Shadow banking, or credit creation by individuals or entities not subject to regulatory oversight, took off in China after the global financial crisis. So wide was its reach that the size of the shadow banking industry was a staggering 87% of the country’s GDP in 2016. Alarmed, regulators launched a crackdown on shadow banking in 2016, to deal with the growing levels of debt. With this, the size of the shadow banking shrunk to 68% of China's GDP in 2018; however, reduced cash flow bruised both of shadow banking’s key clients – local governments and private businesses.
As of today, China’s policymakers find themselves at crossroads with the intensifying US-China trade war adding pressure on the Chinese economy. China's debt problem has worsened due to rising defaults, under the weight of US tariffs and its own deleveraging efforts. According to Bloomberg, bond defaults by domestic companies reached CNY 39.2 bn between January and April 2019, 3.4 times more during the same period in 2018.
Let’s understand the impact of the crackdown on shadow banking and figure out how the country may handle this tricky challenge.
Local governments under a cloud
Prior to the deleveraging campaign, China’s local governments were among the key beneficiaries of shadow banking through their use of funding channels known as the Local Government Financing Vehicles (LGFVs). The flurry of rules aimed at limiting shadow banking created a funding problem for these governments, and a subsequent decline in spending on infrastructure. To curb reliance on LGFVs and address the funding gap, the central government created new special bonds that local governments could use to directly raise capital for infrastructure investment. As the US-China trade war intensified, the government accelerated its bond issuance program by allowing local governments to issue CNY 2.15 tn of special bonds.
Private sector receives a sucker punch
Shadow banking has been the quintessential funding source for China’s private sector, as a large number of entrepreneurs have no or limited access to the formal banking system. The government’s restrictions landed a double punch on private companies – by minimizing liquidity and curbing consumption. Following the campaign, China witnessed a fall in retail sales of consumer goods at both online and brick-and-mortar stores. The sale of automobiles, a key contributor to economic growth, also declined.
China has taken several steps to help the private sector deal with the effects of the trade war and crackdown of shadow banking. The government has lowered the reserve requirement ratio (RRR) by 100 bps and increased its tolerance for non-performing loans from 2% to 3%, to encourage lending to private companies. Additionally, a new 5-year tax policy, effective from January 1, 2019, aims to ease the tax burden on venture capital firms. To further support private firms, banks are issuing perpetual bonds, which buyers can swap for central bank bills, which in turn are secured by the People’s Bank of China (PBOC).
Funding gap continues
Although the Chinese government has come out in support of local governments and the private sector, there is a huge funding gap for projects not covered by formal banking channels.
According to PBOC data, in 2018, China’s total social financing, an indicator of financial demand, i.e., total loans given to the private sector, increased by CNY 19.26 tn. On the other hand, loans issued by banks increased only by CNY 15.67 tn, indicating a large funding gap. Channeling of cash into the real economy remains a key question.
China could look within to find a solution...
In the short run, revival of shadow banking is expected to help counter the negative impact of the US-China trade war on the private sector, providing a much-needed boost to the economy. This is reflected by the current pause in its deleveraging efforts as the central government looks at easing shadow banking regulations. The outstanding balance of combined trust loans, entrusted loans, and undiscounted bankers’ acceptances, which are the three common forms of shadow banking finance increased by CNY 343.2 bn MoM in January 2019.
…and also look around for innovation
To relieve financing and liquidity pressures, China could emulate Hong Kong’s small and medium-sized enterprises (SMEs) financing scheme, which gives banks a financial incentive to provide funding to SMEs, while a government insurance agency guarantees 50–70% of loans. The government can also look at injecting funds directly by purchasing bonds issued by local governments and the private sector rather than relying solely on banks. Lastly, the central bank can boost more manageable and transparent leverage schemes for shadow banking and encourage shadow banks that have good internal risk controls.
According to CNBC, analysts expect that Beijing will roll out more stimulus in the form of infrastructure spending by the end of 2019, which also means it will increase its reliance on debt and shadow banking to boost the slowing economy. Only time will tell if China will resurrect the lucrative yet problematic shadow banking system, or launch a more innovative and transparent mechanism. Until then, the jury is still out.