BIS: Mapping shadow banking in China
Outstanding report bringing some much-needed clarity to China’s “shadow banking” sector
Bank of International Settlements: Mapping shadow banking in China: structure and dynamics
China’s financial sector has gotten a lot more complicated over the last decade. For some reason, whether China is or is not facing an imminent credit-induced crisis is quite a polarizing issue and generates a lot of noise from the perpetual optimists to the perma-bears. This has made it quite difficult to analyze exactly what is going on. But the draft report recently released by the Bank of International Settlements finally starts to clear things up and some of the observations are quite interesting.
First, here is the key table from the report that shows how financing ultimately flows from the creditors to the borrowers. When I first embarked on my career in finance nearly two decades ago this chart would have been a lot less complicated, as there was really only one key source of debt financing available in the form of bank loans.
Some key takeaways from the report:
The state (through the banks) is actually quite involved in the activity of the “shadow banking” sector. [1]
The “bear” narrative has been that the “shadow banking” sector is working to get around regulation and perhaps working in opposition to state directives — the result being greater instability.
However, the reality is that the “shadow banking sector” is sanctioned and facilitated by the state via proxy. As the report points out, the state-controlled banking sector is heavily involved, among others, in the issuance of “shadow banking” products like wealth management products (WMPs) and entrusted loans.
The much-maligned “shadow banking” sector itself has really been a way to provide alternative financing options for China’s private enterprises. [2]
Historically, access to bank loans has been very difficult for non-SOEs (state-owned enterprises) so China’s private enterprises had to rely largely on equity which is the most expensive form of financing.
Through “shadow banking” products like WMPs and entrusted loans, China’s much more productive and efficient private sector now has greater access to a variety of financing mechanisms.
This is a positive development and the explosive growth in “shadow banking” products is a sign of how much pent-up demand there had been for less-expensive financing sources.
In the analyst community, there is a wide range of views on how exactly China’s debt-to-GDP ratio should be calculated. Often, the calculation of this figure is skewed by one’s stance on the “China credit bubble” question. But the problem with some of the higher debt-to-GDP (i.e. more bearish) calculations I have seen out there is that there is significant “double-counting” [3] in the debt figure.
For example, SOEs often re-lend money they have borrowed in the form of entrusted loans which ultimately finds its way (through intermediaries) into the private sector. Here the SOE is basically monetizing its lower cost of financing and making money on the interest rate spread. But if you count both the SOE’s bank loans and the ultimate entrusted loan product at the private borrower, you would be double-counting the effect of the original loan.
Depending on how you calculate the debt-to-GDP ratio over time, the increase in the ratio might overstate the amount of actual new credit in the system. Instead, it may be a measure of increasing complexity in the financial system from the double-counting of credit products.
An increasingly complex financial system of course brings a set of new risks that are not necessarily related to over-investment. However, one must remember that China’s financial system used to be really, really simple (i.e. banks lending to SOEs; equity for everyone else). So taking one or two steps forward does not mean it is overly complicated, especially when you put it up against developed countries. Indeed, the BIS report describes how China’s financial system is still quite a bit simpler than that of the United States [4].
The more accurate narrative about the development of the “shadow banking” sector is that it is merely another step in the long arc of the China financial liberalization story. In this case, “shadow banking” products are effectively providing interest rate flexibility — as mentioned above, primarily for the private sector (which is a good thing!).
“Shadow banking” also provides creditors with more ways to invest their excess capital at presumably higher rates of return.
Historically, because the financial sector was controlled so tightly, households had only a few viable options to park their savings — deposit it in a bank, purchase real estate or invest in the stock market. If you deposited in the bank, you would be earning an interest rate that was below the rate of inflation.
This was a key mechanism in China’s “financial repression” policy where the household was basically subsidizing SOEs through, among others, this negative real interest rate.
Now with “shadow banking” products like wealth management products (as well as a greater flexibility on interest rates on deposits), the household sector can actually earn positive rates of return on their bank deposits.
The net effect of this is like lifting what had been a fairly massive tax on the household sector [5] which is one reason why I think the China consumption story is just getting started.
The report also provides very clear descriptions of the various “shadow banking” products like wealth management products and entrusted loans and how they fit into the overall system.
In any case, I highly recommend a thorough read of the BIS report for anyone who is interested in trying to really understand China’s evolving financial system and/or trying to figure out the “credit bubble” question.
Notes
[1] Page 10: “Commercial banks are the key players at the centre of shadow credit intermediation (Figure 1, rose and red arrows). They are the main linkage between the suppliers and borrowers of funds in both the formal and the shadow banking system. Banks issue key shadow banking instruments such as wealth management products (WMP), they channel investors’ funds and provide liquidity to other shadow banking entities (eg trust companies), and they are holders of shadow banking instruments such as trust beneficiary rights (TBR) or interbank WMPs.”
[2] Page 11: “Shadow banking provides credit to private firms which otherwise would be unavailable or too difficult to obtain. As these firms are typically more productive than their state-owned counterparts (Hsieh and Klenow (2009), Dollar and Wei (2007)), shadow credit is likely to lead to direct economic gains. Traditionally, most private firms as well as smaller state-owned enterprises (SOEs) have difficulties in accessing the formal credit market, as large state-owned banks prefer to lend to large SOEs (Hale and Long (2010), Lu et al (2015), Tsai (2016)). Banks’ preferences for large SOEs reflect historical relationships and high creditworthiness due to implicit or explicit government backing, reducing the credit supply to potentially more productive private firms. Shadow credit intermediation has helped to fill this gap.”
[3] Page 27: “Measures of the size and dynamics of shadow banking in China depend on the specific perspective that is taken. For instance, taking the ultimate creditor view yields a much larger size estimate than taking the ultimate borrower perspective, as a large portion of the proceeds from WMPs is channelled into the bond market. Taking a holistic view by summing up the volumes of shadow credit intermediation over the entire credit intermediation process naturally results in an even higher estimate. But doing so introduces a high degree of double-counting, if the measure of interest is shadow credit to ultimate borrowers. A sizeable share of the underlying investment of bank-issued WMPs, for instance, appears on trust companies’ balance sheets. Adding up the two may capture the total volume of activity by shadow banking intermediaries, but it substantially overstates the amount of shadow credit that eventually flows to ultimate borrowers.”
[4] Page 12: “Shadow banking in China is less complex than in the United States, as it involves fewer entity types and fewer steps of credit intermediation. Mostly, shadow credit intermediation in China is a one-step or two-step intermediation process, as it is effectively based on “plain vanilla” loans or instruments that entail a one-to-one link to the revenues from the underlying debt instruments. In contrast, a typical shadow credit intermediation process in the United States involves seven steps (“vertical slicing”) and a large number of financial entities (Adrian and Ashcraft (2016)).
Nevertheless, the tight linkages between shadow savings instruments and bond market, as well as the new forms of structured shadow credit intermediation, signal that shadow banking in China is growing more complex.”
This was originally published on Quora in February 2018.