Thursday, 12 January 2012

China Must Reform to Beat Shadow Lending, Loan Sharks

China must bring to heel an estimated $1.6 trillion shadow banking system if it is to deflate enormous asset bubbles fuelled by unregulated lending and stop small firms from getting forced to look to loan sharks for working capital.


Guanyu 道 said...

China Must Reform to Beat Shadow Lending, Loan Sharks

11 January 2012

China must bring to heel an estimated $1.6 trillion shadow banking system if it is to deflate enormous asset bubbles fuelled by unregulated lending and stop small firms from getting forced to look to loan sharks for working capital.

Real estate prices that stay stunningly high despite ghost towns of empty apartment buildings and entrepreneurs fleeing gangland creditors are symptoms of China's narrowly-based financial system.

Tightly controlled credit limits keep the system's focus on funding state-backed businesses.

Beijing knows it needs sweeping reform of wholesale and retail capital markets to stop a huge chunk of the nation's 81 trillion yuan ($13 trillion) of domestic deposits being steered from bank loans and savings — which dominate the financial system — into opaque, off-balance sheet, risk-laden vehicles.

If China could deliver enough reform and investment incentive to create regulated bonds and other financial products, Beijing could get the private sector, rather than taxes, to fund some of the $1.5 trillion it has pledged for emerging strategic industries over the next five years.

Getting some of the 10 trillion yuan that analysts estimate is currently channelled towards off-balance sheet bank lending and underground private capital networks that finance loan sharks would be a handy way to pay for economic development.

Reform was the tone of a weekend meeting of China's leaders responsible for the financial sector where Premier Wen Jiabao promised plenty, but was light on specifics.

The meeting was "a step along the road of financial reform. Not a pivot point in policy, but an important signpost," said Nicholas Consonery, Asia analyst at the Washington-based consultancy Eurasia Group.

"Heavy emphasis was placed on avoiding systemic risk, including stating plainly concerns about growth in the 'virtual economy' — a not discreet allusion to the explosion of innovative financial securitization products and bubble-style investment practices that precipitated the U.S. financial crisis," Consonery said.

The absence of properly functioning private sector long-term savings, mutual fund or pensions markets is regularly cited by analysts, insurance companies and money managers as key to financial sector reforms.

So too is creating an active corporate credit market alongside state-run banks, who channel the bulk of their annual lending targets straight to other state-backed firms.

Unifying Bond Markets

One thing Wen said at the once-in-five-year weekend meeting was that he wanted a "standardized and unified" bond market during the 12th Five Year plan period, which runs to the end of 2015.

"It is very rare for the government to explicitly say that it will establish a unified bond market, although Beijing has actually been trying to move towards that direction for many years," said Shi Lei, a fixed-income analyst at Ping An Securities in Shanghai.

Rivalry among ministerial bodies means China's corporate bond market is separated into three parts: debt instruments in the interbank market overseen by the central bank; enterprise bonds approved by China's economic planning agency; and a small listed corporate bond market overseen by China Securities Regulatory Commission.

The government created the interbank bond market in Shanghai in 1997 and drove banks out of debt trading on the exchanges, after large sums were channelled illegally into risky assets, eventually saddling state banks and other firms with heavy losses.

Listed banks have been allowed to trade spot government and corporate bonds on the bourses on a trial basis since early 2009. Analysts say connecting the markets would boost liquidity and trading — cutting funding costs and increasing financing options for cash-constrained private sector firms.

Guanyu 道 said...

"A bigger market pool will attract more investors and funds, which may include part of capital previously circulating in the shadow banking system," said Gao Zhanjun, the executive manager at the bond sales department of the CITIC Securities in Beijing.

Regulatory Spotlight

That would be a welcome benefit, bringing capital from the shadow banking system back under the regulatory spotlight.

Chinese shadow financing has seen explosive growth in recent years as savers sought high-yield wealth management products to escape negative real deposit rates and banks developed a variety of off-balance-sheet vehicles to keep deposits working while officially being required to put more capital aside as reserves.

That has weakened Beijing's control on potential risks in the banking system.

Some analysts say it will take more than a fledgling corporate bond market to restore the official grip, especially as a property-related trust product yields 11-12 percent, compared with a 6-7 percent rate of unsecured real estate company bonds, or the 4-5 percent rate of AAA-rated coporate bonds.

A junk bond market might provide more immediate impact.

"Strictly speaking, China hasn't even had one single high-yield bond product, except for some syndicated bonds issued in Hong Kong," said Li-Gang Liu, head of greater China economic research at ANZ in Hong Kong.

Meanwhile ministerial rivalries may well impede efforts to unify the existing three bond market power bases.

"It is still hard to imagine that different regulators are willing to sit together and evenly distribute their power of governing the bond markets," said a senior manager at CICC's fixed-income department.

"I think it will take a relatively long time for the three ministries to utter one voice someday and therefore bond market integration cannot be something happening overnight."

To Eurasia's Consonery, pronouncements from the weekend conference signal that China's one-party government system is confident time is on its side.

"These signposts are important because they reflect the way Beijing thinks about financial reform — as an incremental story that will take years, indeed decades, to finalize," he said.