The risky strategy of shadow banking has already backfired on the West – but can Beijing make it work, asks Peter Jones
Andy Murray won Wimbledon, the Lions won Down Under, the weather has finally turned properly summery, the economy is on the mend – what could possibly go wrong? Well, erm, another banking crisis, that’s what. Sorry about that. Even worse, there’s not a lot we can do about it, because it is brewing on the other side of the world, in China.
The Chinese have discovered the world of shadow banking. This may sound like a dubious activity but in fact it is perfectly lawful, even necessary. The problem with it comes when it gets out of hand, as it did in the 2000s in Wall Street and the City, eventually causing the financial crisis of 2008-9.
It is a form of lending that doesn’t come out of traditional banking. Anything which is in effect a loan but is dressed up to look like something different – like, say, a corporate bond which a pension fund buys, or money a pawn shop gives out in exchange for granny’s jewellery – is shadow banking. All those jazzy securitised mortgage products and the derivatives based on them which turned poisonous were also shadow banking.
This has boomed in China because, as we know, the Chinese economy has been booming, creating a lot of wealth. A bank may seem the obvious place to deposit this wealth, as China has some of the world’s biggest. Unfortunately, it only has big banks and they are quite tightly controlled by the government, which owns most of them. And because the government has wanted to keep credit fairly cheap to finance continued economic growth, that means interest rates on deposits have been low. Indeed, there have been two periods when deposits lost money – between February 2007 and October 2008, and from February 2010 to October 2011, the real one-year interest rate was negative.
Allied to this, the government, because it has wanted to avoid creating asset bubbles, has put ceilings on how much these banks can lend. Much of the available borrowing has also been taken up by local governments, which are the main engines of local economic development, in order to finance the construction of houses and factories.
What this created was a pool of people looking for somewhere else more rewarding to put their money, and another pool of people looking for credit, which they were unable to get from the big banks, to finance their commercial expansion. Thus shadow banking arrived to meet both these demands.
It has become a vast business. One estimate by JP Morgan puts it at about $6,000 billion. That would make it about a fifth of the size of the traditional or formal banking sector.
Well, China is a huge economy and this is just oiling its wheels, surely. To an extent, it is, which is why the authorities have tolerated it. But then, this was also said quite fervently about the West’s credit boom which led up to the 2008 financial crisis and the Chinese government are not anxious to repeat that mistake.
One of the lessons of that disaster was to prove the worth of work by economist Hyman Minsky. In 1992 he published a paper which interpreted John Maynard Keynes’ general theory of employment, interest, and money in the modern financial world and sought to distinguish between stabilising and destabilising financial systems.
Simplifying a little, he argued that there were three types of debt – hedge, speculative, and Ponzi – not particularly helpful labels as they can be confused with other things. Hedge debt, he said, can be financed by cash flows. So if you own properties, and the rents all comfortably cover the cost of the debt raised to buy the properties, that would be a hedge debt.
Speculative debt is where the cash flows are enough to meet the debt payments, but not enough to pay off the principal of the loan. The value of the properties are such that if need be, they can be sold to pay off the debt. Such a property-based enterprise can continue to function by continually raising new debt to repay the old one.
Ponzi debt occurs where cash flows are not enough to pay either the interest or the principal of the loan and new investment is required to meet existing obligations. This is not sustainable and it is fraud. Arguably it is what happened when financial institutions such as Lehman Brothers collapsed; indeed that event is referred to by some as a Ponzi moment.
The key point to realise is that a collapse in the value of the assets on which debts are being raised can turn, to use Minsky’s terms, speculative finance into Ponzi finance, and supposedly safe hedge debt into risky speculative debt. China’s authorities have been reading Mr Minsky and the history of the West’s financial crisis with great interest. Last November, the chairman of the Bank of China, Xiao Gang, wrote about the huge growth of funds called wealth management products, representing about a third of the value in the shadow banking system, in an article in the People’s Daily newspaper. These are loans to companies, essentially offered through off-balance sheet vehicles so higher interest rates could be charged. These are then packaged up and offered to investors seeking better interest rates than they can get from banks.
Mr Xiao wrote that these wealth management products had “become a potential source of systemic financial risk over the next few years” as “many assets underlying the products are dependent on some empty real-estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations”.
Indeed, the cash flow problems might become such that managers of these products might be tempted to raise the repayment money they need by issuing new products, he feared, adding: “To some extent, this is fundamentally a Ponzi scheme.”
China’s authorities seem to agree. Worried that too much money has gone into property and that smaller companies are starved of finance, causing an economic slowdown and threatening a property price collapse, which in turn may cause a financial crisis, they have been taking action to head it off.
This is painful, involving some jacking up of short-term interbank lending rates, and is itself causing a bit of a slowdown. If it doesn’t work, we might see a return to the panic-stricken days of autumn 2008. But if it does work, we might be looking to Beijing for lessons in how to manage our financial system.