By Yi Wen, Assistant Vice President, and Maria Arias, Research Associate
The low (and sometimes negative) real interest rate environment resulting from government stimulus following the 2008 recession drove numerous individuals and investors to look for higher yields and a more diversified portfolio through the “shadow banking system.” Moreover, significant restrictions were placed on the formal banking system in 2010 to curb rapid credit growth and contain increasing inflation. This reduced credit availability for many individuals and small- to medium-sized companies, which caused many to turn to informal and shadow financing for loans. As a result, shadow banking in China ballooned, growing by 28 percent in 2011 and 42 percent in 2012 and fueled by those looking to circumvent interest rate controls and tighter credit regulations.
Shadow banking can have economic advantages—mainly widening access to credit and better rewarding savers—but its underground nature can cause serious systemic risks, especially when the system is interconnected and parties are highly leveraged.
Amidst slowing long-term growth in cities where the economy is now declining faster, such as the district of Wenzhou, underground borrowers are defaulting on their payments more frequently, widening worries that the shadow banking sector will collapse. In this southeastern district, more than 80 businessmen declared bankruptcy or even committed suicide over a six-month period in 2012 because they could not make payments on underground loans.1 The lack of regulatory oversight thus exacerbates the potential systemic risk.
Though the sector’s rapid growth is concerning, the relative risk is not as large. Including other sources of informal financing,2 the Chinese shadow banking system at year-end 2012 was about 36 trillion yuan, or 69.3 percent of GDP. Trusts and wealth management products, the two largest components, accounted for 14.5 trillion yuan, or 28.1 percent of GDP. For comparison, shadow banking in the U.S. was 170 percent of GDP.3
In contrast to the United States, the relative impact of a system collapse would be more limited in China for several reasons:
- Investors are less leveraged than in the U.S. prior to the Great Recession.
- State banks are more profitable.
- Institutions are less interconnected.
- The boom is mostly driven by domestic investment instead of foreign capital inflows.
Also, the government announced it would not bail out nonbanks in the case of failure. Therefore, the greatest burden would fall on domestic investors, not the government or taxpayers. Finally, the wealth management products and trusts that account for most of the shadow banking boom in China are much less complex than the innovative financial products sold in the U.S. Consequently, a collapse of the shadow banking sector in China would have limited impact on the Chinese economy as well as on the world economy.
Assume the worst possible scenario where a shadow banking system collapse in China is similar in nature to that experienced in the U.S. during the Great Recession. Considering that the level of GDP declined about 10 percent in the U.S. from its pre-recession trend, the level of GDP in China would decline by about 4 percent—given the relative size of its shadow banking system. China represents only about 12 percent of world GDP, so a 4 percent slowdown in economic activity in China would not amount to a large decline in world GDP.
Notes and References
1 “Shadow Loans Hard to Squelch in China City Hit by Suicide.” Bloomberg, March 27, 2013.
2 Zhu, Haibin; Ng, Grace; and Jiang, Lu. “Shadow Banking in China.” JPMorgan, May 3, 2013.
3 “Global Shadow Banking Monitoring Report 2013.” Financial Stability Board, Nov. 14, 2013.
- Central Banker: Mapping the Global Shadow Banking System
- The Regional Economist: A Look at Japan’s Slowdown and Its Turnaround Plan
- Economic Synopses: Currency Returns During the Financial Crisis and Great Recession