Shadow banking has been a hot potato recently. Since the beginning of June, Chinese banks and financial institutions have been wary of lending to each other. We saw sharp rises in inter-bank borrowing rates. The Chinese People’s Bank did not inject cash into the money market to ease an acute credit shortage initially. Although the Chinese central bank stepped in later, the credit crunch has caused serious pain for over-leveraged financial institutions.
China’s shadow banking sector is estimated to hide as much as $2 trillion worth of risky assets in off-balance sheet lending. The concept of shadow banking refers to the lending and borrowing that occur outside the traditional deposit and loan model. In the U.S, hedge funds, venture capital firms and private equity are all forms of shadow banking. In China, however, the structure of shadow banking is different.
In China, the government owns the vast majority of banks. There are also a lot of companies owned by the government. A state-owned company borrows from a state-owned bank at a government-set low interest rate. The company re-lends the money at a much higher rate to a private trust company that is part of the shadow banking sector. That trust company then lends the money into a more speculative part of the economy, such as real estate.
The practice is there for many years, but got worse after the financial crisis in 2008. In response to the global financial crisis, the Chinese government enacted a stimulus package worth $586 billion. The stimulus flooded the economy with cheap credit, thereby fuelling a speculative housing bubble, and propping up inefficient companies.
Analysts warn that shadow banking while helping fuel the rapid growth of credit in a weakening economy could lead to a series of bank failures. As the transparence of doing business in China increases, tighter regulations in the grey area can be expected. It is not surprising that we see this credit crunch happening. It is the growing pain for a better regulated financial market and should be treated as an opportunity rather than a threat.