China’s Next Crisis Lurks in Shadow Banking; “The longer the government takes to address this, the bigger the problem becomes.”

China’s Next Crisis Lurks in Shadow Banking

By Dexter Roberts on May 16, 2013

China’s growing reliance on shadow banking is contributing to its debt problem. Since 2010 the value of the unregulated loans, investments, and other financial products of this sector has almost doubled, to as much as 36 trillion yuan ($5.86 trillion). That’s equal to 69 percent of gross domestic product, says Haibin Zhu, chief China economist at JPMorgan Chase (JPM) in Hong Kong. “Shadow banking poses systemic risks,” warned Moody’s (MCO) in a May 13 report.

The question is how much of this capital carries an implicit guarantee that the national government must cover. “It is our belief that at some point the central government will have to take responsibility for local debt,” says Derek Ovington, head of regional banks in Asia at CLSA Asia-Pacific Markets. The official debt burden of central and local government, which does not take the localities’ shadow banking activities into account, is just below 30 percent of GDP, Moody’s says. In contrast, Ovington estimates that shadow banking liabilities and consumer, corporate, and government debt are now more than 200 percent of GDP. “The longer the government takes to address this, the bigger the problem becomes.”In the shadow sector all manner of players, from securities firms to pawnshops, cater to the borrowing and investment needs of those who want to bypass loan quotas, interest rate caps, and other restrictions. Both banks and nonbank institutions have created wealth-management products such as trusts, in which affluent Chinese invest. A trust may lend the money at well above the official rate to companies struggling to stay afloat.

Developers and local governments have tapped shadow finance to work around restrictions on property development, bank lending, and infrastructure projects. The money can flow to questionable investments that may not quickly provide returns, says JPMorgan’s Zhu. Local governments are sitting on 12.8 trillion yuan in debt, according to Fitch Ratings. Add in loans from the shadow banks and the total could be closer to 18 trillion yuan, Fitch says.

Although trust assets, a major part of shadow banking, grew 65 percent in the first quarter, the economy isn’t expanding any faster. Companies and local governments are simply using the new credit to service earlier loans. “This is not going into the real economy,” says Chen Xingdong, chief China economist at BNP Paribas (BNP) in Beijing.

Chen points out that local governments have land and companies they could liquidate to pay liabilities. Beijing could inject cash into banks, if necessary. The central government has ordered banks to limit the size of their wealth-management products and monitor loans to local governments more closely. Despite the risks, the shadow banks perform a service by channeling capital to cash-strapped private enterprises and local governments. That’s why a broader clampdown on shadow finance seems unlikely: Beijing wants to tame shadow banking, not kill it. Only major reform can change this precarious situation.

The bottom line: China’s official figure for government debt is only 30 percent of GDP, but local governments are borrowing heavily from shadow bankers.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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