Realities of China’s shadow banking

Over the past one week, markets have been on a roller coaster due to various global & domestic factors. One of the key concerns was ‘Chinese Credit Crunch’. China being the 2nd biggest economy in the world contributing a substantial portion of the global GDP, felt like sharing some insights regarding the same to dispel fear among the investing public.

China's central bank has been squeezing funds out of the money market, forcing banks to borrow money at historic interest rate levels (interbank lending rate and 7 day repo rate @ 13% & 25% respectively)to curb shadow banking.

As I write this, liquidity had already eased due to the intervention of its central bank, People’s Bank of China.

However, the intent was no ambiguous signalling the end of a decade old easy credit and forcing the banks to get back to traditional banking, avoid risky loans and excessive expansion of credit.

Shadow banking is nothing but financial intermediaries involved in facilitating creation of credit in the financial system whose members are not subject to regulatory oversight.

Shadow lending have flourished in China because an estimated 97% of the nation’s 42 million small businesses can’t get bank loans & the industry is expected to be valued at 1.5 trillion USD translating to 60%(approx.) of the country’s GDP.

Shadow lenders get their funding from traditional banks, and wealthy individuals wanting higher return on their capital.

These lenders then issue loans @ substantially higher rates to those who would not suit the traditional risk profile for normal commercial and retail bank lending, in turn, leading to high systemic risk affecting the financial system and the economy adversely.

It is no wonder that the central authorities wanted to crack down on this kind of activity given the magnitude of the debt issued by the country’s shadow banking sector from about $US2.9 trillion in 2010, to around $US5.7 trillion in 2012, a whopping 96% jump.

Money supply (Total social financing), a broad measure of fundraising in the economy that includes bank loans, bond issuance and some forms of off-balance-sheet financing, was up 52% year-on-year in the first five months of 2013 aptly signifying ample money supply in the system.

It is widely believed that a broader crackdown on the shadow banking would keep borrowing costs high and potentially reduce the flow of credit in the short term. However, this would lead to cleaning up of the system and facilitate money flowing into productive areas of the economy for a more sustained growth in the medium to long term.

Happy investing!