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Forex Flash: Shadow Banking Darkens China Policy Outlook - Alliance Bernstein

Anthony Chan, Senior Asia economist at Alliance Bernstein notes that the shadow banking system is darkening China´s policy outlook.

He begins by noting that the Chinese Government's measure to cool the property market last week could be the start of a broader tightening campaign and the shadow banking industry might be next in line for action.

He writes, “Outgoing Premier Wen Jiabao’s final economic report last week included a relatively stringent M2 money-supply growth target of 13%—just below actual growth of 13.8% in 2012. The real GDP growth target was basically unchanged at 7.5%. This implies a neutral to slightly tighter monetary policy stance by the People’s Bank of China (PBOC).”

However, he adds that traditional metrics such as M2 and bank loans are becoming less accurate in measuring China´s liquidity since shadow banking, namely off balance sheet or informal lending, surged in 2009. He notes that the PBOC´s broader measure, known as “total social financing (TSF) is a better guage of overall liquidity as it captures a variety of informal funding channels including trust loans, entrusted loans, corporate bonds and equity financing in addition to traditional bank loans.

He continues to explain that in 2012, the TSF stock/GDP ratio jumped to almost 200% from a trough of about 140% in 2008–2009. Further, the PBOC has capped outstanding formal bank loans at about 130% of GDP since 2009, but the informal lending/GDP ratio has surged to 65% in 2012, a 15 percentage point jump over four years. Chan writes, “It’s too soon to say that this is a bubble. Still, it’s clear that traditional bank loans have become less important in funding economic activity, particularly in the past year. Corporate bond financing and trust loans have become very popular. After a surge in recent months, trust loans have surpassed insurance as China’s second-largest financial sector by assets after banking. As a result, informal lending has surpassed formal loans in the TSF flow.

He sees that trust funds have allowed companies to get funding faster, as Chinese banks have become more reluctant to lend to state firms, particularly property developers and local government entities. Additionally, Banks have also sought to circumvent formal lending curbs by making off-balance-sheet loans.

However, Chan feels there are some merits to informal lending. He comments, “It provides a new funding channel for the private sector, particularly small- and medium-sized enterprises. Corporate bond issuance promotes the development of capital markets. And for borrowers, it’s between 100 and 130 basis points cheaper to tap the bond market than to take a bank loan.”

Nevertheless, he feels that there are problems at play. Firstly he feels that there is a duration mismatch for bank´s balance sheets because a new wave of wealth management products (WMPs) have been a major source for informal loans. WMPs now account for about 18% of Chinese households´bank deposits and have an average duration of just three to six months. For bonds that banks purchase, and for informal lending, the duration is three to ten years.

Secondly, he notes that a potential downturn in the property sector is a major vulnerability. While the exact composition of informal lending borrowers is sketchy, we know that developer and local governments have aggressively tapped the trust loan markets. Finally, he feels that the policy response may be a risk too. He writes, “Theoretically, the government can smooth the tightening process. More often, China tends to be blunt and abrupt when cracking down on imbalances.”

Looking to the bottom line, Chan feels that the more extreme the informal lending boom becomes, the greater the potential hangover. He finish by adding, “As China grapples with these challenges, we suspect the government’s overall policy stance may not be as pro-growth as previously thought.”

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