Shadow banking the biggest threat to China's economy

The US Federal Reserve's decision to exit from so-called "quantitative easing" - its massive monthly purchases of long-term assets - is stoking fears of a hard economic landing in China. But the country's strong economic fundamentals mean policymakers have the space to avoid such an outcome - as long as they bring the shadow banking system under control.

As it stands, Chinese consumption and investment growth are expected to remain at roughly last year's levels. Meanwhile, economic recovery in the advanced economies, especially the US and Europe, is reinvigorating external demand, leading analysts to project annual Chinese export growth of more than 10 per cent this year. This would bring annual GDP growth this year to a very healthy 7.5-8 per cent.

The problem is that China's financial sector has accumulated considerable risk in recent years, with broad money (M2) having ballooned to 110.7 trillion yuan (HK$140 trillion) - almost twice the country's gross domestic product - at the end of last year. In an attempt to rein in M2, which could indicate that the economy is overleveraged, the central bank tightened conditions for commercial bank lending, so that, for any given increase in M2, less credit is extended.

But the move failed to contain M2 growth. Worse, restricting commercial banks' role as financial intermediaries and encouraging the growth of unregulated shadow banking has generated even more risks for China's economy. Clearly, a new approach is needed - one that is based on a deeper understanding of the dangers inherent in China's banking system.

While it is true that surging M2 can reflect excessive leverage, it is not a particularly accurate gauge in China, where commercial banks can easily circumvent high reserve requirements and quantitative controls by moving loans off their balance sheets to wealth-management products - practices that fuel artificial credit expansion that looks like M2 growth.

In this sense, it is the monetary authorities' reluctance to open up the formal financial sector to domestic private capital, or to liberalise the deposit rate, that is fuelling the expansion of shadow banking.

With small and medium-sized enterprises - by far the economy's most important growth engine - unable to acquire sufficient funding from the formal financial sector, they have been forced to turn to informal channels. As shadow banking has become the primary source of finance for SMEs - which tend to be higher-risk borrowers - the financial risks in China's economy have grown exponentially.