Understanding Shadow Banking and Its Risks in China

14 Sep, 2023

Understanding Shadow Banking and Its Risks in China

China's real estate woes have brought the risks of shadow banking into the spotlight once more. Shadow banking, a term originating in the U.S. in 2007, refers to financial services provided outside the traditional banking system, which faces stringent regulations.

Unlike conventional banks, shadow banking entities have more leeway in lending but lack the same level of security. This absence of strong safeguards means that sudden demands for repayment can set off a chain reaction.

Additionally, limited regulatory oversight makes it hard to gauge the true extent of debt and the risks it poses. In recent years, China has moved to curb non-bank debt growth.

China's unique financial landscape is dominated by state-owned banks, making it challenging for non-state businesses to access traditional financing. This setup has led to an implicit guarantee that the state would provide support, but recent changes challenge this assumption.

Estimates put China's shadow banking sector in the trillions of U.S. dollars.

The intersection of shadow banking, local government finances, and household assets is evident in China's real estate, a sector comprising roughly a quarter of the economy. Developers borrowed heavily from shadow banks, pushing land and housing prices up.

In 2020, Beijing imposed debt restrictions on developers, leading giants like Evergrande and Country Garden to struggle with debt repayment amid falling home sales.

Concurrently, concerns arose about the ability of trust fund Zhongrong to repay investors, as it had lent to developers.

It's now apparent that some struggling real estate firms hid debts. Property developer Shimao revealed higher debt levels than previously disclosed, surprising its former auditor PricewaterhouseCoopers.

Some of this hidden debt came from trust companies, which are part of China's shadow banking system. These trust funds sold investment products, primarily to wealthier households.

As of March, about 7.4% of trust fund assets in China were exposed to real estate. However, it's estimated that developers' actual borrowings from trust firms exceeded three times that amount.

China's banks also used trust companies to obscure risk levels on their balance sheets while lending to restricted borrowers like property developers and local governments. Shadow banking accounted for nearly one-third of all lending in China from 2012 to 2016, according to Logan Wright from the Center for Strategic and International Studies (CSIS).

Now, China must find alternative economic support as it reins in shadow banking and real estate debt. The deleveraging campaign that began in 2016 contributed to China's economic slowdown.

The future of China's economic growth depends on efficiently redirecting resources away from property-related lending and local government projects toward more productive private sector firms. Otherwise, China's growth may remain slow, reaching 2 percent or lower over the next decade.