What is shadow banking? Unpacking the risks for China

Pictured here are models of a real estate development in Shanghai in 2005, when China’s real estate boom was gaining momentum.

China photos | Getty Images News | Getty Images

BEIJING – China’s real estate woes have drawn renewed attention to the world of shadow banking and the risks it poses to the economy.

Shadow banks – a term Minted in the USA in 2007 – refers to financial services offered outside the formal banking system, which is highly regulated.

In contrast, shadow banking institutions can more easily lend money to more businesses, but these loans are not secured in the same way as traditional banks. This means that a sudden and widespread demand for payments can have a domino effect.

Furthermore, limited regulatory oversight of shadow banking makes it difficult to determine the true extent of debt – and the risk to the economy.

In China, the government has tried to limit the rapid growth of this non-bank debt in recent years.

Developers were able to borrow generously from shadow banks, circumventing restrictions on borrowing for land purchases.

Logan Wright

Center for Strategic and International Studies

What makes the country’s situation different is the dominance of the state. The largest banks are state-owned, making it more difficult for non-state companies to use traditional banks for financing.

The state-dominated financial system also meant that, until recently, participants borrowed and lent money on the assumption that the state would always be there to provide support – an implicit guarantee.

Estimates of the size of shadow banking in China vary widely, but are in the trillions of dollars.

Shadow banking and real estate

China’s real estate sector, estimated to make up a quarter of the economy, lies at the intersection of shadow banking, local government finance and private wealth.

Real estate companies purchased land from local governments that needed the revenue and economic benefits of regional development. People in China jumped at the opportunity to buy their own homes – or speculate in real estate – as prices soared over the past two decades.

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“Developers have been able to borrow generously from shadow banks and circumvent restrictions on borrowing for land purchases,” Logan Wright, chairman of the board of trustees of the Center for Strategic and International Studies on Chinese Economics and Business, said in a statement April report.

“As a result, land prices continued to rise and developers subsequently drove up housing costs to maintain their margins.”

Wright said Beijing’s recent restrictions on shadow banking have prompted ever-aggressive developers to turn to other sources of financing to repay existing shadow bank loans. He noted that developers have started relying more on pre-selling apartments to homebuyers – through mortgages – and slowing construction to save costs.

The deleveraging campaign that China’s leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China’s structural economic downturn began

Logan Wright

CSIS Trustee Chair in Chinese Economics

Then in August 2020, the government took serious action against property developers by placing caps on debt levels.

After decades of rapid growth, Chinese real estate giants like Evergrande and Country Garden are gradually struggling to repay their debts. Their cash flows have dried up, largely due to declining home sales.

Almost simultaneously, news emerged that the Zhongrong trust fund was unable to repay investors for some products. The fund had lent money to the developers.

Hiding money in trust funds

It is clear that at least some of the troubled real estate companies have kept some of their debt off the books.

“Recent disclosures have raised questions about developers’ lax controls and aggressive accounting practices during the boom years,” S&P Global Ratings said in late August.

This summer, real estate developer Shimao disclosed that it had far more debt than previously disclosed – without its former auditor PricewaterhouseCoopers knowing, the S&P report said. PwC resigned as Shimao’s auditor in March 2022.

“Some of these funds, these hidden debts, were provided by the trust companies,” said Edward Chan, director at S&P Global Ratings, in a telephone interview with CNBC.

“These trust companies were essentially part of the shadow banking system in China.”

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Trust funds sell investment products, typically to wealthier households.

According to data from China Trustee Associations cited by Nomura, at the end of March, about 7.4% of the value of trust funds in China was invested in real estate, equivalent to about 1.13 trillion yuan ($159.15 billion).

They estimate that the actual size of property developers’ loans from trust companies is more than three times higher – at 3.8 trillion yuan as of the end of June.

“Some trust products invested in the real estate sector may have failed to disclose the actual use of funds or intentionally made this information less transparent to circumvent financial regulations,” the Nomura report said.

Economic consequences

Banks in China also used trust companies to hide the true level of risk on their balance sheets while making money by making loans to restricted borrowers – such as real estate developers and local governments, CSIS’s Wright said.

He estimated that shadow banks accounted for nearly a third of all loans in China from 2012 to 2016 – and that China’s loan growth was halved following Beijing’s crackdown on the sector.

Today, Beijing’s problem is that it must balance its crackdown on shadow banking and real estate developer debt with other types of economic support.

“The deleveraging campaign that China’s leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China’s structural economic downturn began,” Wright said.

“China’s economic growth over the next five to 10 years will depend on how successfully and efficiently the financial system can shift resources away from real estate-related loans and local government investment projects toward more productive private sector enterprises,” he said.

“Otherwise, China’s economic growth rates will continue to slow to 2 percent or less over the next decade.”

https://www.cnbc.com/2023/09/14/what-is-shadow-banking-unpacking-the-risks-for-china.html What is shadow banking? Unpacking the risks for China


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