Shadow Banking Poses Hidden Risks to China’s Financial Sector

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By Cindy Tse

Dec. 1 – Concerns over China’s overextended debt are being amplified by persistent warnings of a looming fiscal crisis from China’s massive “shadow” financing market.

This aptly named financing market is generally understood to be “gray” credit extended through informal or non-banking channels. Shadow lending can come in a variety of forms and from a wide range of different entities, all of which have in the past been difficult to track. For example, lending can come from Chinese trust companies, micro-finance companies, leasing and guarantee companies, corporate bonds and individual money lenders. The involvement of banks in shadow lending comes in the form of off-balance-sheet loans such as letters of credit and entrusted loans.

The People’s Bank of China estimates the size of the country’s shadow banking market to be over 20 percent of the country’s total outstanding loans, amounting to a whopping RMB3.38 trillion (US$531 billion). While contradicting reports abound about the extent and severity of this largely unmonitored phenomenon, even the International Monetary Fund (IMF) has caught wind of it, releasing an assessment last month of China’s financial stability that identified shadow banking as one of the key risks in China’s increasingly complex regulatory system.

The growth of informal lending channels can be traced back to the government’s response to the recent Global Financial Crisis, in which the country’s main banks were ordered to handout massive loans to state-owned enterprises (SOEs). The resulting inflation led to a subsequent and swift clampdown on lending with harsh quotas that have made credit available only to those SOEs least likely to default, and for the most part shutting out private sector enterprises.

China’s small and medium –sized enterprises (SMEs) account for 60 percent of China’s GDP and 80 percent of urban employment, according to Zheng Xin, deputy director of the SMEs division of China’s Ministry of Industry and Information Technology. Therefore, such preferential loan policies have rendered a massive chunk of the economy strapped for cash with little choice but to turn to informal channels in the shadow financing market.

The commodities gamble
Of particular concern since June of this year has been the involvement of commodity traders in this unregulated market. The state-led credit squeeze beginning in early 2010 forced SMEs and SOEs alike to turn to trade financing as a loophole. Trade loans fell outside the central bank’s restrictions, thus banks were able to offer them for commodities purchases such as copper, steel and soy beans.

The situation would start off harmlessly enough – with a letter of credit from a bank issued on behalf of an established borrower to a steel manufacturer for a given stock of steel. The borrower, perhaps a commodities trader, would then have a short period of time to repay the bank, but the time periods can vary depending on the bank and commodity. In the case of copper, the borrower may have three months to a year, with fees and commissions to the bank that may add up to only about 3.5 to 10 percent of the value of the cargo.

The risky business begins when these borrowers sell their cargo – be it at a loss or profit – and quickly funnel the cash into other investments or to other borrowers at exorbitant interest rates, sometimes upwards of 70 percent. One of the biggest recipients of this cash is China’s ever inflating property market; the very market state regulators have been trying to reign in. And what worries many analysts is the possibility that a fall in commodity prices might coincide with a sharp drop in property prices and demand, triggering a wave of defaults.

“Banks are already heavily exposed to the property sector and if a chunk of their trade finance books is also exposed to real estate, they could be in for a double whammy,” explains Stanley Li, a China banks analyst with Soeul-based financial services group Mirae Assets.

The number of intermediaries in this chain of lending can vary, with large trading companies extending credit to smaller, cash-strapped firms.

“We’ve been lending out money to peer trading companies and using their cargoes as collateral. But as credit conditions have become tighter and tighter, we have increased our interest rates from 15 percent earlier this year to around 22 percent now,” a Shanghai-based steel trader recently told Reuters.

And with reports in local media of entrepreneurs declaring bankruptcy, fleeing creditors, and leaping off buildings, these intermediaries have had to be much more selective in their lending.

“Around three steel trading firms have been sued by banks now, as they used the proceeds from financing for extending private loans, but now can’t get those loans repaid,” said a Wuxi-based commodities trader, who knows of 15 steel trading firms having closed this year due to breaks in their financing chain.

Government response
The precise number of firms tied into this financing market is difficult to ascertain. But whether the actual numbers fall on the high or low end of estimates, the state has turned its attention to the matter, albeit in a somewhat contradictory manner.

Beijing has announced plans to establish a monitoring system for private lending and has cracked down on banks by requiring them to include in their reserve requirement ratio letters of credit and deposits for bank acceptance bills (another commonly used trade financing tool). At the same time, state officials have upheld the legitimacy of private lending as an integral source of capital for SMEs.

“In China’s legal system, there is no concept of private lending. But as a beneficial and necessary complement of formal financing channels, private lending has legitimacy,” said an official at the People’s Bank of China. “Government departments will perfect relevant rules and laws to guide the activities of private lending and build multi-level credit markets.”

Despite the lack of monitoring, there are rules in place, as there is an existing regulation that the interest rate of private lenders cannot exceed 4 times that of the banks. How this limit is enforced is rather less clear.

Outside assessment
The IMF’s assessment, however, does echo the sentiments of the state in that it claims the existence of shadow banking in and of itself is not problematic – rather its explosive growth and light regulation is the cause for concern.

“Regulatory policies applying to shadow banking and their interconnections need to be clarified and made transparent. A more structured oversight, regulatory, and supervisory approach is needed to prevent and to manage systemic risks via cross-market products and institutional structures,” according to the IMF’s Financial System Stability Assessment.

The comprehensive assessment of China’s banking and financial sector – the IMF’s first – identifies supervisory “blind spots” in the sector’s massive regulatory regime where sector-based regulation divides responsibilities among disparate state entities and the central bank. Legal restrictions on information sharing between these entities exacerbate the problems further.

A good example can be seen in private equity funds, which are registered with the Industrial and Commercial Bureau, governed by regulations from both the National Development and Reform Commission and the Ministry of Commerce, and monitored by the China Securities Regulatory Commission. Considering that the estimated 3,500 private equity funds registered in China in mid-2010 held approximately RMB900 billion in assets, it is not surprising that a significant number of funds fell off the regulatory radar.

Future outlook
While the IMF has called for a single entity such as the central bank to oversee and regulate informal and alternative lending channels, the Chinese government continues to promote a less centralized approach, with the State Council in October calling on local governments to implement measures to tame the sudden growth in lending activity and put a stop to illegal means of fund-raising.

That is not to say that the government’s response thus far has not had any immediate effects. If warehouse stocks are any indication of the efficacy of the state crackdown, falling inventories of steel, copper and soybeans in Shanghai’s warehouses should prompt a sigh of relief in Beijing. The major Chinese banks’ have also reported a fall in the volume of trade loans this past quarter.

In the end, none of these measures seem likely to lead to a significant increase in the capital available to the SMEs that make up a considerable share of China’s economy. More direct guidance coming from Beijing – such as the central bank’s announcement today that it would be reducing banks’ reserve requirement ratio for first time in three years – is needed to free up more capital for the private sector.

The IMF suggests a diversification in financial markets and services as an effective way to improve the range of legitimate financing opportunities open to the private sector, such as a more liquid corporate bond market. Meanwhile the state’s NDRC has encouraged enterprises to engage in the “new strategic industries” such as new energy and biotech industries where they will be permitted to issue bonds and stocks.

Whether these types of measures will create sufficient capital for the private sector is difficult to foresee, but what is clear is that both banks and borrowers will continue to find creative ways to evade whatever loan restrictions the state imposes.

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