China’s shadow banking industry is bigger than reported, more dangerous than understood – and probably can’t be stopped anyway.
These are some of the less-than heartening conclusions reached by CLSA’s head of China and Hong Kong strategy, Francis Cheung, the same man who in May said China’s banking sector’s bad debt ratio is really 15% when the big four banks reckon it’s about a tenth of that level.
One is that most of this shadow banking ultimately comes, not from rivals to the banks, but the banks themselves: the Brookings Institution estimates that banks are providing 65% of all shadow financing in order to lend off-balance sheet.
“Shadow banking is driven by banks getting round regulations and lending where they shouldn’t be,” says Cheung.
That, in turn, means that the banking sector is running up considerable debt (about Rmb35.5 trillion) that mostly does not appear in reported numbers on balance sheets and therefore also does not turn up in stated NPL numbers, nor, by extension, in investors’ calculation of bank risk.
Moreover, it’s likely that banks have pushed the riskier stuff, such as loans to over-supplied industries, off the balance sheet, which undermines state efforts to stop lending to those sectors for the very good reason that they are defaults waiting to happen.
Cheung highlights a recent product from China Merchants Bank where the stated allocations are 0% to 50% in bank deposits, 0% to 90% reverse repo into interbank markets, and 10% to 100% asset management plans and trusts.
“They have absolutely no idea what they are buying,” says Cheung.
Another troubling prediction is that the potential bad-debt loss for the shadow-banking system is equivalent to 3.7% of China’s GDP, on top of the banking bad-debt ratio Cheung identified in mainstream banking in May.
And Cheung isn’t just going for the headline worst-case here: he assumes a 40% recovery rate, which is far from guaranteed. Cleaning up both bank and shadow bad debts would cost China 14% of GDP, he says.
Fortunately, China has deep pockets.
“I’m not calling for any systemic risk because of it,” he says, “but that doesn’t mean there won’t be shocks.”
On top of this, banks have developed various opaque ways of getting around regulations.
Two examples are entrusted loans – a bank lends to company A, which then passes on a further loan to company B for a fee, meaning the bank only appears to be an agent in the transaction – and lending through trusts and asset management plans that in turn lend to a separate company.
He thinks shadow financing has a lot to answer for and has played a role in four consecutive years’ worth of market problems.
The most obvious was the Shibor crisis in 2013 when interbank liquidity froze thanks largely to a funding mismatch in shadow wealth management products; then the 2014 property correction was made worse by the fact that shadow financiers had been lending to the property sector; the A-share bubble and crash was exacerbated by leverage shadow finance had put into the system, and the slashing of interest rates this year and consequent outflows of capital were in turn a reaction to the property market problems that shadow lenders had helped create in the first place.