China & the Rise of Shadow Banking

On November 9^th 2008, the Central Peoples Government of China announced a 586 billion dollar stimulus package through investments in infrastructure, real estate and social welfare to combat the economic slowdown created by the global financial crisis.  In 2011, Daniel Rohr noted that China’s gross capital formation, or GCF (investment in physical capital), has grown to an astonishingly high 50% of GDP since the implementation of the stimulus package.  Residential and non-residential real estate now accounts for 25% of GDP and as of 2012, 64 million new apartments remained empty.   In late 2011, economists predicted as much as 20% of all outstanding loans would eventually default and be written off.  

For years, the miss allocation of capital has posed significant challenges to China’s long term economic health.  The lack of a social safety net forces migrant factory workers to save their meager earnings at interest rates outstripped by the rate of inflation. With few alternative legitimate investment options and facing high inflation it is difficult for savers to gain real returns on their savings.  China’s savings rate of 50% of GDP is the highest amongst the world’s major economies.  Access to capital at low interest rates allows banks to issue low interest rate loans to developers and construction companies fueling economic growth.  The low interest rate nature of these loans allows companies to undertake construction projects with questionable prospects for descent returns.  

Low interest rates on savings and government restrictions on outflow of capital have spawned the rise of a massive underground shadow banking industry that now accounts for 2.2 trillion or 25% off all outstanding loans.  Shadow banks –non banks, people, pawn shops, underground banks, trust companies and guarantors make money by borrowing at low rates from traditional banks and lending out at much higher rates of up to 36% to borrowers of questionable credit. 

Fueling the shadow banking industry are savers frustrated by losing money through inflation on their deposits.  Unable to take advantage of offshore investment opportunities due to government restrictions, savers are increasingly turning to shadow banking in search of real rates of return.  Counter-party to savers are small businesses, developers and home buyers.  90% of Chinese small businesses can not access capital from banks and turn to shadow bankers for loans.  Compounding the problem are young home buyers -China requires a 30% down payment to purchase real estate.  Unable to come up with the down payment through saving, young borrowers looking to purchase real estate turn to the shadow banking industry to acquire the funds required for a down payment.  With 70% of the purchase price of a home bought on leverage, the scheme works so long as real estate prices continue to increase at a reasonable rate. 

Opportunities to profit off shadow banking extend to commodity traders.  Traders borrow to buy copper or steel via a bank who issues a letter of credit to the seller on behalf of the trader. The trader can then take his new metal stock and pledge that as collateral for a normal bank loan, which he can then take and make money by lending the funds back into the shadow banking market at a higher interest rate.  

Failure of questionable construction projects, a stall or collapse in real estate prices or the inability of borrowers of questionable quality to make payments on their loans could trigger a Chinese financial collapse with far reaching global consequences.  Already the cracks are starting to appear.  The recent disappearance of shadow bankers in Wenzhou an export hub where up to 90% of families participate in underground trading may foreshadow what is to come.  Since August 11^th, 2012, over 100 people have fled and 800 lending brokers have gone under.  In this murky world, measuring the systemic impact of a shock to the underground financial system is impossible but what is clear, is the time has come for officials to regulate an industry that should have been regulated a long time ago.