China’s Credit Conundrum & Its Shadow Banking Sector
By: Jason Li
After the subprime mortgage crisis triggered a global economic recession in 2008, China’s policymakers infused hundreds of billions of RMB to prevent its economy from falling into a deflationary spiral. As a result, China’s annual GDP growth rates took only a slight dip to hover around 10% during the period of 2008 – 2011 from that of the previous year, which was 14%. However, this emphasis on high growth, alongside efforts to diversify its financial system, has led to an enormous credit buildup as China’s total debt is currently 210% of its GDP. A high level of debt does not necessarily precipitate recessionary effects in an economy, since developed nations, such as the United States and Japan, have
had consistently higher debt-to-GDP ratios than China in the past decade. However, China’s problem has been significant due to the fact that debt has expanded rapidly in recent years and the emergence of its “shadow-banking” sector is a major cause for concern.
The recent surge in leverage has been most prominent in China’s corporate sector, where debt-to- GDP has risen by 56% in the past 5 years. This pace has been the fastest among developed and developing nations and is highly worrisome for the government because the massive credit buildup has led to diminishing returns for the country’s economic growth. The two main reasons behind this phenomenon are that an increasing amount of new capital are being dedicated towards land and existing assets rather than the creation of new assets and other areas of growth that are less-credit intensive have slowed down. With industrial production and demand projected to fall in China, it is hard for economists to depict from where China can rejuvenate its growth.
“Shadow-banking” in China is loosely defined as any form of financing that is derived from the formal banking system. This form of credit exposure, which includes micro-lending, pawn shops, informal lending to SME (loan sharks), trust loans and even junk bonds, is not necessarily unregulated or uncontrolled, but they are most likely less transparent and carry a higher level of risk than traditional forms of credit. In addition, the standards and experience of the lenders and implicit guarantees by the government to some borrowers of this type of credit are highly questionable. Having risen from 22.1% in 2008 to 42% of total debt financing today, the shadow-banking sector is a highly significant source of the
On January 31st, 2014, one of the first “shadow-banking” products, a RMB 3BN 3-year investment trust product issued by China Credit Trust Co. defaulted with $492MM outstanding. A trust product is essentially a private placement of debt with high yields (10%+) that is catered towards high net- worth individuals and is invested in sectors such as industrial and commercial enterprises, local government infrastructure projects (LGFVs) and real estate. It is similar to a SPV (special purpose vehicle), used prominently during the financial crisis, due to its off-balance sheet nature but its funding is mainly pooled from domestic investors as opposed to the more global characteristics of MBSs. Trust products, while only making up 10% of total debt currently, have increased at an annual rate of 50% in recent years and have become a microcosm of the rapidly-escalating shadow-banking problem. The impact on the markets behind this type of trust default is that the realization of any significant loss may cause investors to pull back from other forms of financing, overall credit conditions will tighten rapidly and growth will be stalled. In addition, it brings into question for policymakers on how current and potential losses will be distributed or covered by the financial authorities since most of these “shadowbanking” products are not guaranteed by the issuer. Allowing some trusts to default without any form of bailout will also call into question the quality of related products, which will contribute to a credit crunch. China’s policymakers have a tough job ahead of them with regards to the management of the country’s public debt as they must be delicate and surgical if they wish to avoid an economic meltdown in the near future.