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Shadow Banking: A Stress, not a Threat

The specter of shadow banking, or loans outside the banking sector, has hovered around China's financial system since the government tightened formal lending at the outset of the global crisis. When news of bankruptcies at some private companies in Wenzhou broke out in recent months, stock markets reacted with panic selling, punishing banks beyond reason. This is probably due to the lack of understanding about shadow banking in China. While we may not have seen the last of such bankruptcies—a caution that near-term risks remain—market concerns, in our view, are overblown.

Shedding light on shadow banking

Shadow banking takes many forms, but the concern is in private lending, or loans extended by non-bank entities to borrowers that have been shut out of formal lending. The loans are usually short-term, from a few days to about six months, at annualized lending rates ranging from 24 percent to  40 percent. Private lending boomed in 2010; it now accounts for 30 percent of shadow banking and is its fastest-growing and highest-risk component.

According to a survey by the Wenzhou branch of the People's Bank of China, the main sources of funds for private lending are local companies (30 percent), local households (20 percent), non-local companies and households (20 percent), and banks (10 percent). To them, private lending offers better returns on their cash than the negative real deposit rates. The survey does not identify the borrowers, but we believe most of them are small and medium-sized enterprises (SMEs) and small property developers.

Where are the risks?

The growth in shadow banking has added to the market liquidity in China. Property developers unable to obtain bank loans have used the channel to fulfill their capital needs in the expectation that economic growth would remain strong and property demand robust. It also helps explain the stubbornly high property prices in China even after 18 months of tightening. The result is that shadow banking has undermined China's monetary and property cooling efforts, prolonging the tightening cycle which could then trigger a slowdown in fixed-asset investments.

Another risk lies in the potential halt in private lending due to risk aversion arising from economic concerns and further media reports of borrower defaults. This would create a negative feedback loop: A reduction in the supply of funds would lead to higher borrowing costs, which would then take their toll on the profit margins of SMEs and smaller developers. Businesses that have relied largely on shadow banking to aggressively expand would then run the risk of bankruptcy, leading to further funding squeeze. As most borrowers are small property developers, a private-lending crunch would force some of them to sell their projects at discounted prices, putting pressure on the property market in cities where private lending is more active.

In short, the greater risks are in potential SME defaults and lower property prices. The first would increase the amount of non-performing loans in the banking system, especially the smaller banks that have more exposure to SMEs. The second could mean that some of the smaller and highly leveraged developers would need to be liquidated or consolidated.

How alarming are the risks?

We do not expect these risks to lead to a systemic banking-system meltdown or a property bubble burst in China.

First, while it is growing fast, shadow banking is not yet big enough to threaten China's banking system. There is no official data on its absolute size, but we estimate shadow banking at close to 20 percent of total bank loans, with the highest-risk category, private lending, representing only 6 percent. Overall, Chinese banks are in good shape, having made extra provisions during the good times. As of June 2011, the listed banks' loan-loss coverage ratios ranged from 200 percent to 350 percent, which would cushion even new bad debts that may arise going forward. The banks have also raised new capital to strengthen their balance sheets even amid sustained profit growth for the last two years.

Second, Chinese banks, especially the bigger ones, have relatively low exposure to the property sector. At the six biggest banks, loans to property developers make up only 5 percent to 10 percent of total. The latest official stress tests also suggest that credit risk from real estate exposure, which is currently 20 percent of total loans, would be manageable even if property prices fall 40 percent. This is because 98 percent of all mortgages have loan-to-value ratios below 80 percent, real estate project loans have a collateral-to-loan ratio of 189 percent, and the current non-performing loan ratio remains low at less than 2 percent.

Third, the government has plenty of options to respond to market dislocation. Should property prices drop substantially more than the policymakers deem desirable, authorities could lift the current home-purchase and mortgage restrictions. Given that the underlying housing demand in China remains strong, any relaxation would help with a rapid price recovery, as seen in previous property tightening cycles.


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