China’s Debt Dilemma: Deleveraging While Generating Growth

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Much of the media coverage of China’s economy suggests that the country is headed for a financial crisis. China’s mountain of debt is decried, local government finances are labeled menacing, and a property bubble is called disastrous. But this picture is misleading. While China has serious debt problems, with prudent macroeconomic policies and productivity-enhancing structural reforms, the challenges should be manageable if underlying fiscal issues and growth-related reforms are addressed.

Real but Overstated Financial Risks

    • China’s level of debt has grown rapidly since 2009, but this credit boom fundamentally differs from others. The debt surge is the result of a deliberate state-driven stimulus program to stave off economic collapse in the aftermath of the global financial crisis. It has not been accompanied by the usual external imbalances, fiscal deficits, or overleveraged housing market that triggered financial crises in other countries.
    • While corporate debt has skyrocketed, there is no evidence of widespread distress: risks remain concentrated in particular sectors with excess capacity and large state-owned enterprises. These pockets of distress will see mounting losses, but rising default rates appear to be anticipated and incorporated in the prices of the relevant stocks and bonds.
    • The Chinese government’s balance sheet remains relatively healthy compared to that of its peer countries. The central government has the resources to rescue systemically important firms and banks, limiting the potential damage from mounting financial stress in the corporate sector. But those resources will not last indefinitely.
    • Shadow banking in China is diverse and many forms generate marginal risks or are too disconnected from the banking system to threaten financial stability. The truly risky types of shadow banking account for a relatively small share of financial assets, and their impact on the formal banking system is being scaled back.
    • A property market correction is beginning and will act as a drag on short-term growth, which could fall as low as 6 percent over the next two years. However, while the property correction will affect construction-related activity and production indicators, it will not have a seriously debilitating impact on the financial position of households or the banking system.
    • Altogether, credit losses from the current economic stresses are unlikely to exceed 20 percent of GDP. Dealing with these losses will be costly and complex, but, after a period of consolidation, the country should be able to maintain relatively robust economic growth in spite of the financial upheaval.
    • Still, reforms are needed to ensure China’s long-term financial stability and reestablish rapid but more sustainable growth. Many of the key actions lie in strengthening the fiscal system since the country’s debt problems are merely symptoms of underlying weaknesses in the way that resources are being raised and allocated. China’s leaders demonstrated that they realize change is needed in November 2013 at the Third Plenum meeting, when they laid out a comprehensive plan for reforming the economy.

Implications for China’s Future

Yukon Huang

Huang is a senior fellow in the Carnegie Asia Program, where his research focuses on China’s economy and its regional and global impact.

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The financial sector and the government will have to share the burden of credit losses. Such losses will be incurred as firms default on loans and bond payments and banks need to recapitalize to meet required financial standards. Forcing the financial sector to absorb the brunt of these losses is necessary to make it more risk conscious, but the government will need to periodically step in with bailouts and bank recapitalizations to maintain financial stability.

The government should not resort to financial stimulus to stave off the property market correction. China’s property sector is entering a period of structural oversupply that cannot be sustainably remedied by a stimulus package. This would only exacerbate existing debt problems by encouraging continued construction of housing in excess of long-term needs. At some point, the excess stock would lead to much sharper price decline that could destabilize the financial system. The only sustainable solution is to allow excessive housing construction to be scaled back.

China’s medium- to long-term growth outlook depends on the government’s success in implementing its Third Plenum reform agenda. If China enacts major fiscal and financial reforms alongside productivity-enhancing measures to facilitate a more efficient urbanization process, curb the role of state-owned enterprises, and rationalize regional investment patterns, it could see growth of around 7.5 percent in the years following an unavoidable property correction.

Introduction

Many China hands allege that the country is headed for an imminent debt crisis and has little chance of avoiding it without allowing growth to collapse. Their concerns stem from the fact that China’s level of debt has grown rapidly since 2009, about double the buildup that occurred in the United States before the global financial crisis or in Korea before the Asian financial crisis. At the same time, China’s GDP growth rate has declined from historic double digits to a more modest level of around 7.5 percent. As a result, China’s debt-to-GDP ratio has soared. In nearly all other similar cases this resulted in a financial crisis.

Yet the argument that China is about to fall off a financial cliff is overstated. Generally speaking, only a third of credit booms lead to financial crises. And with respect to China, the world’s largest exporting nation is missing many of the macroeconomic vulnerabilities typically associated with crises, such as large trade deficits or excessive reliance on foreign capital. Although there is anecdotal evidence of nascent financial stress, there is little evidence of widespread insolvency among Chinese firms and local governments that could threaten the broader economy. The risks of shadow banking, which includes the off-the-balance-sheet business of banks and the financial activities of nonbanks, are similarly exaggerated. Most importantly, in all but the most extreme cases, the government has the “fiscal space” in the form of discretionary fiscal and financial resources to bail out the more important distressed state enterprises and local authorities and to recapitalize major banks. This will ensure that any tensions do not turn into the sort of systemic financial crisis that derails the economy.

The process, however, will be messy and costly as the economy slowly hemorrhages financial resources in supporting these bailouts and is forced to throw good money after bad to keep growth in line with official targets. Rapid expansion of shadow banking has also introduced a degree of uncertainty about whether China’s inexperienced new investor class will react to market stresses in unexpected ways. Moreover, upcoming adjustments in an overbuilt property market may further exacerbate vulnerabilities. The origins of all these concerns come from China’s weak fiscal system; the financial stresses are symptoms of the underlying distortions.

These issues point to China’s desperate need for a new round of financial, fiscal, and structural reforms to slow the growth of bad debt, put the finances of local governments on sound footing, and encourage productivity growth. Enacting these reforms and allowing for a period of subdued growth while the property market corrects will unlock sustainable medium-term growth of 7–8 percent, which will ensure that China’s debt burden will remain manageable. The alternative would be continued debt buildup leading to a debt crisis by the end of this decade, accompanied by an economic collapse.

Understanding China’s Credit Boom

In most countries that have experienced a financial crisis, the credit surge has typically been the culmination of a long-term and broad-based deterioration in financial and fiscal indicators. China simply does not fit that pattern notably in its strong balance of payments, modest fiscal deficits, and high household savings rates.

The country’s debt problems are rooted in the government’s November 2008 announcement of a 4 trillion yuan ($586 billion) stimulus package to counteract the effects of the global financial crisis. Rather than being channeled through the government’s budget, the stimulus took the form of an explosion in bank lending, predominantly to state-owned enterprises and local governments (see figure 1).1

By 2010 the worst of the crisis seemed to be over and the government scaled back bank lending by about a third. But shadow banking or nonbank lending through entities other than government institutions and informal channels quickly emerged to fill the gap, and by 2012 nonbank credit accounted for 40 percent of new credit, more than double its share before the crisis (see figure 1).

Altogether, the bank-credit stimulus and shadow-banking boom have left China’s debt at a little over 200 percent of GDP—higher than most developing countries but well below the major advanced economies (see figure 2).2 The bulk of the increase was in the form of corporate debt (a point discussed later in the paper).

This credit boom comes with some risks. The postcrisis credit boom has resulted in an almost unprecedentedly sharp rise in China’s leverage, or the amount of debt it accrues compared to GDP. The investment bank Goldman Sachs estimates that China’s debt-to-GDP ratio rose by 56 percentage points between 2007 and 2012, a sharper increase in leverage than in most other crisis cases and is projected to rise for at least a few more years.3

However, though credit booms can bring new risks such as increased leverage, they can also bring beneficial financial deepening and economic growth. A recent International Monetary Fund (IMF) report explains that only a third of these booms result in a financial crisis.4 Further, countries that experienced credit booms between 1970 and 2010 saw 50 percent more growth in per capita incomes over the same period than countries that experienced no credit booms.

What is more, while almost all financial crises are preceded by credit booms, implying that China is in store for a crisis because of its debt surge, China has few of the common risk factors for financial crises. Indeed, the country has none of the external vulnerabilities that often trigger a crisis, with a current account surplus of 2 percent of GDP, external debt of only 10 percent of GDP, foreign exchange reserves at 40 percent of GDP, and a currency that is generally seen as being undervalued rather than overvalued.5 Similarly, China’s banks are highly liquid and not particularly vulnerable to a U.S.-style freeze of the interbank lending market because loan-to-deposit ratios are unusually low—below 70 percent—and the banks are minimally dependent on large institutional accounts, drawing instead on a huge population of household savers. Household debt has increased rapidly, but it remains small relative to household incomes and the economy (25 percent of GDP), giving little cause for concern because on a net basis households are financially strong.

Corporate Debt

The clearest area of concern for China is corporate debt. Over 80 percent of the rise in China’s debt-to-GDP ratio can be attributed to the explosive growth of corporate debt, which rose from 96 percent of GDP in 2007 to 142 percent of GDP in 2012.6 It is much more menacing than household debt, and it now makes up 60 percent of China’s total debt. As of 2014, China has one of the highest corporate-debt-to-GDP ratios in the world, even compared to major developed economies like the United States (see figure 3). Even so, the risks associated with rising corporate debt in China are mitigated by the fact that much of it is concentrated in state-dominated sectors where government support is available and industrial profitability has remained acceptable.

Although corporate leverage in China has risen significantly, it is not clear that it has reached crisis levels. The IMF estimates that in 2012, China’s nonfinancial corporate debt had reached just over 100 percent of equity, slightly above the Asian median of 96 percent.7 Yet this is still quite modest compared to median debt-to-equity ratios of the East Asian financial crisis countries, which were 240 percent in Thailand, 190 in Indonesia, and a shocking 350 in South Korea in the year before the crisis.8

There is also little evidence that this overall rise in corporate leverage has led to widespread financial stress among firms. Wells Fargo bank analyzed the financial position of the industrial sector, which accounts for 60 percent of China’s corporate debt, and found no cause for alarm.9 Revenues have kept pace with debt accumulation in the industrial sector, and contrary to popular perceptions, interest expenses have been declining steadily, holding at about 1 percent of revenue, and giving no indication that the servicing of debt has become an unmanageable burden (see figure 4). And although profit margins have seen slight cyclical fluctuations since the crisis, they are still in line with precrisis levels (see figure 5).10

That said, there are prominent pockets of weakness. The steel, cement, aluminum, sheet glass, and shipbuilding sectors are not as productive as other sectors, utilizing just 72–75 percent of their production capacity compared to typical utilization rates of around 80 percent.11 Firms in these sectors account for 10 percent of industrial assets but only 2 percent of industrial profits, and their return on assets is less than half that of the industrial sector overall.12 Utilities and raw materials producers have also become highly leveraged, and the solar sector suffers from similar issues of excess capacity and falling, if not negative, profits. Overall, there is a significant impact on financial indicators but less of an impact on growth because the valued added in these sectors is relatively less pronounced than in other activities.

These sectors’ struggles largely reflect the fact that they are dominated by state-owned enterprises, which are, as a class, highly leveraged and poorly managed. Given their dominance in high-risk sectors and weaker financials as a group, it is likely that any financial stresses will be concentrated among SOEs.

According to the investment bank Morgan Stanley, at the end of 2012 SOEs’ debt was 4.6 times their earnings, compared to just 2.8 times for private firms.13 The research consultancy firm Gavekal estimates that the debt-to-profit ratio of privately listed firms is 5 percent lower than in 2008 compared to a 33 percent rise for state-listed companies, with similar trends observed in other leverage ratios.14 The contrast between the financial position of private and state companies becomes even sharper when you consider their cash holdings: according to Goldman Sachs, private firms have 60 cents in operating cash flows for each dollar of current liabilities, while central government SOEs had just 30 cents.15 And SOE returns on assets fell from a peak of 7 percent in 2007 to around 4 percent (see figure 6). Even industrial SOEs, which have the strongest incentive to perform because of private sector and international competition, have seen their returns fall from around 6.7 to 4.5 percent, while private firms have seen their returns rise from 8 to 11 percent.16 Narrowing this difference represents a major opportunity for improving productivity (discussed later in the paper).

These trends should not be surprising. In 2003, the newly installed government of President Hu Jintao had put an end to the widespread privatization and shuttering of underperforming SOEs.17 This removed the threat of failure and left SOE managers with little reason to behave in a financially responsible manner. Any remaining incentives to behave prudently were eliminated by the postcrisis bank stimulus, when SOEs were charged with propping up growth.

Also providing a cushion for the SOEs, particularly the larger ones, is the fact that they are likely to be bailed out, shifting the liability for their bad debts onto the government. While the government might consider allowing some minor players to go bust as a means of disciplining financial markets, allowing major players and employers like Sinosteel or Dongfang Electric to fail is hard to imagine.

Yet, it is precisely the firms most likely to be bailed out that are most likely to need a bailout. Some studies have shown that the larger firms have been increasing their net debt-to-earnings ratios in recent years, while smaller ones have actually deleveraged since the financial crisis.18

Even if the financial risks are not entirely concentrated in state enterprises, much of the bad debt is likely to land on the government’s balance sheet in one way or another. For example, the government has been known to bail out private firms that are seen as strategically important. The city of Xinyu, which receives 12 percent of its tax receipts from LDK Solar, arranged to pay off all $80 million of the solar firm’s debt rather than allow it to default.19 Similarly, when the city of Wenzhou’s vibrant underground financial system began to collapse in 2011, the local government pressured state-owned banks to step in and bail out many of the private firms that had relied on informal lending markets rather than allowing their bankruptcies to become a drag on the local economy.20

As in any emerging economy, there will be genuine defaults in the corporate sector that are not absorbed by the government. Gavekal has pointed to three criteria for identifying firms that will suffer defaults: those experiencing financial stress, those in excess capacity sectors, and those small enough to lack friends in high places.21 Applying these criteria to the nonfinancial corporate bond market, Gavekal finds that just 1.2 percent of the bonds coming due this year are at serious risk of default. It is possible that even this moderate level of defaults could spook investors into withdrawing liquidity from the bond market, driving up the cost of borrowing for companies.

But these defaults are not out of the ordinary for an emerging economy, and they are unlikely to have a significant negative impact. At least a portion of these bonds will be paid back and few of those that default will be 100 percent losses, so the risks are not significant enough to seriously disrupt the financial system. What is more, most of these defaults will be well-anticipated—and well-anticipated defaults rarely cause crises. There have already been two defaults by weak borrowers, the first by Chaori Solar and the second by Xuzhou Zhongsen, a construction materials manufacturer.22 Yet despite being China’s landmark first and second onshore bond defaults, the market response was subdued with a very modest increase in the yield on low-rated corporate bonds.23 More defaults, especially in the property sector, are likely in store, but the experiences with Chaori Solar and Xuzhou Zhongsen demonstrate how unremarkable the coming defaults are likely to be.

In reality, the at-risk companies and sectors in China are well-known, and the risks are for the most part already factored into the price of their bonds or stocks. Damage is unlikely to spread far, and any spillovers that occur are likely to be limited to other small, financially weak private companies in similarly excess capacity sectors. That is not an entirely undesirable outcome since China needs a process to weed out nonviable firms.

Local and Central Government Debt

Government debt, which is incurred predominantly at the local level, is not as high as corporate debt nor has it grown as dramatically. For these and other reasons, central and local government debt is unlikely to prompt a financial crisis. But its complex and opaque structure may hide unpredictable risks.

The strength of the central government’s balance sheet on its own merits is uncontroversial: it had debt of just 29 percent of GDP in 2009, and it fell to below 25 percent at the end of 2013.24 But this is an incomplete picture of the government’s financial health because it does not account for China’s local governments, which take on the majority of the public debt while being implicitly guaranteed by the central government.

Unfortunately, accounting for local debt is easier said than done because local governments have been prohibited from officially running deficits or issuing debt since 1994. This has forced local governments in China to take a more circuitous route to finance their expenditures.

In particular, local governments rely heavily on local government financing vehicles, or LGFVs. These are state-owned enterprises set up by local governments to conduct activities that would normally be undertaken directly by the governments themselves, such as building roads and power plants. Local governments support the LGFVs by injecting cash into or transferring state land to them, which the LGFVs use as collateral to borrow from banks and capital markets. The LGFVs then invest that cash in projects to develop the local economy, particularly in the areas of transportation, energy, and water infrastructure or in new housing developments. The distinction between LGFVs and other local government SOEs is blurred and controversial, but even under the conservative official definition there are well in excess of 10,000 LGFVs active in the country.

The borrowing of LGFVs through bank loans and bond issuance is relatively transparent and easily tracked through periodic financial disclosures by the LGFVs or banks that lend to them. Altogether these transparent sources of credit accounted for about $2.1 trillion in June 2013, up from $1.5 trillion in 2010.25 These modest increases in local governments’ visible debt have been outpaced by economic growth, allowing local government debt in the form of bank loans and bonds to fall from about 24 percent to about 23 percent of GDP between December 2011 and June 2013.

Local governments also borrow through the less transparent shadow-banking system. Such borrowing is not regularly disclosed and is difficult to track, forcing observers to rely on rough estimates and sporadic audits.

However, in December 2013 the government announced the results of the most comprehensive audit of local government debt to date, which indicated that shadow banks and other forms of nonbank financing have grown from $360 billion at the time of the 2011 audit to almost $1.2 trillion in June. Some of this growth is artificial, resulting from the inclusion of village governments in the 2013 but not the 2011 audit and from incorporating a broader range of shadow-banking liabilities.

Even so, the audit results demonstrate that the expansion in local government debt is predominantly occurring through shadow banking and other informal arrangements since generally the local governments are not allowed to borrow from the formal banking system for such investment needs. According to the audit, local government debt by June 2013 stood at just over 33 percent of GDP, up from just under 27 percent in 2010 (see table 1).

Adding the audit’s estimate of central government debt to the estimate of local government debt leaves China’s total public debt at 56 percent of GDP, which is relatively low compared with other major economies (see figure 7). This is still much lower than most developed countries, below the generally recognized prudent ceiling of 60 percent, and lower than the 65 percent level seen in the comparable BRIC economies of India and Brazil. Fully 32 percent of the government’s debt is in the form of contingent liabilities. These are predominantly explicit and implicit guarantees of SOE debts, which is not included in debt estimates for other countries.

Yet even if the share of bad SOE debts the government has to absorb is double the historical average, the government’s “expected debt” for comparison purposes is just 44 percent of GDP (see figure 7). This is in line with the IMF’s estimate of China’s “augmented” public debt, which the organization concludes is eminently manageable and leaves sufficient “fiscal space,” meaning the government has the discretionary resources to assume the debt of local government units that are in trouble and additional losses from the corporate sector as necessary.26

Unlike other countries, China can directly access valuable assets should it actually run into debt-servicing problems. According to the Chinese Academy of Social Sciences,27 China’s foreign exchange reserves, at almost $4 trillion or 40 percent of GDP, are roughly equal in size to China’s expected government debt. The government’s land holdings are also immensely valuable, although the use rights to much of the land have already been sold and some is potentially overvalued by a property bubble. Finally, the combined assets of China’s 100,000 SOEs are worth roughly $13 trillion according to the Ministry of Finance. After accounting for SOE debt, the net asset value of SOEs is $4.4 trillion, or roughly 50 percent of GDP.28

While it is true that many of these assets cannot be easily liquidated during a cash crunch, they can finance a bailout over several years, and their mere existence can head off a sudden loss of confidence. If the economy continues to grow in the mid-to-high single digits and the government’s take in taxes steadily rises, the debt burden would also be more manageable.

The Local Fiscal Problem

Although overall public debt is not particularly worrisome and the government is clearly solvent, LGFVs and the localities that support them do face short-term-liquidity challenges. Much of the debt they have incurred is in the form of short-term loans from banks or borrowing through the shadow-banking system, which involves loans of short maturities. Over 40 percent of local government debt will come due within the coming year according to the recent audit. Meanwhile, many of their investments will not produce returns for years. As a result, many are experiencing liquidity shortages. The ratings firm Moody’s and Nomura Securities estimate that up to half of all local governments have insufficient cash flows to cover their debt repayments due in 2014, and Macquarie Capital estimates that 29 percent of new borrowing by LGFVs is used to discharge existing debts.29

Most LGFVs are strong enough to cover interest payments, so debt settlement are likely to be rolled over.30 Although such rollovers tie up banks’ working capital and prevent them from lending to more productive new projects, they represent a slow restructuring of local government debts rather than a crisis.

Beyond short-term liquidity challenges, there are at least three long-term vulnerabilities associated with local government debt: the misaligned fiscal system, incentives for local officials to overinvest, and the lack of transparency in local finances.

Before 1978, the government relied on the profits of state-owned enterprises to pad its budget. When economic reforms were introduced in 1978 to liberalize the centrally planned economy, SOE profits plummeted. The government’s revenues fell from over 30 percent of GDP in 1978 to less than 12 percent in the mid-1990s, leading to a major fiscal reform in 1994.

The restructured fiscal system has steadily increased government revenue, which is currently around 22 percent of GDP, but it has also created an imbalance between the central and local governments: while the local governments were left responsible for funding more than 70 percent of government expenditures, they only collect about half of the tax revenue (figure 8).31

Transfers from the central government address some of this gap, but this fiscal misalignment between the expenditure needs and the cash means of local governments drives much of their reliance on borrowing. Giving local governments access to more reliable revenue sources and a larger share of the fiscal pie is necessary to ensuring their long-term financial sustainability.

At the same time, local government officials are evaluated almost entirely on the basis of their ability to produce economic growth. This incentive structure has been integral to China’s economic success over the past three decades, but it has also come at the cost of creating a system that favors short-term growth over long-term financial, environmental, and social sustainability.32 Although much local investment is in fact needed as China rapidly urbanizes and develops its transportation network, local officials’ incentives are more aligned with investing heavily than they are with investing productively, leading to overinvestment and overindebtedness.

Estimates of local government debt vary widely, since those governments do not provide clear and comprehensive statements. This lack of transparency manifests itself not only in the rapidly rising level of debt but also in the way it is managed. The 2011 audit revealed that “of thirty one provincial governments, seven haven’t created debt management systems . . . 14 haven’t established debt repayment funds, and as many as 24 of them haven’t installed risk monitoring and control systems.”33 This dearth of risk management systems has made it easy for unmonitored risks to accumulate.

In addition, local governments are highly exposed to rising interest rates because much of their borrowing has to be refinanced annually and an increasing share of local borrowing has been coming from the lowest levels of government, which are least prepared to manage risks.

Dealing With Fiscal Misalignment

These concerns have not gone unaddressed. The economic reform plan announced following the Third Plenum meeting of the party leadership (formally, the Third Plenary Session of the 18th Central Committee) gave pride of place to reforms intended to better align the fiscal system.34 A portion of spending on social services is to be transferred to the central government to lighten the burden on local finances, and local revenues are to be increased through the expansion of property and other taxes that flow directly to local governments. The party also seems to recognize the need for more holistic assessments of local officials’ performance, announcing in December 2013 that a variety of factors, including local debt levels, will be incorporated going forward.35 This will hopefully encourage the development of better risk management systems and help to improve the structure of local debt.

While these steps are not a complete solution, they show that China’s leadership understands the vulnerabilities posed by the structure of the fiscal system and local officials’ incentives and that they are serious about remedying them.

What is less clear is how the leadership intends to improve the transparency of local government debt. China’s leaders have acted on their intention to use more local government bonds, which will help because bond financing involves ratings agencies and formal audits. In early 2014, the government selected a few localities and cities to launch a pilot bond-financing program to supplement their revenue needs. However, the local governments included thus far were specifically selected because of their relatively stronger financial positions. This leaves unresolved how to improve the transparency of the localities most in need of reforms.

Shadow Banking

Cutting across both corporate and local government debt is the issue of shadow banking. Broadly construed, shadow banking includes informal lending between individuals and companies, loans made by nonbank financial institutions like trusts and investment funds, and some common banking practices like bankers’ acceptances. In China, there is no formal definition of what activities constitute shadow banking, leading many to simply refer to all lending activities that occur outside of banks or off of bank balance sheets as shadow banking.

The most useful definitions of shadow banking, from the perspective of financial stability, are those that include all systemically important activities while omitting marginal forms of lending. In particular, activities that are strongly linked to the formal banking sector, namely wealth management products (WMPs) and bankers’ acceptances, and those that are large relative to the size of the economy, namely trust products and entrust loans, are the key components of shadow banking, while minor activities, such as underground lending,36 are excluded.37

Estimates that are in line with this definition place shadow banking at around 50–60 percent of GDP or around 25–30 percent of banking assets in China. These figures are not abnormal in international comparisons of shadow banking. The Financial Stability Board (FSB) estimates that globally, shadow banking averaged about 117 percent of GDP, respectively, in the major Organization for Economic Cooperation and Development economies and 52 percent of banking assets, more than double the figures for China. In at least three other major emerging markets, shadow banking represents a larger share of banking assets than it does in China (see figure 9).38

Opinions on the issue of shadow banking in China are divided. Many financial experts have noted that shadow banking is more responsive to the needs of private small and medium enterprises that have traditionally lacked access to the state-dominated banking system and that those enterprises have played a major role in driving productivity growth and employment. An estimated 97 percent of China’s 42 million small and medium enterprises are unable to access traditional bank lending, according to Citic Securities, because they lack a strong track record and there is a bias in favor of state-owned enterprises.39 The People’s Bank of China estimates that half of all the firms it regularly surveys have accessed some form of shadow banking.40 Others are alarmed by the rise of shadow banking in China because it is widely perceived to be more risky than traditional bank lending, which is subject to more stringent oversight.

As with the broader debt, concerns about China’s shadow-banking system often focus on debt’s rapid growth rather than its absolute level. Shadow-banking activities in China have expanded dramatically since the end of the bank-credit stimulus in 2009. Goldman Sachs estimates shadow banking’s share of the flow of new credit has doubled in recent years, from 22 percent in 2008 to 42 percent by June 2013, at which point it accounted for roughly a quarter of the outstanding credit stock.41 In the first quarter of 2014, shadow banking was scaled back modestly,42 although it is unclear whether this is a temporary deviation from the trend toward increased shadow-banking activities or something more permanent.

Regardless, rapid growth of shadow banking is not atypical of emerging markets in recent years. According to the FSB, seven major emerging market countries have experienced growth above 15 percent, and China’s pattern is broadly similar. Such growth rates should not be considered inherently problematic for countries developing their nascent shadow-banking systems from very low bases.

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