Precisely a year ago, a summary report by Fitch shone the first, if relatively weak, light on the massive Chinese securitization industry which had for years allowed the country to fund its housing bubble without forcing the banks to actually take much if any of the loan risk associated with this unprecedented expansion. At the time of the Fitch report, the securitization discrepancy was not deemed to be excessive and at about RMB 1 trillion in annual issuance it was promptly swept under the rug. Nonetheless the key statement remained: "Fitch believes the vast majority of these transactions are not publicly disclosed by Chinese banks, and few, if any, traces of the loans remain in financial statements." More recently, and long overdue, Moody's took a refresh look at the same problem and on July 4 released a rather disturbing report which found "that the Chinese audit agency could be understating banks' exposures to local governments by as much as RMB 3.5 trillion." At 10% of GDP, the number sure is starting to get larger. Today we present what we believe is the most comprehensive report we have seen to date on the matter of the Chinese "Shadow Banking" industry courtesy of SocGen. For those who enjoy putting things into perspective, SocGen quantifies the total shadow banking system in China to be as large as RMB10 trillion (or 55%, of the Total Social Financing of RBM18 trillion): nearly USD1.5 trillion. While the number is not massive (considering that the most recent corresponding shadow banking number for the US is well higher at about $16 trillion), it keeps increasing as a portion of GDP. Why is this important? Because as SocGen's Wei Yao says, "The currently unsupervised development of the informal financing market delays the intended impact of monetary policy tightening, but adds to the risk of precipitating a liquidity crunch of the entire financial system later."
Yao adds: "However, we don’t think the solution lies in simply banning such channels. Instead, they should be brought into daylight and better regulated, as China badly needs to deepen its financial system beyond the big commercial banks." While we will not hold our breath on the regulation aspect, we are concerned by the implications of what shadow banking may imply for China's attempts to slow its economy via conventional means, especially since round after round of RRR and interest rate hikes have so far proven useless at slowing inflation which at last check was well over 6%. So it this Chinese shadow banking system a potential monetary time bomb, destabilizing the PBOC's efforts at normalization and adding materially to systemic risk? Read on.
From SocGen's Wei Yao:
China’s shadow banking system awaits sunlight
China’s formal bank lending has been under restraint since the People’s Bank of China stepped up quantitative tightening late last year. However, unregulated financing activity is sprouting up like weeds throughout China. Trillions of yuan in capital have been raised through investment trusts, underground money markets and high-yield retail investment products to sustain short-term liquidity for those who are cut off from the formal credit market, especially small- and medium- enterprises, private property developers, and more recently, local government financing vehicles.
The currently unsupervised development of the informal financing market delays the intended impact of monetary policy tightening, but adds to the risk of precipitating a liquidity crunch of the entire financial system later. However, we don’t think the solution lies in simply banning such channels. Instead, they should be brought into daylight and better regulated, as China badly needs to deepen its financial system beyond the big commercial banks.
For starters, it is important to understand that China’s “shadow banking system” is much less sophisticated than that in the US. Although China has moved to open up its economy in order to honour its WTO commitments, its financial sector is still very much undeveloped, highly protected, and largely dominated by the big banks. The private sector remains underserved by regulated commercial banks and can only seek credit from unchartered channels. Yet, many operations of China’s shadow banking sector would not be regarded as shadow in other economies with more developed financial markets.
China’s shadow banking sector is growing fast but still lightweight.
As in the case with any shadow system, data related to China’s nonbanking financial entities are fuzzy. In order to better gauge China’s domestic liquidity conditions, the PBoC introduced a new measure called “total social financing” (TSF) this year, which is similar in concept to flow of funds data. The series adds up bank lending, entrusted loans, trust loans, bank acceptance bills, bond financing, and stock market share issuance.
According to the latest release, formal bank lending provided nearly 60% of the CNY 7.76trn TSF in H1 2011, with the bond market and equity market contributing another 12%. Trust loans extended by banks – a form of securitised bank loans – contracted 84.8% yoy due to the harsh curbs by the banking regulator since H2 2010; entrusted loans, which mostly went to finance private property developers, increased 120% yoy.
There is no doubt that the TSF series from the PBoC still omits a number of credit channels. Fitch Ratings has developed its own version of TSF, which adds letters of credit, credit from domestic trust companies, lending by other domestic nonbank financial institutions, and loans from Hong Kong banks. The agency estimates the adjusted TSF to reach CNY 18trn in 2011, which could be one-third more than PBoC’s reading. In that case, the formal banking sector’s share as a financing channel would drop to less than 45%. This would represent a significantly lower level than in previous years, but still strikingly high compared to the financing patterns in other economies.
If we look at the stock rather than the flow, the shadowy sector would appear even more lightweight. We estimate that China’s commercial banks’ share of total financial institutions’ assets are no less than 80%, vs. only 30% in the US.
The liquidity risk is rising.
Capital raised via shadow channels has largely gone to three types of companies – private small- and mediumsized enterprises (SMEs), private property developers, and local government financing vehicles (LGFVs).
SMEs have been underserved by China’s banking system for years, and the PBoC’s quantitative policy tightening pushes this structural problem to its extreme. The scale of this credit market is the most difficult to gauge. According to the PBoC branch in Wenzhou, China’s No.1 city of entrepreneurship, 16% of SME funding came from underground banks in Q1, which charged an average annual interest rate of 25%. However, numerous reports suggest that interest rates on working capital loans have reached exorbitant levels of 6~10% per month in some cases.
Property developers have been turned down by banks since the central government got serious about curbing property prices late last year. The interest rates charged range from 15% to 30% per annum. LGFVs are also forced to borrow at higher cost from these channels because of tighter regulation. Although the total exact volume is unclear, we think it should be a relatively small amount, as LGFVs still have the closest ties to local government and are able to negotiate debt restructuring with formal banks. The obvious risk with these two types of entities is the mismatch between the durations of short-term borrowing and long-term investment.
Borrowing at such high levels of interest rates in the shadow banking system is clearly not sustainable. Resilient domestic demand may support this operation, but those enterprises probably operate on the hope that currently tight liquidity conditions will not last long. The availability of alternative credit channels merely reinforces this hope and delays the impact of the PBoC’s tightening. Therefore, if the PBoC continues to keep a firm hand on credit growth, the Chinese economy could run into a systemic crunch.
Depositors are benefiting for the moment, but regulatory loopholes need to be addressed.
On the flip side, the average Chinese household has options to earn higher return than the 3.5% deposit rate and even above the inflation rate, via high-yield investment products (HYIPs). In this sense, this is a good development. While the Chinese government is moving painfully slowly towards deposit rate liberalisation, the competitive shadow banking system is test-bedding this idea. This is why we don’t think the solution should be a straightforward ban.
Initially, the HYIPs were just pools of fixed income securities packaged by commercial banks. In order to compete for household savings, more exotic and riskier assets were added to boost yields, including structured securities and even private equity investments. Yet investors are often not properly informed of the risks they are exposing themselves to. If losses occur on a large scale, it could quickly ignite social discontent in the currently delicate environment. In H1 2011, the commercial banks issued CNY 8.5trn of HYIPs, but the total outstanding amount is only CNY 2tn. This extraordinary high velocity indicates high vulnerability to changes in overall liquidity conditions.
Regulation and monitoring are needed. The banking regulator has begun to tackle this issue and ordered a suspension of six types of HYIPs with high risk ratings last week. This intervention is constructive, but also likely breaks some weak links in the system. The hope is to have continued good growth, while the government gradually tidies up the unregulated market. But what we have now is an unstable equilibrium.