As we kick off 2017, constructive, though prudent, economic reform is likely to hold precedent over all other New Year’s resolutions for the world’s second largest economy. Despite China’s efforts to quell the substantial growth of its shadow banking sector in the beginning of 2015, the industry has bloated to take hold of a fifth of China’s lending market. Investors, while generally optimistic and hopeful about the Chinese climate in the short-run, are increasingly cognisant of this potential credit bubble, and for good reason. This development comes along with an especially volatile climate, subject to several macroeconomic factors at play: the strengthening US dollar, an expected rise in US interest rates, capital outflows from China, and speedy Chinese debt growth to name a few in particular.

Having an important causal effect on this current economic development is the peculiarity of the Chinese shadow banking industry, and its concomitant relationship to local governments. Shadow banking, while sounding mysteriously ominous, is not necessarily so menacing. In fact, most, if not all, developed countries require some kind of shadow banking to raise capital. In the US and Europe, it is often witnessed in the form of lending and credit that resides off banks’ books provided as a financial service by private equity funds, hedge funds, and other financial intermediaries. In China, the system is significantly more complex. In 2008, after the financial crisis, the Chinese government sent out a stimulus package, inundating the markets with credit. The government carried out this stimulus through China’s banks, which are by in large controlled by the government itself. In effect, Chinese officials not only have the power to dish out funds, but also have immense influence over where the money goes. As a result, a lot of this credit was directed towards local government financing vehicles, which are companies that act as financial intermediaries for the government, preventing the borrowing from appearing on government books. These local government financing vehicles would invest heavily in the country’s infrastructure, often providing boosts to housing and state-owned enterprises (SOEs). However, leveraged investment in infrastructure can only go so far, as declining global demand has demonstrated China’s dependence on foreign consumption and investment. State-owned enterprises cannot generate the returns they had before the financial crisis; manufacturing and exports will no longer serve as the backbone of China’s economy. This has spurred an increased focus on domestic demand, as China looks to transition to a services-based economy. In an era of grounded, near-zero interest rates, a seemingly insatiable demand for higher yield has saturated markets worldwide, giving rise to riskier credit investments and a more volatile market, induced by shadow banking.

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A major product of such a climate, the wealth management product (WMP), was engineered to satisfy this need for a higher yield curve, whilst residing off banks’ balance sheets—another invention, courtesy of the Chinese shadow banking sector. WMPs became so popular that they swelled to $3.9 trillion, 35 per cent of China’s overall GDP, fermenting a delicate credit bubble with extensive exposure. More alarming than the sheer size of the investment in these WMPs is the pace at which they continue to grow, despite recent efforts to regulate these products. The People’s Bank of China (PBOC) estimates that WMPs grew 30 per cent in 2016, outstripping normal lending, which grew only 10 per cent. It seems that demand for higher yield, while investors cannot acquire such returns with a mere 1.5 per cent on bank deposits, has curbed bank deposits while money supply continues to soar. As is typical of the nature of shadow banking products, WMPs have no reserve requirement ratio, where normal bank deposits limit the amount of funds available for reinvestment to 83 per cent of deposits as per their reserve requirement ratio. Effectively, WMPs allowed for the growth of money supply at breakneck speeds while deposits remain markedly the same. Companies, which receive funds backed up by WMPs, are free to take that money and reinvest it entirely into another WMP, creating a multi-layered chain of WMP investments dependent on each other. Often called WMP-squareds, these chains are very reminiscent of the collateralised debt obligations (CDOs)—products with tranches of mortgage-backed securities—that contributed to the financial crisis of 2008.

In 2014, China attempted a crackdown on its shadow banking sector in efforts to reduce the risks of such a heavily leveraged country, preventing local governments’ use of LFGVs in obtaining funds. While this temporarily caused a large reduction in shadow banking activity, the demand of higher yield was left unseated, creating the WMP dominant climate in 2015 when LFGVs were allowed to serve again as intermediaries between governments and banks. Now, China holds its breath, trying not to wake the bear with oppressive regulations. Beginning this year, China has begun to test markets, implementing a regulation mandating that banks raise an additional capital amount of 1 per cent of their WMP investments. The country will now have to walk the fine line between too much and too little regulation, as there is no room for error in buffering this fragile $3.9 trillion house of cards.