In China today, the term "shadow banking" has a negative meaning. Over the past year, the China Banking Regulatory Commission has issued numerous policy directives to try to contain its explosive growth. Xiao Gang , the head of the Chinese securities watchdog, called shadow banking "a Ponzi scheme" in an opinion piece he penned last year while still serving as chairman of the Bank of China.
But why is shadow banking still all the rage, despite the hostile regulatory environment?
In the past two to three decades, China has implemented an extremely inflationary monetary policy. Since 1986, for example, its money supply has grown at a compound annual growth rate of 21.1 per cent, and its bank loan balance by 18.2 per cent. Of course, Chinese citizens have not become richer as fast, and much of the growth is merely a monetary illusion.
Why did credit grow so fast for so long? Apart from a robust economy, the reason has been the regulated and negative real interest rate. Due to financial repression, demand for loans has been artificially boosted, as bad investments become feasible on subsidised credit. Indeed, it has been a vicious cycle.
First, the fast growth of loans worsens inflation, which weakens the purchasing power of money. To facilitate the same amount of business, corporate China needs more credit. And as more credit is released into the economy, the purchasing power of money shrinks further. I call this an iterative escalation of credit and inflation. There is a constant shortage of credit no matter how fast credit grows. The reason? Bank loans are impossible to refuse as they are heavily subsidised. Homebuyers and speculators know this all too well.
The Chinese government frequently talks about prudent monetary policy but does not really have the political will to tighten credit for fear of job losses and a recession. Even in April, the broad money supply (M2) has grown at 16.1 per cent compared to the same time last year. That is a very high rate on a high base. China is still inflating rapidly despite repeated declarations of credit controls by government officials.
The results of financial repression are visible everywhere, from industrial overcapacity to excess real estate construction, and the unstoppable growth of shadow banking.
Over time, the Chinese statistics (particularly on inflation) have lost credibility among citizens. Despite high inflation that is widely believed to be somewhere between 5 and 10 per cent a year, Chinese depositors are paid an average of 2 per cent interest. Naturally, they want better deals. While many have chosen to speculate on property, others have embraced shadow banking, including microcredit and wealth management products. After consistently deflating for two consecutive decades, the domestic stock market remains very expensive, with banking stocks being the possible exception.
Negative real interest rates on bank loans constitute a subsidy for borrowers. Unfortunately, access to finance is neither equal nor fair. State-affiliated companies and well-connected private-sector borrowers take the bulk of funds for loans, leaving very little for small businesses. The underprivileged have to resort to the curb market, involving trading outside the official stock markets, pawnshops, microcredit firms and high-cost funds arranged by trust companies.
In other words, China's shadow banking is a reflection of the financial repression. The high interest rates prevalent in shadow banking activities are a result of the low rates in the formal banking sector.
Financial repression has accentuated the uneven playing field for the two types of borrowers. Normal bank loans carry a 6 per cent annualised interest rate, while the shadow banks typically charge 15-30 per cent per annum.
If Beijing really wants to help small businesses, or deflate the property bubble, it should raise interest rates steadily. As a result, the growth rate of money supply will decline to 7-8 per cent within two to three years. Yes, this will risk an economic recession, but a recession may be exactly what is needed to avoid the next global financial crisis. This time, unlike in 2008, the crisis will be made in China.
China's iterative escalation of credit and inflation has severe social consequences, too. Ordinary savers are punished, and are left further and further behind by the rising prices of assets such as property. If President Xi Jinping wants Chinese people to realise their own "China dream", he must tame the credit monster. Shadow banking is only the shadow, not the monster waiting in the shadows.
Joe Zhang was chairman of Wansui Micro Credit Company in Guangzhou from 2011 to 2012, and is author of a new book, Inside China's Shadow Banking: The Next Subprime Crisis?