Quartz has two graphics that explain the much discussed Chinese shadow banks. Briefly, the Chinese government caps the interest payable on savings accounts to 3% and impose a very high 20% cash reserve ratio on bank deposits. The former, coupled with capital controls and the lack of alternative investment opportunities for a nation of ultra-high savers, encourages the search for higher yields among savers. The latter, coupled with the search for capital for riskier investments among various market participants, incentivizes the creation of channels to funnel savings that can bypass the formal banking sector.
The result has been the growth of intermediaries called trust companies that are not allowed to accept deposits or make loans, but can manage money. These firms have established Wealth Management Products (WMP), which yield higher returns and are marketed by formal banks for a commission. The money raised through WMPs are invested in higher risk projects. Real estate firms, local government entities, and commodity companies have relied heavily on these trusts to raise relatively short-term (2-3 years) capital to finance their aggressive investments. This capital circulation is in the "shadow" in so far as it does not sit on the balance sheets of banks that market them. Neither does it show up on the balance sheets of the end-borrowers too, as they invariably invest in high-risk projects through special purpose vehicles.
The lending cycle of a typical WMP looks like this.
The result has been the growth of intermediaries called trust companies that are not allowed to accept deposits or make loans, but can manage money. These firms have established Wealth Management Products (WMP), which yield higher returns and are marketed by formal banks for a commission. The money raised through WMPs are invested in higher risk projects. Real estate firms, local government entities, and commodity companies have relied heavily on these trusts to raise relatively short-term (2-3 years) capital to finance their aggressive investments. This capital circulation is in the "shadow" in so far as it does not sit on the balance sheets of banks that market them. Neither does it show up on the balance sheets of the end-borrowers too, as they invariably invest in high-risk projects through special purpose vehicles.
The lending cycle of a typical WMP looks like this.
The circulation of capital in the shadow banking system, as highlighted below, generates a much higher money multiplier than with bank lending, leading to excessive credit growth.
The problem with such exuberant lending cycles (the value of WMPs have doubled to nearly 10 trillion yuan in two years since Q4 2011) is that they are invariably associated with excessive risk taking. The lending cycle was sustained by the prolonged period of investment driven economic growth, especially fueled by government investments in massive infrastructure projects, which inflated both real estate and commodity bubbles. This naturally exposes the lending counter-parties to the risks posed by declining investments - fall in the underlying real estate and commodity prices.
Two issues here.
1. While one could rationally argue, with numbers showing that the share of risk exposure is within manageable limits, nobody can be certain about how things will pan out once a cycle of defaults get triggered. It is almost certain that not even the Chinese government has any idea about the degree of riskiness associated with all the massive investments undertaken by its local governments and real estate firms.
2. Two, till now the Chinese government's ability to impressively manage various emergent challenges has been, in large part, due to the momentum created from rapid economic growth. Rapid growth not only papers over the adverse effects of distortions, but also creates the space for calibrated reforms. And some of the challenges are truly formidable - eg, the transition from the current investment spending of 48% of GDP to a lower path, and the increase of private consumption from an ultra-low 36% of GDP to something more normal like 55-65%. Most importantly, and especially important in an authoritarian polity, growth is often a pre-requisite to contain social and political tensions.
Update 1 (12/6/2014)
Commodities lending has been one of the large sources of the Chinese shadow banking system. In a typical commodities loan, copper (or any other commodity) is imported using letters of credit, warehoused in duty-free zones and pledged as collateral for cheap bank loans. The loan proceeds are used by the importer to speculate in higher-yielding, short-term investments. When the letter of credit comes due, the importer then either sells the commodity or the investment product. Goldman Sachs estimates that more than $160 bn has flowed into China through commodity backed loans since 2010.
This market has been disrupted by recent news that multiple loans may have been made on the same collateral, copper and aluminium stockpiled at the Qingdao Port in northeast China. Several global banks including Citigroup have lent to borrowers against this collateral. While this route of raising capital was remunerative when commodity prices were rising, the recent declines in commodity prices have also raised questions about the potential failures from this market. One company, Decheng Mining was suspected by the authorities of having pledged the same stocks of the metals — about 100,000 tons of aluminum and 2,000 to 3,000 tons of copper — as collateral for multiple loans, amassing bank debt exceeding 1 billion renminbi ($160 million).
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