Understanding China’s Shadow Banking System and Its Fatal Risks

Chinese yuen currency.

China's shadow banking is a risk to financial stability. (Image: moerschy via Pixabay)

China’s lending bubble has been a huge concern for economists for the past several years. A big chunk of the debt lies in the country’s shadow banking sector, which only increases the risk of China’s financial collapse. As reported by the Bank of International Settlements (BIS), the overall Chinese debt is currently at around 255 percent of its GDP, while corporate debt is at 160 percent. This is a far higher debt-to-GDP ratio than even developed countries like the U.S. and Japan have.

China’s shadow banking is a disaster waiting to happen

Shadow banking is the unregulated segment of the Chinese financial environment. This sector sells anything from investment trusts to wealth management products, creating a false sense of economic expansion beyond official avenues. Though shadow banking also exists in other countries like the U.S., China’s shadow banking differs in a significant aspect.

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“Unlike in the U.S., traditional commercial banks drive shadow banking, or unregulated lending, in China. That’s because the banks have been able to keep shadow-banking assets off their balance sheets, thereby sidestepping regulatory constraints on lending,” according to Bloomberg.

Shadow banking is the unregulated segment of the Chinese financial ecosystem.
Shadow banking is the unregulated segment of the Chinese financial ecosystem. (Image: via Pixabay)

China’s shadow banking is estimated to be a US$10 trillion ecosystem and uses various instruments to keep the money rolling. Asset Managed Products (AMPs) are the biggest funding source for shadow loans in the country. These are deposit accounts that offer high-interest rates. All major institutions, right from banks to brokerages, issue AMPs. Since it is believed that the Chinese government supports the country’s financial institutions, AMPs generated huge trust among investors. Its issuance is estimated to be around US$16 trillion.  

The problem is that a big portion of funds raised through the AMPs has been utilized by the institutions to lend money to weaker borrowers and invest in speculative markets, like stocks and real estate. Since profits made from such investments often fail to match yields promised to the investors of deposit accounts, the institutions are at risk of failing to honor the promised returns. Other shadow banking instruments, like entrusted loans, interbank funding, and Internet financing, all have this vulnerability. And this threatens to rip apart the entire Chinese financial ecosystem.

China’s enormous unregulated shadow banking sector poses risks

In a 2018 report, the International Monetary Fund (IMF) asked China to increase its oversight of shadow banking, warning that opaque, large-scale interconnections of the Chinese financial system posed significant stability risks.

In a 2018 report, the International Monetary Fund (IMF) had asked China to increase its oversight of shadow banking.
In a 2018 report, the International Monetary Fund (IMF) asked China to increase its oversight of shadow banking. (Image: via kurzweilai.net )

The Chinese government has initiated a number of measures to curtail shadow banking activities and bring them under regulatory control. In November last year, Beijing proposed new regulations to oversee almost US$15.9 trillion in the asset management sector, which is plagued with highly leveraged instruments.

“Despite these [derisking] efforts, vulnerabilities remain elevated. The use of leverage and liquidity transformation in risky investment products remains widespread, with risks residing in opaque corners of the financial system,” the IMF report stated (South China Morning Post).

The IMF suggested Beijing limit borrowing for low-risk products and quickly phase out the implicit guarantees offered by investment vehicles. In fact, Beijing has set a deadline of 2020 for the country’s financial institutions to comply with a tougher set of lending rules and break the widespread idea that somehow all investments are implicitly guaranteed by the government. Beijing also hopes that the institutions will curb risky lending by this time.

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