Dark Underbelly of Chinese Shadow Banking Beginning to Spiral Out of Control

Dark Underbelly of Chinese Shadow Banking Beginning to Spiral Out of Control

By Gregory L. Tuttle

The Lending and Financing of China’s Extreme Growth

In order to fuel GDP growth, lending is imperative. Lending helps expand operations and finance projects that companies cannot internally fund. The source of these funds is becoming more reliant on shadow banking in the Chinese economy. Shadow banking is comprised of unregulated debt instruments provided by wealth managers and investors, not banks, commonly in the form of trust loans and investment opportunities. The funds are gathered from investors, as are all other debt instruments, but then they are sent into the world without investors knowing into whose hands the funds will fall. These are “shadow” loans because they are off-balance sheet items and their destination is uncertain.

The terms on the shadow loans are typically payments or repayments within 3 to 6 months, but the loans themselves are pushed to firms for years at a time. The only way the shadow banks can make the payments to depositors are to find more depositors, creating a Ponzi-scheme like vehicle that will inevitably crash. Many of these loans, promising higher returns with no risk, are beginning to default and are creating concern within the Chinese government about economic health and stability.

Some of the creators of these loans are insurance companies, and this poses a large risk for their solvency in the case of widespread defaults and the need to insure the policies the insurance companies provide. In the US during the Great Recession, the imbalance of liabilities and unsafe assets caused a bail-out of AIG, one of the world’s largest insurance companies. The worry for China is that this will materialize for their insurance firms, but on a much grander scale, as the shadow banking industry has ballooned to approximately $9.7 trillion by the end of 2017. Bloomberg shows the numbers at approximately $15 trillion. If the hole bursts in the dam of shadow debt, the fear is a ripple felt world wide.

Next Steps for Bringing Light to the Shadows

Leadership in Beijing is assessing the situation and the inherent risks of this complex web of off-balance sheet liabilities. They are also attempting to enact regulations to ensure that the risks can be mitigated. This past year, the Financial Stability and Development Committee was created in Beijing to asses these risks and find solutions for the problem.

Not only are leaders worried about financial and economic repercussions of the potential catastrophe of the failing shadow banking system, they are worried about national security as well. Countries around the world, including Japan, the US, and Australia, are keenly watching how events unfold because China is becoming one of the most powerful economic forces for trade in all sectors, including military arms. A large inflection of reduced asset prices and foreign exchange volatility could push a ripple through the economies of the world and send everyone into a credit crunch like those of the Great Recession, or worse, worrying the government of potential attack.

The big question isn’t how will this be resolved, rather, when will the beast rear its ugly head in full force?