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Finance & Economy

Pushing the envelope – Inside China’s vast shadow banking sector

Wu Ying’s rise to riches was like a Horatio Alger story on steroids. A native of Zhejiang province, Wu dropped out of college to work in a beauty salon, then later opened her own salon down the street. By 2006, at the age of 25, Wu had built a conglomerate of hotels and other businesses and had accumulated assets of US$569.4 million, making her the nation’s sixth-richest woman, according to the Hurun Report.

But then the success story went wrong. The police arrested her in 2007, confiscating more than 100 luxury apartments and dozens of cars and businesses. Her alleged crime was financial fraud: Wu had raised US$112 million from 11 people by promising outsized returns. She was sentenced to death in 2009, and China’s supreme court is now preparing to review her case.

Wu’s harsh sentence triggered an uproar. For many, it hammered home the realisation that China cannot continue to allow the informal lending sector to operate in a state of quasi-legitimacy. Soliciting the public for funding, as the prosecution argues Wu has done, is illegal. However, it has become so commonplace as to seem tacitly approved.

Regulators have repeatedly called on China’s state-owned banks to increase their lending to the private sector, but banks remain risk averse; they continue to prefer lending to well-connected, government-supported enterprises. So a vast network of small firms, rich individuals and loan sharks has stepped in to provide the unregulated and sometimes illegal loans that support China’s private sector. While there is no official data on the extent of informal lending, UBS estimates the sector may be US$316-632 billion, equivalent to nearly one-tenth of the country’s GDP last year.

Informal lending is especially common in Zhejiang, where it has aided in the emergence of a vibrant private sector. Chen Jun, vice-chairman of the Zhejiang Chamber of Commerce in Beijing, wrote on his microblog that if authorities want to pursue more cases of illegal lending they “can point a machine gun anywhere in Zhejiang and go on rampaging. I can guarantee that every single person who gets shot will be a lender.”

Top leaders have acknowledged that informal lending should be brought into the fold. At a press conference at the National People’s Congress in March, Premier Wen Jiabao answered a question about Wu Ying’s case by saying that China should “guide and permit informal capital into the financial arena, standardising it and bringing it into the open, encouraging its development and strengthening its supervision.” Wen added that the Chinese central bank and the China Banking Regulatory Commission are considering launching trial reforms for the informal lending sector in Zhejiang.

But these changes would likely necessitate reforms for the state-owned banking system as well. Shadow banking is so prevalent in China because it meets private-sector demand that the state-owned banking system does not. As long as Chinese banks are guided by policy rather than market forces, informal lending will continue to have an important function.

Competing interests

China’s central bank currently fixes bank deposit rates at artificially low levels and also sets a minimum lending rate. (Lending rates are technically allowed to go into the double-digits, but analysts say banks tend avoid these loans as risky and suspicious, creating a “soft ceiling” on lending rates.) The system supports state-owned banks by allowing them to pocket the spread between the deposit and lending rates as guaranteed profit.

But private business and individual depositors lose out. Since the central bank fixes the amount banks can lend, small enterprises are often turned away outright, even if they are willing to pay higher premiums. Meanwhile, savers are stuck with little or no returns as inflation eats away at their bank deposits. Chinese people who can find more profitable investments – almost always the wealthy – put their money elsewhere, including into the informal lending system.

Market forces are constantly pressuring this system to evolve. Recently, those pressures have resulted in a booming market for wealth management products offered by state-run banks. These products are typically bundles of securitized loans that offer higher returns than the one-year deposit rate, effectively allowing banks to compete for capital in one product type. Depositors have rushed to invest. Citi estimates that wealth management products accounted for 7% of Chinese banks’ total deposit base at the end of 2011, after doubling in the previous year.

Some argue that the appearance of these products represents a de facto liberalisation of deposit rates. China’s banking regulator has largely turned a blind eye to their proliferation, besides banning products with terms of less than one month due to excessive risk last November. And the written opinions of newly appointed regulators suggest a strong faction within the government favours adopting more market-driven interest rates. Zhou Xiaochuan, the governor of the Chinese central bank, argued in a magazine article published in mid-March that conditions were “basically ripe” for interest rate reform.

But if these products are intended to orient the system towards interest rate reform, their work remains incomplete. Wealth management products offer more market-oriented deposit rates, but they do nothing to reform artificially low lending rates for state-backed companies. The result is that banks pay out more in interest while taking in the same low returns on their loans. Over time, this will inevitably squeeze balance sheets, potentially destabilising the official banking system.

Moving to market-based lending rates, the missing piece of the puzzle, is likely to be much trickier. Such a move is sure to incite opposition from the powerful state-owned enterprises that will see interest rates on their loans rise. That could

trigger a wave of bankruptcies at state companies, potentially destabilising the economy.

Gripping the reins

China will need to standardise the informal lending sector sooner or later, and preferably sooner. Top leaders cannot afford to allow so much borrowing and lending to occur outside of their purview for long. First, it could limit their ability to carry out policy goals. The informal lending system has stepped in to support China’s ailing property sector, for example, seemingly against Beijing’s wishes.

Second and perhaps more importantly, unregulated banking can easily trigger social unrest. The country has already seen a wave of bankruptcies from Zhejiang’s informal lending sector, and the explosion of wealth management products is increasing the risk that some middle-class investors will lose their savings. Wealth management products remain both unguaranteed and opaque, and analysts caution that it could prove complicated for banks to match the timing of payments.

The government has acknowledged the risk inherent in allowing so much borrowing and lending to take place outside of official regulations. But incorporating market-based lending into the official system is likely to require big changes. It’s difficult to tell whether China’s regulators will continue with reforms or reverse their course. But regulators must do one or the other,  or watch while the risk accumulates.

China Economic Review

About Craig Hill

General Manager at Craig Hill Training Services * Get an Australian diploma by studying in your own country * Get an Australian diploma using your overseas study and work experience * Diplomas can be used for work or study in Australia and other countries. * For more information go to www.craighill.net


2 thoughts on “Pushing the envelope – Inside China’s vast shadow banking sector

  1. Reblogged this on Craig Hill.


    Posted by Craig Hill | April 7, 2012, 11:16 am
  2. Sentenced to death – then half of the world’s investors would have the same sentence too. Fraud or not .. the sentenced is terrible. A VEeeEEEer interesting reading. I hope to God that they will review her case and sentence..


    Posted by viveka | April 8, 2012, 12:24 am

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