role in allocating credit and managing the financial system.

Shadow banking in China now involves a complex network of non-bank financial institutions, including trusts, pawnshops, and microfinance companies. These institutions often operate outside of the formal banking sector and are not subject to the same regulatory requirements.

The size of shadow banking in China is difficult to quantify, but it is estimated to be a significant portion of the country's total credit market. In fact, some estimates suggest that shadow banking accounts for up to 40% of China's total credit market.

The rapid growth of shadow banking in China has been driven by a combination of factors, including the country's rapid economic growth and the government's desire to stimulate the economy. However, this growth has also created new risks and challenges for the financial system.

Shadow banking in China is closely tied to the formal banking sector, with many banks providing financing to shadow banking institutions and vice versa. This has created a complex web of relationships between the two sectors.

The Chinese government has recognized the risks associated with shadow banking and has begun to take steps to reform the sector. However, the process of reform will be complex and will require significant changes to the country's financial regulatory framework.

The size and structure of shadow banking in China is similar to that of other countries, such as the US, where non-bank financial institutions have also played a significant role in the financial system. However, the speed and scale of China's shadow banking growth are unique and pose significant challenges for the country's financial regulators.

Here are some key statistics on the size of shadow banking in China:

Note: These figures are estimates and may vary depending on the source.

China's property sector is a massive contributor to the economy, making up an estimated one-fourth of it. Real estate companies have been at the center of a shadow banking system that's fueled rapid growth in the property market.

Developers have been borrowing freely from shadow banks to buy land from local governments, which has driven up land prices and subsequently housing costs. They've also been relying on pre-sales of apartments to homebuyers to secure financing.

The government has taken steps to crack down on shadow banking, but it's had a ripple effect on the property market. Chinese property giants like Evergrande and Country Garden have struggled to repay debt due to falling home sales.

In China, the property sector makes up an estimated one-fourth of the economy. Real estate companies bought land from local governments, which needed the revenue and the economic benefits of regional development.

Developers were able to borrow liberally from shadow banks, bypassing limits on borrowing for land purchases. This allowed land prices to continue rising.

As a result, developers then pushed up housing costs to maintain margins. Land prices continued rising, with developers pushing up housing costs.

Chinese property giants such as Evergrande and Country Garden have successively struggled to repay debt. Their cash flows have dried up, largely due to falling home sales.

Developers started relying more on pre-sales of apartments to homebuyers – via mortgages – and slowing construction to save costs.

Regulators in China have been working to reduce the risk posed by the links between banks and NBFIs, a key objective of the regulatory reforms.

Banks in China have been reducing their on-balance sheet exposures to NBFIs as part of these reforms.

Channel investing, where banks lend or invest using NBFIs as an intermediary, was appealing to banks because it allowed them to circumvent regulatory requirements.

Reforms have also tightened the regulatory requirements for banks' off-balance sheet investments in NBFIs, which typically occurred via AMPs.

As a result, the growth of banks' lending to NBFIs slowed sharply over 2017 and 2018.

The level of banks' lending to NBFIs remains high, but the sharp decline in trust assets for the purpose of 'affair management' since 2017 indicates a significant reduction in channel investing.

Private sector analysts consider trust assets for 'affair management' to be a proxy for channel investing, which has seen a sharp decline since 2017.

In China, trust funds have been involved in hiding debt by providing funds to real estate companies, often without disclosing the actual use of funds or making this information less transparent. This has led to a significant amount of hidden debt, estimated to be over 3.8 trillion yuan as of the end of June.

Some trust products invested in the property sector may not have disclosed the actual use of funds, intentionally making this information less transparent to circumvent financial regulations. This lack of transparency has raised concerns about the lax controls and aggressive accounting practices of developers during the boom years.

Trust firms in China have a significant exposure to real estate, with about 7.4% of their value tied to the sector, equivalent to around 1.13 trillion yuan as of end March. This exposure has raised concerns about the potential risks to the financial system.

The liquidity crunch at trust firms may cause turmoil in the local bond market and put financial pressure on Chinese companies and local government entities. This could trigger a bond price correction and hinder companies' financing access, potentially leading to debt-servicing challenges or even default pressure.

China's economic growth over the next 5 to 10 years will depend on how successfully the financial system can shift its resources away from property-related lending and local government investment projects toward more productive private sector firms.

Shadow banking represented nearly one third of all lending in China from 2012 to 2016, making it a significant contributor to the country's economic growth. After Beijing's crackdown on the sector, China's credit growth was cut in half.

The deleveraging campaign that China's leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China's structural economic slowdown began.

China's economic growth over the next 5 to 10 years will depend on how successfully the financial system can shift its resources away from property-related lending and local government investment projects toward more productive private sector firms.

Banks in China used trust companies to hide the true level of risk on their balance sheets, making money by lending to restricted borrowers such as property developers and local governments.

Shadow banking represented nearly one third of all lending in China from 2012 to 2016, and after Beijing's crackdown on the sector, China's credit growth was cut in half.

China's leadership launched a deleveraging campaign in 2016 to reduce systemic financial risks, which is the only logical starting point to explain how China's structural economic slowdown began.

If the financial system fails to shift its resources effectively, China's economic growth rates will continue to slow over the next decade to 2 percent or below.

The Chinese government has taken steps to reduce financing risks by introducing measures to reduce leverage, improve transparency, and strengthen risk management practices in the financial system.

In 2016, the People's Bank of China began conducting quarterly macroprudential assessments of banks, which were extended in 2017 to include off-balance sheet products, including trust and entrusted loans, and asset management products (AMPs).

Banks that scored poorly in these assessments faced penalties, including higher required reserve ratios, higher central bank borrowing costs, and suspension as primary dealers.

The authorities also increased the amount of debt that local governments could directly issue, reducing a demand for shadow financing.

A new Financial Stability and Development Committee was established under the State Council, consisting of the main Chinese financial regulators.

The China Banking and Insurance Regulatory Commission (CBIRC) was formed by merging the China Banking Regulatory Commission (CBRC) and the China Insurance Regulatory Commission (CIRC), clarifying regulatory responsibility for shadow finance activities.

The stock of shadow financing activity has contracted from over 60% of GDP to around 40% as a result of these measures.

The regulatory tightening and subsequent decline in shadow financing activity have had wide-ranging implications for participants in China's financial system, and the financial system as a whole.

The restrictions on shadow financing have contributed to lower aggregate credit growth, and the contraction in shadow financing has disproportionately affected activity in sectors that relied heavily on it, such as local governments, private firms, and real estate developers.

Data on assets of trusts show that trust company loans to most sectors have declined since 2017.

In contrast, local governments have been less affected by the contraction in shadow financing due to the central government's strategy of 'opening the front door and closing the back door'.

For local governments, the contraction in shadow financing has been less severe due to the central government's strategy of allowing them to raise debt in a transparent fashion directly from bond markets.

This has resulted in local government borrowing becoming less reliant on shadow finance, a significant shift from before 2015.

Private firms, on the other hand, have seen their use of shadow financing slow down in line with the broader decline in shadow finance, making it harder for them to access credit.

Real estate developers, however, have experienced a mixed bag, with trust company investments in the sector increasing since 2017, but then declining in 2019 when authorities turned their attention to the sector.

Savers in China have historically had limited returns on their deposits due to benchmark deposit rates. This has led many households to seek higher returns in the shadow financing sector.

The regulatory tightening on shadow financing has made it less attractive to invest in these products. As a result, growth in saving deposits picked up in 2018.

Households have had less incentive to invest in shadow financing products due to policies like banning principal and income guarantees. This has forced financial institutions to adapt by offering on-balance sheet products like structured deposits.

Regulators have since ensured that the returns offered by these products are in line with benchmark rates. This means that savers are no longer at risk of earning unusually high returns that may not be sustainable.

Savers are now better equipped to understand the risks associated with shadow financing products, thanks to stricter reporting requirements. AMP issuers must now frequently report a marked-to-market value to investors.

Entities borrowing through shadow finance channels have typically had restricted access to traditional bank credit. This includes local governments, private firms, and real estate developers.

The contraction in shadow financing since 2017 has disproportionately affected activity in these sectors. Local governments have been less affected, thanks to the central government's strategy of 'opening the front door and closing the back door'.

Trust company loans to most sectors have declined since 2017, with the exception of real estate. This is consistent with authorities continuing to restrict the flow of formal credit to the real estate sector.

Real estate is the only industry where trust company investments have increased since 2017. However, trust company investments in real estate began to decline in 2019 when authorities turned their attention to the sector.

Access to credit could get even more challenging for some property developers if the PBC goes ahead with a 'three red-line' policy to curb lending to property developers in January 2021.

Financial intermediaries need to adapt to the changing landscape of financial services, with 70% of consumers expecting a seamless digital experience. This requires investing in digital infrastructure and training staff to provide personalized support.

The rise of fintech and digital payment systems has led to a 25% increase in online transactions, making it essential for intermediaries to have a robust online presence. This includes secure payment gateways and mobile banking apps.

Financial intermediaries must also navigate the increasing complexity of regulatory requirements, with 90% of compliance costs attributed to regulatory changes. This includes keeping up-to-date with anti-money laundering (AML) and know-your-customer (KYC) regulations.

Intermediaries can benefit from partnerships with fintech companies, which can provide innovative solutions and expertise in areas such as risk management and customer onboarding. This can lead to cost savings and improved efficiency.

As consumers become more tech-savvy, they are expecting more from their financial intermediaries, with 60% wanting to manage their finances entirely online. This requires intermediaries to invest in digital tools and platforms that provide a seamless user experience.

Asset quality has become a major concern in China's shadow banking system. The value of distressed trust assets has increased strongly over the past couple of years, from less than CNY 200 billion in 2018 to over CNY 600 billion in 2020, which is around 3 per cent of total trust assets.

Weaker economic growth has led to a deterioration in shadow financing asset quality, making it harder for some borrowers to service their existing stock of shadow borrowing or roll over maturing products. This has resulted in a sharp fall in shadow financing growth.

Allowing some assets and financial institutions to default for the first time in decades, most notably Baoshang Bank, has attempted to unwind some of the perceived implicit guarantees underpinning China's financial system.

Asset quality has taken a hit in China's financial system, particularly in non-bank financial institutions (NBFIs). The value of distressed trust assets has increased strongly, from less than CNY 200 billion in 2018 to over CNY 600 billion in 2020.

Regulatory tightening has led to a sharp fall in shadow financing growth, which has reduced risk in China's financial system. However, this has also led to a deterioration in shadow financing asset quality.

Weaker economic growth has contributed to this deterioration, making it harder for some borrowers to access finance and roll over maturing products. This has resulted in a significant increase in distressed trust assets.

The authorities have attempted to unwind implicit guarantees by allowing some assets and financial institutions to default for the first time in decades. This includes Baoshang Bank, which has set a precedent for future defaults.

At least 4 of China's 68 trust firms have had investor protests outside their offices due to concerns that they will not recoup their investment. This highlights the risks posed by the weakening of implicit guarantees.

Crisis triggers defaults because a significant decline in asset quality can lead to a crisis, such as a bank run or a sovereign debt crisis.

Defaults are more likely to occur when a borrower's creditworthiness is severely compromised, as seen in the case of a borrower with a high loan-to-value ratio or a borrower with a history of non-payment.

A crisis can trigger a default when a borrower is unable to meet their debt obligations due to a sudden and severe economic downturn, such as a recession or a natural disaster.

Defaults can also be triggered by a crisis when a borrower's assets are severely devalued, making it impossible for them to meet their debt obligations, as seen in the case of a real estate market crash.

A crisis can have a ripple effect, causing a chain reaction of defaults that can spread across the entire financial system.