China Slowdown Stymies Plan to Curb Shadow-Banking Risks

China’s economic slowdown threatens to derail efforts to curb underground lending -- measures championed by Premier Wen Jiabao as crucial to future growth.

The country grew in the second quarter at the slowest pace since the depths of the global financial crisis in 2009, 7.6 percent, putting pressure on China’s leaders to boost stimulus spending. Wen’s proposals to rein in the shadow-banking system, estimated to be about one-third the size of official lending, may be sidelined as a result, according to half a dozen economists interviewed by Bloomberg News.

“With an economy slowing more aggressively than the authorities perhaps want, the imperative to crack down on shadow financing becomes increasingly conflicted,” said Alistair Thornton, a Beijing-based economist with research firm IHS Global Insight Ltd. (IHS) “With the government increasingly in firefighting mode, the desire to push through tough reform in the financial sector inevitably takes a back seat to staving off a hard landing and managing global economic volatility.”

Wen, whose term ends next year, has led calls to control what IHS estimates is $1.3 trillion of private financing, an amount equal to last year’s U.S. budget deficit. He has proposed channeling that money through government-regulated institutions to break what he called a “monopoly” on lending by state-owned banks and open a cascade of capital to China’s 42 million small and medium-sized businesses.

‘Terrible Damage’

Only 3 percent of those companies are able to get bank loans, according to Citic Securities Co. (6030), the nation’s biggest publicly traded brokerage, with underground lending by family, friends and acquaintances largely funding the rest.

As growth from low-cost labor and productivity gains from adapting technologies developed abroad lose steam, China’s future expansion must rely more on an efficient distribution of capital, as well as on increased innovation and the development of service industries, the World Bank wrote in “China 2030,” a report published in February.

Tamping down underground lending as the economy cools poses risks, said Fred Hu, a Beijing-based economist and former greater China chairman at Goldman Sachs Group Inc.

“Shadow banking is much vilified, but without it the Chinese economy would have had a hard landing long ago,” Hu said. “The issue here is how to legitimize the sector and make it more transparent to reduce some of the potential downside risks, but not to shut it down. If the government were to try, that would do terrible damage to the economy.”

Pilot Program

Apart from calls by policy makers since 2010 for banks to increase loans to entrepreneurs and the start in June of a junk- bond market to fund small businesses, the only government initiative has been Wen’s pilot program in Wenzhou, a city in southeastern China where underground lending is prevalent.

Of 12 measures proposed by Wen, only one -- a registration center to monitor private lending -- has gotten off the ground. The reforms could lead to “national financial restructuring” if they succeed, the premier said when he announced the plan at a State Council meeting in March.

“There’s a willingness to make pretty big changes because the state-driven banking system isn’t getting enough credit to small and medium enterprises, which is where most of the growth in the economy is,” said Charlene Chu, senior director at Fitch Ratings Ltd. in Beijing.

The China Banking Regulatory Commission also is allowing banks to issue special-purpose bonds earmarked for small- business lending, to lower risk-weightings assigned to such loans and to tolerate more defaults. Loans to small businesses in China rose 20.5 percent in the first quarter from a year earlier, a faster rate than to large state-owned enterprises, according to the central bank. Even so, credit issuance slowed from the 25.8 percent increase last year.

Bank Recapitalizations

“This isn’t really an environment where you want to be messing with the financial sector,” said Jonathan Anderson, a former chief economist for emerging markets at UBS AG who now runs Beijing-based Emerging Advisors Group, citing the possibility of bank recapitalizations after a binge of stimulus lending in 2009-2010.

With China’s economic growth weakening, the central bank has cut the benchmark deposit rate twice since the beginning of June, to 3 percent, a move that may prompt more people to chase higher returns in shadow-banking investments. These riskier opportunities, in areas such as commodities and property development, typically offer returns of 20 percent and can reach 100 percent annual interest or more.

Economic Risks

Underground lending accounts for only part of the capital circulating outside Chinese banks. Shadow banking, including loans changing hands between friends, families and companies seeking capital as well as the off-balance-sheet business of lenders and trust companies, totals as much as 15 trillion yuan ($2.4 trillion), about one-third the size of China’s official loan market, according to estimates by Societe Generale SA.

While underground lending isn’t illegal, having a large amount of capital sloshing around outside regulatory oversight poses economic risks. It makes it difficult for a government to control its economy through mechanisms such as interest-rate policy and money supply, said Nobel Prize-winning economist Joseph Stiglitz, who travels frequently to China.

“Shadow banking undermines government attempts to bring macroeconomic stability,” said Stiglitz, a professor at Columbia University in New York. “If you have shadow banking, if the government squeezes, money just shifts from the formal to the informal sector. Monetary policy becomes ineffective, and the government loses an important force for stabilization.”

Crisis Management

The government also is unable to intervene if a large number of underground loans suddenly go bad in a crisis, Stiglitz said, because there’s no centralized place to put the money, as in a bank bailout. Reducing the risk of social unrest is also a consideration.

“The government always takes the blame when things go bad,” Stiglitz said.

Thousands of people protested Jan. 1 in Anyang, a city in Henan province, after losing their savings in illegal investment scams. In Wenzhou, more than 80 suicides or bankruptcies by indebted businessmen in a four-month period last year prompted Wen to visit the city in October and pledge help.

“Shadow banking is a double-edged sword,” Liu Mingkang, China’s former chief banking regulator whose term ended in October, said in an interview. “If it is handled properly, lending will be more efficient because the lenders know the community around them. But the bad thing is people are greedy.”

Three Executions

“Lenders use every possible means to make sure borrowers pay back,” said Liu. “The mob may be involved, and coercions will happen. That’s why governance is needed.”

China has executed three people and sentenced to death at least 17 others for illegally raising funds from individuals, according to Chinese press accounts compiled by Bloomberg. In Wenzhou, more than 22,000 lawsuits brought by borrowers involving 21 billion yuan are pending, the official Xinhua News Agency has reported.

Shadow banking financed the growth of Wenzhou’s more than 400,000 small firms over the past decade, with almost 90 percent of families and 60 percent of companies taking part in 110 billion yuan of underground lending and borrowing, according to a local People’s Bank of China survey last year.

Bringing unregulated lending into the mainstream is part of a larger effort by China’s policy makers to give markets a bigger role in setting interest rates and to remove restrictions on capital flowing into and out of the country.

Idle Capital

“Chinese companies, especially small ones, need access to funds,” Wen, 69, said after the annual National People’s Congress in March, his last before he’s due to step down. “Banks have yet to be able to meet those companies’ needs, and there is a massive amount of idle private capital. We need to bring private finance out into the open.”

The explicit call from such a highly placed official highlights the importance the government places on bringing shadow banking into the mainstream economy, said IHS’s Thornton.

“The fact that Wen came out and said that means there are people in the system who view the status quo as detrimental to the economy’s sustainable growth,” Thornton said. “Banking- sector reform is crucial. We’re transitioning into an era where credit needs to be allocated more efficiently.”

Most of the measures, including giving lending companies direct access to overseas investment and establishing professional asset-management firms, are still at the planning stage. They won’t be carried out before Wen leaves office, said Alicia Garcia-Herrero, chief economist for emerging markets at Banco Bilbao Vizcaya Argentaria SA in Hong Kong who formerly worked for the International Monetary Fund.

’Daunting Task’

“This is going to take years; it’s not going to happen all of a sudden,” Garcia-Herrero said. “It’s a daunting task.”

Bank loans accounted for only 13 percent of Chinese small enterprises’ funding needs in 2008, the latest year for which data is available, with 36 percent coming from underground lenders and 41 percent from their own retained earnings, according to a Citic Securities note in October. Small and medium-sized businesses provide jobs for as much as 80 percent of China’s urban workforce, some 600 million people.

“Shadow-banking activity can amplify financial cycles since it tends to grow during booms and contract during busts,” the Basel, Switzerland-based Bank for International Settlements said in its annual report published in June, adding that it played such a role in Sweden and Japan in the 1990s and in the global financial crisis of 2008 and 2009.

’Ridiculous’ Absence

Shadow banking also exists in developed economies, including the U.S. It totaled $60 trillion in the developed world in 2010, according to the Financial Stability Board, which coordinates the work of regulators around the world.

“Anything that involves lending and borrowing should be regulated, and shadow banking is no exception,” said Liu, the former regulator. “It’s ridiculous that we haven’t got it.”

Private financing is thousands of years old in China, where clans traditionally funded the businesses of their family members, and has spread to include the general public.

As long as borrowing and lending are on a voluntary basis and the borrowing rate charged doesn’t exceed four times the benchmark set by the central bank, such underground lending is legal, according to China’s Supreme Court.

The more than 4,800 small firms set up mostly by private investors over the past three years and monitored by the central bank have given out 445 billion yuan of loans as of the end of March, about 0.7 percent of the country’s lending market.

The ability of such firms to make loans is limited as they are unable to take deposits to finance them unless they’re approved by the banking regulator to transform themselves into rural banks. None has won approval yet.

Wenzhou Experiment

The trial program in Wenzhou is making only limited progress, effectively cutting off lending to small businesses without providing alternatives. Less than 1 percent of the underground money available surfaced after the local government set up a private registration agency to monitor underground lending and borrowing, officials said. More than 800 informal agencies, mostly credit-guaranty firms, have been shut down after failing to make payments, Xinhua reported on May 13, citing the local banking regulator.

Wenzhou’s private lending in the first three months of this year dropped by 41 percent from the previous quarter, the National Development & Reform Commission of Zhejiang Province said in June, based on a survey of 50 local businesses. The city of 9 million people now has as much as 1 trillion yuan of idled private capital, said Zhou Dewen, head of the Wenzhou Small and Medium-Sized Enterprises Development Association.

‘Useful Tools’

That the reforms aren’t happening faster may be a good thing, said IHS’s Thornton.

“Closing down curbside lending in Zhejiang or tackling trust structures feeding into the property market will simply exacerbate the slowdown,” he said. “Indeed, it was the reliance on non-traditional avenues of credit issuance that saved the economy from the global financial crisis. They are useful tools to turn to in times of panic.”

China’s state-owned banks, including Industrial & Commercial Bank of China Ltd., the world’s largest by market valuation, probably won’t welcome competition from new, more nimble lenders suddenly turned into legitimate credit unions and cooperatives, and might find it difficult to maintain continued profit growth, BBVA’s Garcia-Herrero said.

Bank Bailouts

Chinese banking shares tumbled in Hong Kong the day after Wen called for breaking the big banks’ monopoly in April. ICBC dropped 1.6 percent on April 5, and its shares are down 11 percent this year, compared with an increase of 5.5 percent for the benchmark Hang Seng Index. China Construction Bank Corp. (939), the country’s second-largest lender, lost 2 percent, with its year-to-date performance down 11 percent.

The Chinese government spent more than $650 billion over a decade through 2008 bailing out its banks, including ICBC and its three largest peers, which are invested in a system that helps them profit from cheap loans to state-owned companies.

Profit growth of China’s publicly traded lenders may slow to 17 percent this year from last year’s 29 percent after the central bank in June gave lenders more freedom over pricing, hurting their margins, according to Ping An Securities Co.

“The financial system in China serves the political system,” said Andy Xie, a former Morgan Stanley chief Asia- Pacific economist based in Shanghai. “Without political reforms, there will never be a market-based financial system.”

Albanian Collapse

Economists including Stiglitz and one of his fellow former World Bank economists, Louis Kuijs, now at the Fung Global Institute in Hong Kong, cite the example of Eastern Europe in the 1990s, when former Communist countries were turning capitalist, as what can happen when governments fail to police non-bank financing adequately.

In Albania, the economy almost was wiped out after about two-thirds of the population invested in Ponzi schemes that peaked at about half the size of gross domestic product, according to the IMF. After the investments collapsed, the government fell and the country descended into a near civil war in which some 2,000 people were killed, the IMF said.

China’s shift to a more market-driven economy has been marked by scams and scandals on a smaller scale. Two women from Zhejiang province, Si Chaxian and Du Yimin, were executed in 2009 for defrauding investors by promising returns as high as 108 percent annually, CCTV reported.

‘Rich Sister’

That same year, Wu Ying, nicknamed “Rich Sister,” was sentenced to death for losing $55.7 million of investors’ money. Her sentence was suspended in April following Wen’s comments about the need for alternative sources of small-business lending, after which he added that the Supreme Court, which was about to rule on her appeal, should handle her case carefully.

In Anyang, the city’s newspaper reported that Mayor Zhang Xiaodong told government departments to “prioritize tackling illegal financing and maintaining social stability before all other tasks.”

China’s banking regulator has been tightening oversight of trust companies since 2010 after banks used them to evade lending restrictions. Trust firms also were major lenders to the nation’s property developers by pooling investors’ money.

“Recent moves -- the Wenzhou pilot, the narrowing of the interest-rate spread, stricter regulation of trust companies -- are not insignificant,” said Il Houng Lee, the IMF’s chief resident representative for China in Beijing.

‘Clear Steps’

The central bank on June 8 gave banks more freedom over pricing by permitting them to pay as much as 10 percent more than the benchmark on deposits, the first time a premium has been allowed. Lenders now can offer discounts of as much as 30 percent on borrowing costs, up from 10 percent. The spread between the benchmark one-year lending and the deposit rate paid by biggest banks narrowed to 2.75 percentage points from 3.06 percentage points before June 8.

“While the consequences of these changes remain to be seen, these are clear steps in the right direction,” said Lee. “The ultimate objective is efficient resource allocation.”

Even without Wen’s urging the reforms will probably continue, said Hu, the former Goldman Sachs executive who founded investment firm Primavera Capital Group in Beijing.

“The reform calls are getting more vocal,” said Hu. “We are now into a once-in-a-decade leadership transition. Many liberal economists and open-minded officials may view this as a fresh beginning, a new opportunity.”

--Luo Jun and Kevin Hamlin, with assistance from Paul Panckhurst, Justina Lee and Marco Lui in Hong Kong. Editors: Sheridan Prasso, Robert Friedman

To contact Bloomberg News staff for this story: Jun Luo in Shanghai at jluo6@bloomberg.net; Kevin Hamlin in Beijing at khamlin@bloomberg.net.

To contact the editors responsible for this story: Paul Panckhurst at ppanckhurst@bloomberg.net; Chitra Somayaji at csomayaji@bloomberg.net.

Bloomberg reserves the right to remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.