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China’s Shadow Banking Problem

Business, China, Company Strategy, Economics
By John Richardson on 06-Dec-2012

By John Richardson

IN the best of all possible worlds, more than a billion people in the emerging markets will become a great deal richer over the next few decades.

As a result, they will be able to much more easily afford all of the things made from, or containing, chemicals and polymers – such as plastic wrapping for their food, refrigerators, automobiles and homes.

This was the assumption underlying many of the discussions the blog had with industry executives at last week’s Gulf Petrochemicals and Chemicals Association (GPCA) conference in Dubai last week. Yet again, as we have heard so many times before, it was widely assumed that “if we take care of feedstock advantage, and other key elements of cost efficiency, all we have to do is build capacity in basic petrochemicals and demand will take care of itself.”

Perhaps this upside scenario will prove to be correct. But what if it proves to be wrong? How smooth will the process of emerging-market personal wealth growth ultimately turn out to be?

An example of the increasing complexity of the demand environment – China’s shadow banking system – has gained more attention this week.

“Shadow banking is flourishing in China, helping to make non-bank institutions as big a source of credit as banks themselves since July – something that has never happened before,” wrote the Financial Times, in this article.

“Chinese bankers, leading rating agencies and the International Monetary Fund have all warned about risks from the surge in loosely regulated lending, with some even pointing to parallels with developed economies before the global financial crisis. But the Chinese government itself has taken a permissive stance,” added the newspaper.

The FT said that:

*Estimates about the size of shadow banking vary widely depending on how it is defined. Tying together various threads of official data, UBS economist Wang Tao believes it is no smaller than Rmb13.6tn ($2tn), or about one quarter of this year’s gross domestic product, and could be as big as Rmb24.4tn, or nearly 50% GDP.

*Trusts, the backbone of the shadow sector, had Rmb6.3tn of assets under management at the end of the third quarter, up 54% from a year earlier and five-times more than at the start of 2009 (see the chart below for another estimate of the growth in trust funds).

 

MI-BS656_CTRUST_NS_20121126185104.jpg

 

A problem is that, just as was the case with sub-prime, people are investing in the shadow-banking system on the assumption that asset prices will always increase in value. In tomorrow’s post, we will explore why this idea might be flawed.

“It has begun to get to a degree like we saw in the financial crisis in the west. Products are being created that regulators don’t fully understand, banks don’t fully understand and customers don’t fully understand,” a commercial banker, who used to work as a regulator, told the FT.

We also worry that the small and medium-sized enterprises’ continued reliance on the shadow-banking system indicates the difficulty in increasing their economic role at the expense of the over-dominant, economically-damaging SOEs.

And in general, the opacity and complexity of the shadow-banking system suggests to us that the government will struggle to prevent further misallocation of capital and asset bubbles.

What do these latter two points mean for economic rebalancing?