A Brookings Institution Paper (May 2015) by Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy and Dr Yu Qiao, Nonresident Senior Fellow, Foreign Policy, Brookings-Tsinghua Center, throws further light on China's perceived Shadow Banking risks.
The Paper notes that such risks do exist but are often over-exaggerated. It points out that ""societal benefits, on the whole, appear to be even greater. Therefore, China's shadow banking should be reformed, to reduce the risks and increase the benefits, and not abolished or shrunk simply for the sake of reducing its importance".
The following is a summary of selective extracts from the Paper -
"Shadow banking in China must be viewed in the context of a system which remains dominated by banks, especially large state-controlled banks, and in which the state provides a great deal of direction to banks, through a variety of regulations and formal and informal guidance.
In the last few years, those constraints have become sufficiently binding that business has flowed to shadow banks.
There are a number of pressures pushing business away from banks towards shadow banks, including the fact that:
• There are caps on bank lending volumes imposed by the People’s Bank of China (PBOC).
• The limit of bank loans to deposits of 75% has been constraining.
• Regulators discourage lending to certain industries.
• Most non-bank channels have lower capital and liquidity requirements.
• Shadow banks are not subject to bank limits on loan or deposit rates
• Shadow banking avoids costly PBOC reserve requirements.
Six reasonable estimates in the recent past produced figures ranging from about RMB 5 trillion to RMB 46 trillion, or roughly 8 to 80 percent of the size of China’s Gross Domestic Product (GDP).
Dr. Yu, a co-author of this paper, estimated the size at RMB 25 trillion, or 43% of GDP, in 2013. This compares to an estimate from the Financial Stability Board (FSB) that global shadow banking assets were equivalent to 120% of GDP. On the same basis, the US was at 150%. Thus, China’s shadow banking sector is relatively small compared with advanced economies.
Using figures from the PBOC’s measure of Total Social Finance (TSF), shadow banking accounted for about 18% of net flows of TSF in 2014.
However measured, it is clear that, despite its rapid growth, shadow banking remains substantially less important than formal banking as a source of credit in China.
The financial system and the central government appear to be well positioned to deal with such a crisis.
First, shadow banking is small enough compared to the size of the total financial sector to be handled without disaster. Second, most of the shadow banking is closely enough tied to banks that they are likely to end up honouring their implicit guarantees and dealing with most of the mess on their own. Third, the authorities have more than enough fiscal capacity to deal with even a large shadow banking crisis, given quite low central government debt to GDP ratios, even when adjusted for off-balance sheet obligations, such as the need to rescue some local and regional governments.
In fact, the Chinese central government has taken already taken important measures to tackle this issue in recent years. In October of 2014, a document entitled “The Directions of the State Council on Management of Local Government Obligations” was issued to outline a framework and principles for regulating how local governments raise, use and repay their debts.
In the beginning of 2015, the Ministry of Finance (MOF) approved a local debt swap scheme with a quota of RMB 3 Trillion. Under this scheme, each provincial government is able to sell low-interest local bonds directly to commercial banks to replace high-interest debts obtained from shadow banking channels. A quota of RMB 1 trillion has been allocated to the provincial level as of the first quarter of 2015.
In sum, China’s shadow banking sector is not especially large by international standards, is relatively simple (with low levels of instruments such as securitized assets and derivatives), and is overseen by regulators who have so far shown themselves alive to the most important risks (namely funding risk and lack of transparency) and have taken prudent steps to minimize these risks. The authorities take seriously their mandate to maintain financial stability, and have acted pre-emptively (for instance in the inter-bank squeeze of June 2013) to nip in the bud practices that might threaten that stability.
We believe there are eight key objectives that should be pursued in designing a better regulatory approach to shadow banking:
• Expand financial services to SMEs, rural businesses, and households
• Diversify financial services provision beyond the current bank-centric model
• Increase the efficiency of the financial sector
• Strive for a level playing field across the financial sector
• Promote the wider financial reforms being introduced in China
• Increase systemic safety
• Increase consumer opportunity and safety
• Help ensure the PBOC can exercise appropriate monetary policy tools
Seven Reform Strategies are recommended -
• Free the banks of most policy obligations and constraints that are not about safety
• When using the financial sector for social policy, work through all relevant financial institutions, not just banks
• Clearly define the nature of the safety net for the different financial institutions
• Heighten the regulation of shadow banks and increase their transparency
• Move monetary policy away from an overreliance on banks
• Focus on building the corporate bond markets and the institutional investor base
• Focus on cleaning up equity markets and corporate governance"
The Brookings Paper resonates with other more-balanced recent research into China's shadow banking problems. See my recent summary entitled "Shedding light on China's shadow banking".
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