China Shadow Banking

In China, the size of the shadow banking sector appears to be very large, representing half of the new credit issues in 2012. Shadow banks in China take the form of corporate bonds, entrusted loans, bankers’ acceptances and trust loans. Corporate bonds are the largest component in the form of shadow banking. Shadow banking give investors high yield compare to products in normal banking system. Loans provided by shadow banks have been growing rapidly in China in recent years (refer to figure 1 below, the pink area). Borrowers that use the shadow banking systems are generally with higher risk and unable to get through traditional resources. Borrowers are including small to medium size businesses and even the local governments. Local governments fall into this category because their sources of revenues and abilities to repay prior loans have declined. Most of the “ghost towns” in China developed by local government are funded by shadow banks. Many of the characteristics of shadow banking systems in China appear to be speculative in nature and are similar to the subprime bubble in the United States. The PBOC (People's Bank of China) estimates the shadow banking accounts for over 20% of all outstanding loans.

There are a few factors what makes entities walk away from banks and turn to shadow banks to borrow.

• Government and regulatory impact

Chinese government impose a strict loan approval process to banks and there arecaps on bank lending volumes, due to the limit of 75% loan to deposit ratio. On the other hand, shadow banks are not regulated under such loan to deposit ratio. By avoiding high reservation required by PBOC, shadow banks realise a higher interest profit. Unlike the many other countries, the interest rates offered by commercial banks in China are set by the government not by the market. This encourages commercial banks to give loans to big and well-connected state-owned companies and they feel no matter how the company performs, Chinese government will always back them.

• Small and medium-sized enterprises difficult to get loans

Since the global subprime crisis, many state-owned businesses has been functioning the so called shadow banks that lending money to small businesses. The small businesses are unable to get loans from the regular banks due to the tightening of the financial market policies so they take the high interest loans (36-60%) that shadow banks are offering.

Risk and Returns

On the positive side, shadow banking has significant benefits on boosting Chinese Economy. It makes funds available for small and medium-sized enterprises which are not qualified to obtain a loan from legal banking system.

However, we cannot deny the negative side brought by the shadow