China’s Shadow Banking Industry

On Thursday, June 20, 2013 China’s overnight interbank lending rates — the rates at which banks borrow from each other — spiked to their highest levels ever: The seven-day repurchase rate reached a record 12.45%, closing at 11.62%, triple the year’s average of 3.85%, according to Bloomberg.

China’s central bank, the People’s Bank of China (PBOC), declined to inject liquidity to calm the markets. On Monday, June 24, 2013 the Shanghai Composite Index witnessed its biggest decline in four years and continued to drop the following day until the PBOC said finally that it would infuse more money to stabilize the system.

An explanation emerged: The central bank allowed the squeeze on bank credit to rein in irresponsible bank lending to the so-called shadow banking industry. With trillions of dollars in reserves and money supply growing at 15.8% during the last year, China has no real liquidity shortage. Yet, small to medium sized enterprises are starving for capital, while bank loans fund speculative shadow banking wealth management products and questionable local government backed projects instead, according to Xinhua, China’s official news agency.

Shadow Bankers

In a popular practice, shadow bankers raise funds from investors through wealth management products (WMPs), often offering 6% annual interest, compared to ordinary bank deposits carrying a low, government-set 3% rate. The shadow bankers, in turn, lend the proceeds from WMPs to small- to medium-sized enterprises or local government projects otherwise unable to get bank loans.

The problem: WMPs are short-term, often maturing in three or six months, but are funded by these longer-term loans. To pay off investors when the WMPs come due, WMP lenders borrow from banks, which get their funds through the interbank lending market. The Chinese liquidity shortage in June was the PBOC’s attempt to squelch the growth of WMPs.

Shadow banking, or lending that takes place beyond China’s regulated banking industry totaled $6 trillion at the end of last year, or 69% of Chinese GDP, according to JPMorgan Chase.

The low cost of money now guarantees banks a 300 basis point profit for every loan, compared to 100 to 150 basis points for their Western counterparts. Low deposit rates enable Chinese banks to make loans often without regard to creditworthiness.

Last year, the PBOC started liberalizing rates, giving banks the flexibility to set 10% plus-or-minus benchmark lending and deposit rates, and the next step could be to widen that band by 20%. In addition, the government is likely to develop a corporate bond market, to privatize further at least one of the biggest Chinese banks, and to open the sector to foreigners to provide more competition to domestic banks.

As China starts playing a role in determining global interest rates, it will be harder for the United States Federal Reserve and the European Central Bank to control things as they’ve done so far.