CGI Response: “Avoiding a shadow banking crisis”, by Dr. Jianguang Shen

China RenminbiThis post is in response to a recent piece, “Avoiding a shadow banking crisis” from Dr. Jianguang Shen of Mizuho Securities Asia Limited, which is being reproduced here with their generous permission.   Please see below, along with a deeper analysis linked here: AVOIDING A SHADOW BANKING CRISIS – CMM_20140206.

The Shadow Banking crisis is being talked about in all types of ways. It is not easy to form a broad understanding, and this analysis attached does not give big weight to the concern that Chinese banks are borrowing in dollars and lending in renminbi, creating a potential loss as the dollar rises.

Do we understand that? Some of us do and some do not. It is the problem with comprehending this “issue”. It is unlikely that the total amount involved in shadow banking is greater than the funding needed to develop the Chinese economy. But it is complex and important. SO IT’S WORTH STRUGGLING WITH.

The problem is that being unregulated, there are inexperienced people borrowing and lending to risky end borrowers, scam merchants taking from the rich and doing them with sub-prime type investments, even if they look at first glance as lending to miners or manufacturers.

Shadow banking in China is the result of the highly successful banking regulators sorting the balance sheets of the main State Banks, and keeping them away from the risks of Investment Banks. As wealth has spread in the market economy, and SOEs have built large reserves, so this “hot money“ has sought better returns than those offered by the main banks. Sound Familiar?

In China these “shadow banking“ operators, often subsidiaries of main State Banks, are relatively unregulated and very inexperienced in the analysis and judgments required for lending or investing. Their main goal is fees – sound familiar?

So the Party policymakers will have expected this to happen, and will have prepared regulations to regulate this area, and plans to prevent provinces operating in the financial services sector.

So we shall see regulation, regulators, approved bodies and less margins but the money being funneled into the needs of the nation in safer vehicles.

This is an aspect of “Socialism with Chinese Characteristics” – the capitalist forms of the market create development and problems, and left to their own devices, the market would develop major diversions of funds and the arrival of Madoff’s by the hundreds.

The article described, in outline, below and attached in detail, is, a useful deeper analysis of the problem and its likely impact. (DEEP ANALYSIS PDF DOWNLOAD: AVOIDING A SHADOW BANKING CRISIS – CMM_20140206)

Do throw questions at us if you have any.

– Stephen Perry

 

On behalf of Dr. Jianguang Shen:

Avoiding a shadow banking crisis 

Shadow banking and policymakers’ dilemma
Market scare over the potential default of China Credit Trust’s product in January confirmed our view that shadow banking is the main risk for China’s 2014 economic outlook (see Liberalizing financials too quickly poses risk, 3 December 2013). China’s shadow banking has experienced phenomenal growth since 2010, driven by: 1) a strong desire to evade tight banking regulations under the banner of financial liberalisation; and 2) rising demand from the property sector and local governments. That said, shadow banking lacks a robust regulatory framework and the ability to conduct due diligence; instead implicit guarantees have been built into market expectations as investors pursue high-yield products regardless of risks (see 10 questions on China’s shadow banking, 9 January).

The State Council released Document 107 in December 2013, which defined the shadow-banking system as all financial intermediaries outside the traditional banking sector, involving trusts, entrusted loans, and wealth management products. Document 107 recognized such entities as positive and inevitable developments in the financial market and proposed measures to: 1) accurately identify risks in the shadow-banking system; 2) minimize the potential impact on the stability of China’s financial system; and 3) maximize the benefits to economic growth (see Potential default exposes risk in China’s shadow-banking system, 15 January).

While the China Credit Trust product has received a de facto bailout by a consortium formed by ICBC, China Credit Trust, and the Shanxi government, we believe that the incident may be the tip of the iceberg. In contrast to the CNY3b asset in question, we estimate the total size of the shadow-banking system at up to CNY30t. The bailout avoided a potentially devastating default in the short term, but it could also reinforce investors’ perceptions of an implicit government guarantee for these products. Thus, it is introducing an even larger moral-hazard problem, as it encourages risk-taking behavior (see A bailout — Chinese style, 28 January).

Avoiding a systemic financial crisis

Nevertheless, we maintain that it is still possible to avoid a systemic financial crisis, but the government must: 1) shrink the overall size of the shadow banking industry; 2) manage the market’s liquidity situation more smoothly; 3) expand the bond and security market to replace shadow banking; 4) stabilize market expectations using rate-based monetary targets; and 5) correct market distortions through structural reforms (see Trust product default risk: dilemmas and implications, 22 January).

Shadow-banking products that invest in the mining and private-manufacturing sectors are the riskiest, in our view. In comparison, local government debt appears under control despite rapid increases in recent years. New debt was raised mainly by city-level governments issuing local-government-financing-vehicle bonds to fund urban infrastructure, transportation facilities, and land development. The only concern we have is that much of the debt must be repaid this year. However, with the National Development and Reform Commission (NDRC) announcing that it would allow local governments to rollover debt, we believe immediate risk triggered by local government debt burden remains low (see Local government debt under control, 6 January).

A shadow over the 2014 economic outlook

We believe that the shadow-banking system has widespread economic and monetary implications (see Shadow banking key risk on 2014 growth, 20 January), namely:

  • Money-market rates will likely remain high in 2014, as capital demand by property developers and local governments is strong and insensitive to interest rates.
  • Overall investment growth will decelerate due to liquidity stress and rising funding costs, squeezing out demand from the real economy and private sector
  • The PBoC will intervene when necessary to pre-empt further credit crunches (see PBoC intervenes to pre-empt short-term liquidity stress, 22 January)
  • The liquidity problem needs to be solved through sweeping structural reforms, which cannot happen without pain.

In order to counter the investment slowdown from the more interest rate sensitive sectors of the economy, the National Development and Reform Commission (NDRC) also pledged to implement more effective fiscal investment in 2014. This includes the key construction projects as specified in the 12th Five Year Plan, and investment on strategic area where the market is not fully effective such as social housing and environmental protection. The government stated that it has no limit on fiscal investment, as long as it helps improve China’s economic structure (see NDRC to boost investment using fiscal money, 24 January)

External demand will also be a bright spot for growth in 2014, on the back of returning demand from the advanced economies. As evident from soaring GDP growth in the second half of 2013, and strong consumer confidence, demand from the US is recovering. Meanwhile, sentiment in the EU is also improving, with increasing confidence that the worst of the crisis may be over. We think the PBoC will continue to prevent a sizable RMB appreciation to maintain China’s export competitiveness, with the renminbi staying around CNY6.05/USD in 2014 (see Resilient export outlook despite distortion, 10 January)

Reform and Innovation to sustain China’s growth

China’s 4Q 2013 GDP growth showed that improving exports and resilient consumption are leading China’s economic growth. Meanwhile, government related investment remains the wildcard. We expect this divergent development (of rising exports and consumption amid declining investment growth) to continue in 2014. Barring a financial crisis, we are cautiously optimistic for China’s 2014 outlook, with GDP growth projection at 7.6% YoY (see 2014: The end of China’s Keynesian policy stimulus, 20 December 2013).

Beyond steadying growth in the short term, we believe the push toward supply-side economics will be a possible solution to China’s unsustainable growth. In particular, in the context of China’s structural reforms in the next decade as outlined at the Third Plenary Session, we believe the benefits of the reforms will be immense. For example, a national policy to relax the one-child policy could help alleviate China’s aging problem and boost consumption. The reform of state-owned enterprises (SOEs) could be seen as an attempt to improve labour productivity at SOEs and promote competition between the SOEs and the private sector (see Growth through reform and innovation: Setting the course for policy in 2014, 20 December 2013).



Categories: Investment, Policy, Shadow banking

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