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The Growing Problems in China’s Shadow Banking System

Last Weeks move by Central Huijin Investment to begin buying shares in China’s big four state banks was greeted with enthusiasm driving up the share prices of ICBC by 8.9%, CCB’s by 9.1%, BOC’s by 9.8%, and AgBank’s by 12%. Remember that Central Huijin Investment is the domestic arm of China’s SWF China Investment Corp. (CIC) and already the largest shareholder in the big four banks. The last time Huijin made share purchases in major banks back in 2008 the Shanghai Composite rose 9.5% the very next day but then fell more than 25% within about a month. As Jim Chanos pointed out in a recent Bloomberg interview, the recent share purchases are more symbolic than anything and if the Chinese government really wanted to shore up banks they would buy stock directly from the banks not on the open market, I concur wholeheartedly.

However the real danger in China’s financial sector could lie in China’s shadow banking system. In a Bloomberg article almost 2 weeks ago it was estimated that non-bank lending has increased from about 4% of all Chinese loans in 2002 to an estimated 55% by the end of this year. From the article:

Lending by non-bank institutions such as trusts, leasing companies and pawnshops, which accounted for 4 percent of loans in China in 2002, according to estimates by Barclays Plc (BARC), could rise to 55 percent of the total next year, Fitch estimated in a July report. The ratings firm said all new lending in 2011 will increase to 18 trillion yuan from 16.5 trillion yuan in 2010.

“Trusts are facilitating the movements of assets off the balance sheets of banks — there are no regulations on where it can go,” said Charlene Chu, a Fitch analyst in Beijing who co- wrote the report. “When there aren’t enough guidelines, who knows what’s going into this stuff?”

The shadow-banking credit boom could lead to a new pile of bad debt. Almost half the money managed by trusts is invested in infrastructure and real estate projects, according to figures from the China Trustee Association, an industry group. Local governments had 10.7 trillion yuan in debt borrowed through financing vehicles at the end of last year, according to a June report by China’s National Audit Office. Nearly a third of those entities are losing money, according to a study by Beijing-based analysts Zhang Xu at Guosen Securities Co. and Qiao Wei of China Asset Management Co.

The whole article is well worth a read, of particular interest are the parallels to the U.S. bank panic of 1907 and the fact that some property developers are borrowing at rates of between 12 – 25% to fund their projects. We have seen this movie before, when large amounts capital are redirected into the shadow banking system that operates with little or no regulation it never ends well. China’s excesses are currently overshadowed by the unfolding drama in Europe but I expect we’ll be hearing more about it in the months ahead.

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