Tag Archives: shadow banking

China’s Banking Purgatory

As of yesterday, the Yuan fell to its lowest value relative to the dollar in ten months because the Chinese government “doubled the currency’s daily trading range” over the weekend.  With the goal of reducing capital inflow so as to decrease the risk of asset bubbles, this policy is part of China’s plan to replace strict currency controls with financial regulation.  Ultimately, China hopes to achieve greater financial stability in doing so.

Personally, I find this rhetoric hard to believe.  We learned in class that China benefits from reduced capital inflows.  Reduced capital inflows imply an increase in net capital outflows, which in turn leads to a boost in China’s net exports, a depreciation of the Yuan, and an increase in GDP.  For this reason, it seems hard to believe that China is committed to loosening currency controls.

This wishy-washy policy is what places China in “banking purgatory.”  By directly impacting financial institutions and private banking, China’s inconstancy places it in an awkward purgatory between fully controlled markets (economic Hell) and capitalism (economic Heaven – obviously my opinions are made very clear here…).

Specifically, China’s wishy-washy policy impacts banking and financial institutions in the following way: given China’s commitment to decreased currency manipulation, many private firms in China (both financial and non-financial) have already pursued billions of dollars worth of options contracts to hedge against an appreciating Yuan.  That said, when the government steps in and redirects changes in the Yuan’s value, these options generate losses for private firms.  In 2014, the Yuan is down 2% relative to the dollar, and this depreciation has resulted in over $2 billion of losses for Chines firms.

For Chinese firms making exportable goods, the losses on these options are minimized by a boost in exports.  However, financial firms, which do not usually export any tangible goods, are not so fortunate.  Given the already unstable state that Chinese financial firms are in (the government is just beginning to warm up to private banking), these losses could have significant implications for shadow banking.

China’s currently uses a public banking system.  This policy has ultimately hurt small businesses, as it is harder for them to meet the strict borrowing requirements set out by a highly risk-averse institution like the Chinese government.  Unable to qualify for public loans, small business turn to shadow banks instead, which force many small businesses into unaffordable loans (shadow banks are financial intermediaries that carry out typical banking activities like commercial lending, but without the limits of traditional depository regulations).

Because China’s small businesses cannot qualify for public loans and cannot afford shadow loans, they are left with very few options for sustainable growth.  Given that small businesses in China are responsible for 60% of China’s GDP and 75% of China’s new jobs, this predicament poses a serious threat to China’s economic sustainability.  A simple solution would be to allow for private, regulated, banking.  And in the beginning of 2014, China did just this, approving a pilot plan for the establishment of 3-5 private banks.  That said, given the losses that Chinese financial firms are experiencing currently (caused by the government’s currency manipulation), I find it unlikely that the proliferation of private banking will come anytime soon.

In this way, China is stuck in an uncomfortable middle ground on its way to economic deregulation; like the Catholic destined for heaven but in need of purification, China is struggling in purgatory as it develops into a capitalist economy.  While China has committed verbally to currency deregulation (a very good step in my opinion), the country’s policies do not yet align with this verbal commitment.  Certainly, it is difficult for a country as big as China to abandon such an engrained tradition of currency manipulation.  But until China commits to doing so, inconsistent policy will plague financial institutions, which will in turn reduce the chances of successful private banking and increase the pain small businesses feel from shadow banking.  Complete commitment to looser currency controls is therefore necessary for China to escape its banking purgatory and fuel sustainable, long-run growth.

Turmoil in Chinese market

Last week in China, Shanghai Chaori Solar Energy Science & Technology Co. Ltd-one of the Chinese solar company confessed its inability to repay $14.6 million interest to the investors. This happened to be the first corporate bond default that occurred in the China mainland.

This time, the government and state-owned banks gave up their previous policy of bailouts and debt extension to ease defaults. According to the article on WSJ, the absence of actual defaults is leading to more risky lending practices and could cause more wasteful investments in industries that have already suffered overcapacity. To put restrictions on the shadow banking system in China, it is necessary for the government to stop supporting unregulated risky investment activities and lay the economy on the right track.

Yesterday, copper prices skidded to their lowest level since June 2010, also the prices of iron ore fell to its lowest level on Monday since 2012. This is because of several reasons.

First, the default last week brought down the faith of Chinese economy, some investors may expect more defaults after this first one.

Second, the slack of the growth speed of GDP leaded to the worries about the decline in demand of copper and iron. Mostly consumed by China each year, copper and iron prices are bellwethers of the Chinese economy.

Third, the pressure on the copper financing forced selloff of copper. Regulated by the strict lending standard, many companies used copper as collateral to get funding and use that either to import more copper or invest in high-earning assets. However, the fear of default and curb of demand transfer those copper from collateral into market, then the raise of supply pull the copper price down.

Those unwanted extra metal in the market has leaded to more worries about the large commodity such as oil. Brent crude for April delivery on London’s ICE Futures exchange was down 69 cents, or 0.6%, at $107.86 a barrel. On the New York Mercantile Exchange, light, sweet crude futures for delivery in April were down $1.40, or 1.4%, at $98.63 a barrel. This is because that China is the main force in emerging market countries that were hoped to increase demand for oil, according to the recent report from OPEC. On the contrary, gold price rose to a five-month high today due to the investor’s increasing demand for safe assets.

As approaching to the burst of the bubble in Chinese house market, those news showed that the government is starting its regulation over the unhealthy economy. In the short run, we may experience more turmoil in Chinese economy.

Revised: Shadow Banking in China: the Second 2008?

Shadow banking issue in China has been appearing on the headline of several newspapers for quiet a while. Since the global financial crisis, China’s debt has been growing in a pattern similar to that of U.S. before 2008, whose lending soared, but then as the banking system crashed down, producing deep recession.

The fastest part of the lending surge has been among shadow lenders, which include banks’ off-balance-sheet lending arms, trust companies, leasing firms, insurance firms. Between 2010 and 2012—a period during which traditional banks scaled back lending—shadow credit doubled to 36 trillion yuan ($6 trillion), or about 69% of China’s gross domestic product in 2012, estimates J.P. Morgan Chase & Co.


Shadow lending looming in Chinese economy concomitant to the issue of “Money shortage”, a term frequently coined by Chinese economists to refer to the situation of credit shortage. It seems counter intuitive that China is facing with both over excessive liquidity issue as well as “money shortage”.  In my last post about China’s exchange rate, I talked about how hot money contributed to expanding foreign reserves and excessive liquidity in China, causing inflation and asset price to rise. To curb inflation, PBOC raised the reserve deposit ratio among its affiliated banks to counteract the increasing money supply.

You might get perplexed: if PBOC raised the reserve deposit ratio to solve the excessive liquidity, how on earth could China still stuck in inflation and “money shortage”?

It turns out that all the unresolvable can be solved if we take concrete analysis to concrete problem. China is not a player that follows the rule of free market economy. Most of the lending in China are provided by state-owned banks to investment projects designated by the government. This is because those project guarantee higher and more reliable returns than those of smaller and relatively risky investment projects from private sectors. As the interbank interest rate rises, it makes the costs of investing even more higher for small private businesses. Thus small firms resort to borrow money from other sources, such as non-bank financial institutions, which are out of the reach of financial regulation. So “money shortage” only happens when private projects are unable to compete with state-initiated projects in getting funding. This short video from WSJ captures the essence of China’s situation.

“Money shortage” in local governments and new housing projects also contributed to increasing borrowing from shadow banks. Chinese local officials, eager to meet growth targets set by the central government, are overly investing in infrastructure, mounting up local government debt. Speculative activity in housing markets leads to increasing borrowing from shadow banks to finance new housing projects, despite supply well exceeded demand, which is manifested as “Ghost City” propagate throughout China. The ever-inflating housing bubble is astoundingly similar to that in U.S. housing market before 2008.

Few economists predict a sharp downturn for China, at least in the short run. “The concern is that China will repeat Japan’s story of the 1990s,” says J.P. Morgan’s top China economist, Haibin Zhu. “Financial risks continue to rise. The government keeps delaying structural overhauls. Debt keeps getting rolled over. That creates zombie banks and zombie corporations. Eventually it causes GDP to weaken and the financial sector to deteriorate.”

What is even more worrisome is the stance Chinese officials takes on this potential crisis. For several years, the central bank and banking regulators looked benignly at the growth of shadow banking, saying that the “Shadow banking exists in China, just like it exists in many other countries,”

If we take a look at the chart below, from The Wall Street Journal, which shows the rise in China’s debt levels compared with other countries before their respective financial crises. You will find the pattern eerily similar.


However, if China were to ignore the systematic risk, then the similarity will not only exist in over lending, but a recession as devastating as 2008 as well.

**Some opinions about “cash famine” referred to a Chinese research paper from Chinese Academy of Social Science.