From being considered a “backward” country only 30 or 40 years ago with a very high level of poverty, China has become a world economic powerhouse. Many now speculate that China will surpass the United States as the global leader, yet others predict that China will trip and fall. A great deal of concern has focused on China’s shadow banking system, and whether that system is reliant on a real estate bubble that will ultimately collapse, bringing the economy down with it.
The recent global financial crisis, in which the U.S., the U.K. and other world leaders tripped and fell, makes this scenario seem very possible. The urge to consider it likely, however, may also result from envious competitors anticipating the delicious schadenfreude they would experience if it came to pass.
Let’s look at how China’s shadow banking system operates and whether the fears of collapse are justified.
We’ve seen it before
I had a ringside seat when Japan became a major exporter a few decades ago. Amid China’s more recent export surge, we may forget how big Japan’s was.
When I was 16 years old, I got a summer job as a “feeder” in a dingy, dirty warehouse in Boston where shoes were retagged by women sitting at rows of dusty tables. My uncle, a buyer for the shoe company, “pulled strings” to get me the job. I don’t know how hard he had to pull those strings because the job was one of the worst jobs in the world.
The shoes were brought on pallet movers in boxes stacked in high piles. When they arrived, they bore the manufacturers’ labels. The women’s job was to retag them with the retailer’s tag. The women were paid by the piece, so they wanted no delay in receiving the shoes at their tables. When they finished retagging a boxful of shoes they would yell, “work” until one of the two “feeders” brought them another box. To bring shoes to them, I would shake one of the piles of boxes (I am short and was shorter then) until the top box came off, catch it and open it with a one-two punch, breaking the tape across the top and ripping open the flaps. I then brought the box to the last woman who had shouted, turned it, propped it on her desk and opened the flaps so she could pull out each pair of shoes and retag it. I would close the box she had just finished and stack it on another pile.
When I started, I was paid $1.10 an hour. About a month into the job, the minimum wage was raised to $1.12-1/2 cents an hour, so I got a raise. But I didn’t receive all of it because it was a “closed shop”; a portion was automatically withheld for Teamsters Union dues. At least the job made me stronger.
When I started, each box weighed about 36 pounds, a lot of weight to catch. About a third of the way through the summer, heavier boxes began to arrive – as I recall, 60 pounds each – filled with cheap sneakers from Japan. After a while, all of them were sneakers from Japan.
The rise and fall of Japan
After World War II, Japan was in ruins. As it set about its recovery, it began to make goods for export. But they were low in quality. In the 1950s “Made in Japan” was a laughingstock, a synonym for “piece of junk.” According to legend, to avoid that label some companies even set up plants in the Japanese village of Usa, so they could say their products were “MADE IN USA”.
With the help of American efficiency experts like W. Edwards Deming, who couldn’t get companies in the U.S. interested in his methods but could in Japan, Japan gradually became a manufacturer of high-quality export goods. It was so successful that in the late 1980s the United States worried that it was no longer “competitive” and needed to pursue a government-led “industrial policy” like the one firmly scripted and guided by Japan’s Ministry of International Trade and Industry (MITI).
The U.S. became so concerned about this that Clyde Prestowitz’s 1988 book “Trading Places: How We Allowed Japan to Take the Lead” – and others like it – were bestsellers. Japan got so rich that, according to The Economist, “the price of land surrounding Japan’s Imperial Palace (about the size of Disneyland) was said to be worth more than the whole of California.” Over the decade of the 1980s, according to Stephen Roach, author of the book Unbalanced: The Codependency of America and China, “the bilateral U.S.-Japan deficit accounted, on average, for 40 percent of the total U.S. merchandise trade deficit – nearly 10 percentage points more than the share traceable to China over the decade ending in 2012.”
But in 1991 Japan’s real estate bubble burst. After that it didn’t seem so fearsome anymore. Other “Eastern tiger” countries, including Korea, Taiwan, Singapore, Thailand and Malaysia, rose. For a while, the U.S. somewhat snidely believed that their successes were due to the supposed practice of a specifically Asian brand of “crony capitalism.” But the fear of loss of competitiveness to Japan waned.
Could a similar downfall occur in China because of a bursting bubble?
The growth in China’s shadow banking
The source of this concern – or wish – has recently been the rapid growth in China’s shadow banking system. Europe’s Financial Stability Board (FSB) defines shadow banking as “Credit intermediation involving entities and activities (fully or partially) outside the regular banking system.” According to Joe Zhang, author of Inside China’s Shadow Banking: The Next Subprime Crisis?, “Between 2008 and 2012, its size tripled to RMB20 trillion [about USD3.2 trillion], equivalent to 20% of the country’s GDP.”
But in his book, Zhang provides a firm answer to his title’s question, “The next subprime crisis?” His answer is no. Andrew Sheng, Ng Chow Soon, the Oliver Wyman consultancy and other collaborators sponsored by the Fung Global Institute and HSBC give the same answer in two related documents: the comprehensive Bringing Shadow Banking into the Light: Opportunity for Financial Reform in China by the Fung Global Institute (FGI), edited by Sheng and Ng and the shorter Bringing Light Upon the Shadow: A Review of the Chinese Shadow Banking Sector by Oliver Wyman.
One problem is defining the size of China’s shadow banking system. FGI notes that many calculations of its size have double-counted liabilities because of liabilities backed up by guarantees and other liabilities, and some have failed to count particular liabilities. FGI estimates the size of China’s shadow banking system at the end of 2013 at 53% of GDP. But it notes, “Placed within the global context, shadow banking in China appears small relative to the global average of 117 percent of GDP.” According to Oliver Wyman, the Financial Stability Board (FSB) has estimated the shadow banking sector to account for 84% of GDP in the U.S. and 177% in the U.K.
So China’s shadow banking sector is still small compared to those of other countries. Furthermore, it is not primarily servicing a speculative bubble, but a need arising from a Chinese regulatory practice often called “financial repression.”
China’s financial repression
China’s regulators impose caps on commercial deposit banks’ interest rates and lending rates. These capped rates are very low – lower than inflation – so that the real interest rates have been negative. This is like the situation that prevailed in U.S. savings and loan banks before the cap was removed in the Reagan era. That removal was followed by competition for depositors among savings and loans, pushing rates up and driving the banks to seek out high returns in risky investments. The savings and loan crisis and bailout that followed cost the government $124 billion in 2004, according to econlib.org.
Perhaps that experience has made Chinese regulators chary of removing the caps. The Chinese authorities are known to derive cautionary lessons from history. For example, they learned from Gorbachev’s glasnost – the increased openness and transparency of the 1980s that ultimately led to the Soviet Union’s breakup – that openness and transparency can pose a danger to a political system; so they have maintained limits on openness and transparency.
Thus, they may have decided from the U.S.’s savings and loan experience that it’s not safe to let China’s commercial banks off the leash. That, at least, is what Zhang believes to be the reason why Chinese authorities continue to maintain the caps. He says, “What will happen if the government were to remove the controls on the interest rates the banks can pay to depositors? The government thinks that would be unimaginable! ‘How can we ever possibly allow the banks to compete for deposits on prices? The banks would engage in reckless competition, and push the deposit rates skyward.’” Most ordinary Chinese have accepted the low capped rates on bank deposits because they had little choice and because it was a parking place until better opportunities arose.
The two-tiered Chinese lending system
Chinese bank lending is also constrained by loan-to-deposit ratios and annual loan caps. The result of that, combined with the low interest rate caps, is that low-interest bank loans go only to the most reliable (i.e. implicitly central-government-backed) borrowers, large state-owned enterprises (SOEs) and local governments, while a shadow banking market developed for much higher interest rate loans to small-and-medium-sized enterprises (SMEs). SMEs can pay as much as 20% interest, and more in the microcredit market, in the shadow banking system.
All of the authors cited believe China’s shadow banking system serves a useful purpose. Although there are some Ponzi elements, it is not like the practice of U.S. banks like Citicorp prior to the financial crisis; that is, creating special investment vehicles (SIVs) off balance sheet for the sole purpose of skirting regulations to keep reserve requirements low.
For example, Chinese trust companies match more risky borrowers with lenders seeking higher returns than they can get on bank deposits. Zhang says these trust companies provide services comparable to those of Michael Milken’s Drexel Burnham Lambert in the United States in the 1980s and 1990s. Milken tripped up and violated laws but provided a useful service by funding with high-yield bond offerings (then called “junk bonds”) a number of struggling cable companies, telecoms and other small firms.
Chinese shadow banking takes many other forms also: microcredit, pawnshops, financial guarantee companies and wealth management products. Some of these are facilitated by, or implicitly backed by (or believed by lenders to be backed by), the commercial banks themselves. The commercial banks in turn are believed to be implicitly backed by the government. Says Zhang, “Strictly speaking, there is no bank insurance system in China, unlike in the United States or elsewhere. However, the public thinks that the banks have an implicit contract with the government.”
The government role
So, not unlike in the U.S., there is an uneasy relationship between the government, the banking system and the shadow banking system. The public assumes the government is backing the system even though it is not officially; but when push comes to shove, as in the U.S., the government does indeed back the system. This was conclusively shown when the U.S. Federal Reserve bailed out the supposedly private entities Fannie and Freddie in the financial crisis, and when the U.S. Treasury established in 2008 a temporary guarantee program for money market funds that would otherwise have “broken the buck” (returned less than the amount invested).
In China, in 2002, the central government provided backup for nonperforming loans (NPLs) by creating four entities (think of them as “bad banks”) to take over those loans from the four major Chinese banks: Industrial and Commercial Bank of China, Agricultural Bank of China, China Construction Bank and the Bank of China. Zhang says, “They were similar to the ‘resolution trusts’ of the United States.” Resolution trusts were formed by the U.S. government to take over devalued assets from savings and loans in the 1990s and resolve them by selling them off. Some people got rich buying those assets, unbundling them and reselling them at higher prices. Similarly, the four entities the Chinese government set up in 2002 to take over the NPLs came up smelling like roses when the real estate assets they had acquired subsequently soared in value.
In China, of course, the government is less skittish about playing an intrusive role in the system than is the case in the U.S. When bailouts occur in the U.S., it is with a “last resort” mentality and comes with considerable embarrassment, enduring criticism and political risk. In China the government is more proactively involved in oversight and is much less criticized and politically vulnerable for playing that role. It is cautious and seeks to maintain stability. This has reduced many of the kinds of risks that have threatened the U.S. system.
For example, there is no possibility of a subprime home ownership mortgage crisis in China. Loan-to-value ratios are very low. Oliver Wyman says, “The mortgage indebtedness of RMB 8 TN is less than 10% of the estimated value of household ownership of real estate of RMB 96 TN. This is because over 80% of urban and rural households own their residential property outright, and many of these were bought earlier, at levels below the recent property price increases. Thus, even though individual households may be vulnerable to a sharp drop in housing prices, the risk of widespread residential mortgage default is small.”
It is true that many bad loans have been made to local government-affiliated entities for large real estate development projects, resulting in some cases in “ghost towns.” These ghost towns were meant to house thriving new businesses and residents in smaller (but still large) inland cities, but house few or none. This is because many cities saw the booming development of eastern seacoast cities like Shanghai and thought they could produce their own boomlets by investing in commercial infrastructure, using the land the government owned as collateral.
Although there are – and have been in the recent past – many nonperforming loans, especially to politically well-connected local governments and SOEs, these NPLs are not a great concern. China’s central government and many of its provinces are so well funded that they are able to provide the liquidity to restructure and work through these NPLs, and they are not shy to do so. Furthermore, because China is a net lender to the world, any difficulties with domestic debt will not spill over to other countries.
Reforms needed
Nevertheless, in spite of their lack of immediate concern about China’s debt and shadow banking, all of the authors believe substantial reforms are needed. Most of China’s corporate capital needs – especially those of SOEs – are funded by short-term debt. China has a minuscule bond market, both for long-term corporate and municipal debt, and as yet only a small equity market. All of the authors believe these markets need to be developed, to provide alternatives both to bank lending and to shadow banking’s debt market to fund SMEs.
They also believe the financial repression of rate caps needs to end gradually and that reforms planned by government – U.S.-style deposit insurance and implementation of the legal entity identifier (LEI) initiative, a bank resolution/exit mechanism – need to be speedily implemented.
The interesting angle that is not especially played up by any of the referenced works is that, as with infrastructure development, China could play a major role in financial systems development by evolving a model that works better than the ones we have. It has become commonplace since the global financial crisis of 2007-2009 to say that Western financial systems theory and practice have not worked very well. Financial intermediary markets, especially equity markets, while underdeveloped in China are grossly overdeveloped in the West, to the point that much of the activity is either speculative or only for fee-seeking purposes. This adds to complexity that can undermine stability.
China, with a one-party government free to experiment without excessive political risk and not overly burdened by outworn models or theories, may be able to develop a better system. As long as it is rich enough and has stockpiled reserves enough not to face major imminent risks, it could experience – and perhaps lead – a golden age of financial system reinvention.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a principal and chief strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, has just been published by Berrett-Koehler.
Read more articles by Michael Edesess
