Black Holes at China's Shadow Banks

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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When I speak of cracks in China's institutional foundation, I'm thinking in large part of China's banking system -- which as far as I can tell, isn't really a banking system the way that we think of it.

Banks are controlled by the government, with interest rates for both deposits and loans set by fiat. The government also feels free to tell banks how much to lend, and to mandate that they buy government bonds at particular prices. When I went to China in 2010, one of the bankers there told us that a huge chunk of their Tier One capital consisted of special government bonds that couldn't be sold and paid about 5 percent interest -- at a time when inflation was, according to most of the experts I talked to, well above that.

In a Western banking system, you'd expect this to lead to a crisis. But what would that even mean in China? Its currency isn't convertible, and financial links to the outside world are tenuous. Maybe the government can just keep ordering banks to keep making loans at low interest rates, and declare by fiat that the loans are performing. That seems like a crazy thing to say, but it's also hard to describe how a crisis would happen.

In the years since I visited China, I've asked various experts to explain its banking system to me in a way that makes sense. No one has been able to so far.

The fact that the mechanics of a crisis are hard to sketch out doesn't mean that the system works well. You know those Chinese ghost cities, the eerie forests of apartment buildings and commercial complexes equipped with everything except people? Those homes are a major store of value for Chinese families. With bank account interest rates fixed, a fledgling stock market full of speculative issues, and few financial connections to the outside world, the Chinese have been forced to look into nonfinancial stores of value for their massive savings rate. Like us, they often choose real estate. But not to rent, because that would devalue the property; the Chinese place a high value on new. No, they buy the houses and keep them empty, as stores of value rather than places to live.

In recent years, China has moved to liberalize things slightly, since obviously it makes no sense to plunge so much of the nation's investment capital into empty houses and similar "assets." But this, too, creates issues, as a recent New York Times article on China's shadow banking system illustrates:

"China's regulators -- and a fair number of economists, policy makers and investors -- worry that legitimate banks are using lightly regulated wealth management products to repackage old loans and prop up risky companies and projects that might not otherwise be able to borrow money.

Analysts warn that shadow banking is helping drive the rapid growth of credit in a weakening economy, which could lead to -- in the worst situation -- a series of bank failures. "This is the biggest uncertainty I've seen in my 18 years following the China market," Dong Tao, an economist at Credit Suisse, said of shadow banking. "You don't know how banks are deploying capital. And you don't know the credit risks."

What banks are doing, analysts say, is pressing customers to shift money from the old, regulated part of their operations — savings deposits — into the new, less regulated part consisting of high-yielding wealth management products that can circumvent government interest rate controls and be used to finance high-interest loans to desperate customers."

The old system worked, in the sense that it was probably quite stable, but it caused wildly inefficient capital allocation. The new system may ease some of the inefficiencies, but at the price of instability. Apparently, shadow banking has created a credit boom that the government would like to choke off. But when they try, the resulting squeeze threatens the growth they need to maintain political peace.

If China wants to make the transition to an advanced economy, it will eventually need to regularize its banking system, dismantling a lot of its current controls and mandates and replacing them with a comprehensive regulatory and monetary regime. But can it do this before an economic slowdown creates a crisis?

We've never watched a transition like China's before. What we can say is that there are a lot of institutional problems that will need to be fixed — and it would be better to fix them before the fixes are truly and desperately necessary.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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Megan McArdle at