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What the shadow market enthusiasts don’t tell youThe growth of off-balance-sheet and underground lending may look like a stealth liberalisation of mainland financial markets but is it really a healthy development?Tom Holland08 December 2011China’s shadow banking system has attracted something of a fan club lately. More and more analysts and commentators seem to regard the rapid growth of off-balance-sheet and underground lending as a good and healthy development; in effect, a stealth liberalisation of financial markets.I can follow their reasoning. Unfortunately, they are missing the point.There can be little doubt about the speed with which the shadow market has ballooned. As the authorities sought to crack down on regular bank lending in order to cool overinvestment and inflation, lenders and borrowers turned to informal channels to keep the supply of credit flowing.There are a range of ruses banks use to disguise their lending and evade government loan quotas. Typically, the banks might charge a fee for arranging a loan directly from a cash-rich corporation to another company in need of funds. Alternatively they might arrange structured notes which they sell to their depositors as wealth management products, with the proceeds used to finance local- government-backed infrastructure projects.Either way, the effect is much the same. Depositors are promised a premium return on their savings, while cash-starved companies and projects get access to credit, albeit at a higher interest rate than they would pay for a regular bank loan.Enthusiasts believe the growth of this shadow market is a thoroughly good thing. They argue that it amounts to interest rate deregulation by the back door. Thanks to the shadow market, savers who would otherwise be earning a negative real interest rate on their bank deposits can now get a decent return. And borrowers who would otherwise be denied access to loans can get credit, simply by paying a market-determined rate. Market forces triumph again.It’s a seductive argument. But it misses a couple of key points.First, because the shadow market is largely unregulated there are big concerns about the risk involved in informal lending.For example, most of the high-yield structured notes sold to savers as wealth management products have a maturity of less than three months. At the same time, the loans which they fund are often to long-term infrastructure projects.To get around the mismatch, the trust companies which structure the notes pay all the proceeds into a common pool, relying on income from the sales of new notes to repay the holders of maturing wealth management products. In other words, the market, which according to ratings agency Fitch was worth 7.7 trillion yuan (HK$9.43 trillion) at the end of September, looks a lot like a giant Ponzi scheme. If something scares off investors and the sales of new products flag, then there will be widespread defaults by trust companies as existing products mature.Second, the growth of the shadow market has threatened to make a nonsense of government efforts to curb rampant overinvestment. As the banking sector has been forced by government-imposed quotas to scale back its formal lending, so shadow financing has expanded. According to economic consultancy Dragonomics, shadow loans accounted for more than 40 per cent of new lending over the 18 months to June this year.That’s worrying. As the first chart shows, if you factor in shadow finance, then outstanding credit shoots up from 120 per cent of gross domestic product to a sky-high 160 per cent. In other developing economies, that is the sort of credit-to-GDP ratio that usually precedes a nasty debt crisis.
This rapid growth of shadow lending has allowed local governments and corporations to continue to invest at a furious pace. Over the first 10 months of the year, fixed-asset investment rose at an annual rate of 25 per cent. That’s faster even than last year’s growth rate despite Beijing’s attempts to rebalance the country’s economy away from an over-reliance on investment.The consequence is a dangerous bubble in fixed-asset investment, says Adrian Mowat, chief Asian strategist at JP Morgan. As evidence he points out that China has used more than 1.5 tonnes of cement for every man, woman and child in the country this year.As the second chart shows, that’s more than either South Korea or Spain at the height of their construction bubbles, even though China is poorer than either of those countries was at the time.Informal lending is partly - even largely - to blame for continuing to inflate this bubble over the last year. So although the growth of the shadow financing market may well represent a back-door liberalisation, it’s rather less clear that this is a healthy development.
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