In 2019, we can confirm the first full-year decline in terms of Chinese shadow banking volume in over 10 years (2018 compared to 2017), after the authorities started paying serious attention to this dimension of the financial sector as of 2017. Still, we’re looking at a whopping $9.1 trillion in outstanding shadow banking loans, which might be 6.5% lower than the volume for the previous year but still… well, a lot, certainly an amount that makes a potential bailout scenario tricky at best and unrealistic at worst.
Before going into that, let’s (very) briefly explain what shadow banking actually is. To keep things simple, “traditional” banking revolves around entities (from regular people to companies and even local authorities) establishing a long-term relationship with a bank from which they borrow a more or less significant amount of money. A fairly straightforward relationship in which the bank provides the capital a certain entity needs and then that entity pays the bank back, plus interest, over a period of several months or years.
However, when there is a lot of demand for loans, perhaps more than what banks can handle, the financial sector tends to get creative and this is how shadow banking came about. Unlike regular banking, the equation is more complex. For example, the bank establishes a relationship with an entity that needs money through a loan arrangement but then packages many of these loans in the form of financial products and sells them to investors. Or packages these loans, sells them to various financial industry companies, which then sell them to retail investors… it can even get much more complicated than that.
So complicated, in fact, that risk assessment becomes a challenge.
The 2007-2008 Global Financial Crisis was actually brought about by shadow banking to a (very) significant degree, due to products called Mortgage Backed Securities being recklessly created, sold and even insured. Once enough people stopped paying back their loans, the entire house of cards collapsed: investors lost money, financial industry companies became insolvent and even insurance giants such as AIG were unable to meet their obligations.
Again, simply because these products can be so complex that risk assessment mistakes end up inevitably being made.
What were the implications with respect to China?
As expected, the Chinese authorities wanted the economy to recover after the crash and encouraged lending so as to facilitate just that. Ironically, the shadow banking industry in China started taking off in the aftermath of the Global Financial Crisis. Simply put, there was more demand for loans than the Chinese banking sector could keep up with, so the previously-mentioned “creative” banking solutions appeared, with everyone seeming content with the arrangement:
- Various entities in China had better access to financing
- Banks could expand their activities and, as a bonus, shadow banking-related ones could be kept off their books
- The Chinese GDP was able to keep growing
… however, all of this came at a cost: increased systemic risk.
In other words, what would happen if things go wrong? Of course, in light of the fact that the financial system was bailed out in the West, most analysts expect the exact same to happen in China, especially in light of the fact that there is a clear precedent, with two state-owned banks being bailed out to the tune of $45 billion back in 2004. Such precedents, corroborated with the increased willingness of the Chinese authorities compared to their Western counterparts to be in control of its what is happening in various sectors of the economy, make it likely that those in power will be willing to bail out the financial sector.
But will they be able to?
It’s not 2004 anymore and even with the 6.5% YOY decrease in 2018 compared to 2017, shadow banking volume represents roughly 68% of China’s GDP and 23.5% of its banking industry. Let’s just say $9.1 trillion is a more challenging bill to foot than $45 billion. Also, as mentioned previously on ChinaFund.com, China is not yet considered a “safe haven” destination and as such, should turbulence occur, access to capital is more likely to be problematic than in let’s say the United States.
For this reason, it is vital that the Chinese authorities continue aggressively working on the shadow banking problem, even if it inevitably leads to collateral damage such as financing being harder to come about and economic growth being affected. Steps seem to be taken in the right direction and rational investors are more than willing to accept today’s more prudent 6%-6.5% GDP growth rates rather than continuously aim for the 10%+ results of the pre-2010 period at the expense of stability and sustainability.
As a conclusion, 2018’s YOY decline in shadow banking volume is most definitely a positive development but a multi-year trend continuation would be required to bring things on the right track when it comes to the systemic risk posed by shadow banking activities.