China: Avoiding a shadow banking crisis

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China: Avoiding a shadow banking crisis

China: Avoiding a shadow banking crisis

Asia Pacific Economic Outlook, March 2014

Recent events threaten to cause a sea change in China’s shadow banking system, which could lead to a severe shrinkage of credit growth and consequently slower economic growth.

China_photoA large part of credit growth in China has involved the shadow banking system, and a large part of that system has involved the sale of securitized loans sold by banks. These “wealth management products” (WMPs) are bundles of bank loans sold as securities to investors. While the banks don’t guarantee a positive return on these assets, they have generally paid investors principal and interest even when the loans behind the securities have failed. Yet that nearly changed recently.

ICBC, one of China’s state-run banks and the world’s largest bank, initially refused to reimburse investors who purchased a WMP for which the bank acted as custodian and sales agent. The principal amount for the WMP was $495 million. The WMP was arranged by a trust company, and the principal amount was, at one time, in danger. Although there have been defaults of some small WMPs, the threat of default on a large one was a sea change. Previously, investors who purchased WMPs believed that the high interest rate they obtained was virtually guaranteed, even though there was no explicit insurance against default. If the implicit guarantee is broken, the risk is that investors will shun WMPs. In addition, investors might become averse to excessive risk. The money banks obtain when they sell WMPs is used to fund off-balance-sheet trust companies that provide further lending through the shadow banking system. If the supply of funds for WMPs dries up, the shadow banking system could dry up as well—leading to a severe shrinkage of credit growth and consequently slower economic growth. As such, the surprising move by ICBC might have huge ramifications.

Why do investors purchase WMPs? WMPs are often highly attractive: The interest rate of the ICBC product was 10 percent versus the 3 percent return from depositing money in a bank account. WMPs packaged by trust companies and sold through banks often yield 8–12 percent and mature in one to three years. The problem has been that WMPs have often been backed by assets of questionable quality and poor transparency. Going forward, if a large number of the loans backing WMPs go bad, banks will either have to default on WMPs or be bailed out by the Chinese government.

It is likely that the problem of failed investments will rear its ugly head once again—and possibly soon.

As for ICBC, after threatening to allow investors to lose money, it said that investors will be able to recoup their principal investment by selling the assets to an unnamed buyer—and thus a default has been avoided.1 However, there is concern that ICBC’s action will encourage other investors to engage in excessively risky behavior, knowing that they cannot lose. On the other hand, a default would have wreaked havoc with Chinese and global financial markets, which are already uneasy.

The prospect of default led to fears about the stability of the entire shadow banking system. ICBC’s product involved raising $495 million for a coal mining company that has since collapsed following the arrest of its owner. Investors were promised a return of 10 percent per year for three years. The product expired at the end of January 2014.2 Although ICBC is going to make the investors whole, this is an example of a much larger problem. There are roughly $1.7 trillion of such products in existence, many of which could ultimately fail. Will the banks bail out investors? If so, will the government bail out the banks? And if the banks don’t bail out the investors, will the shadow banking system collapse? The answers to these questions cannot yet be known.

Now that a default in the shadow banking market has been avoided, some investors are still concerned that China simply temporarily avoided a massive crisis. While investors were made whole in this instance, it is likely that the problem of failed investments will rear its ugly head once again—and possibly soon. At some point, a large bank will decide that it cannot afford to cover such losses, and the government will have to decide if it wants to avoid another such event.

Slowing growth

China’s economy slowed slightly in the fourth quarter. The government reports that in the fourth quarter real GDP was up 7.7 percent from a year earlier. This compares with growth of 7.8 percent in the third quarter. For all of 2013, real GDP was up 7.7 percent, the same as the revised numbers for 2012. This was the slowest growth since 1999, when the economy grew 7.6 percent. Here are some highlights:

  • In the fourth quarter, real investment in fixed assets was up 19.2 percent, the slowest rate of growth in several years. In 2013, investment accounted for 54 percent of economic growth, more than the 50 percent in 2012. Clearly China is not yet shifting away from growth based on investment toward growth based on consumer spending. This is a problem. The imbalances in the financial system may ultimately force a cutback in credit to the private sector, which in turn could lead to a slowdown in fixed asset investment. Absent a government effort to boost consumer spending, the result could be slower economic growth.
  • For all of 2013, investment funded by foreigners declined 3.7 percent from 2012, while investment funded by domestic lending was up 14.4 percent. This is interesting because foreign interest in direct investment in China is clearly waning.
  • Also, for all of 2013, real (inflation-adjusted) retail sales were up 11.6 percent, a relatively weak showing. The government crackdown on official gift giving has had a negative impact on retail spending.
  • Urban per capita real income increased 7.0 percent in 2013, the slowest rate of growth since 2000. Although wages have risen, there has been a shift in employment away from manufacturing (with relatively high wages) and toward services (with lower pay).

About The Author

Dr. Ira Kalish

Dr. Ira Kalish is chief global  economist of Deloitte Touche Tohmatsu Limited.

Asia Pacific Economic Outlook, March 2014: China
Illustrations Jessica McCourt (Cover), Stephanie Dalton Cowan (China)