Shadow banking boom pushes China to edge of debt sustainability

Booming shadow banking growth has pushed China to the outer limits of its ability to service debt and keep its economy functioning smoothly, though spillover risks from a bursting of the credit bubble are containable, experts said on Monday.

With total leverage in the Chinese economy now topping 280 per cent of gross domestic product, it was clear that credit quality was deteriorating, Primavera Capital Group founder and chairman Fred Hu told delegates at a Fung Global Institute forum.

"It is not yet the end of the world, but it is approaching the limit of debt sustainability," Hu said.

Debt sustainability, the ability to service debts, is a key measure of solvency. Analysis by the McKinsey Global Institute earlier this year showed debt in the Chinese economy had roughly quadrupled between 2007 and the middle of last year to US$28 trillion, leaving it with a debt-to-GDP ratio more than twice that of crisis-wracked Greece.

Hu said the potential systemic risks caused by the boom in shadow banking could not be ignored, even though its emergence in China as a crucial funding source in the wake of the global financial crisis in 2008 had helped underpin economic growth.

Shadow banking in China is loosely defined as off-balance-sheet credit provided outside the formal banking system, either through special funding vehicles or trust products.

Its growth was prompted in large part by strict limits set by the central government on bank lending that restrict the ratio of loans to deposits, leading banks to find ways around the rules to put capital to work - and charge rates of interest far above the state-mandated level.

Liu Mingkang, the former chairman of the China Banking Regulatory Commission, told the same forum that time was running out for the government to reform the financial system and liberalise credit markets sufficiently to obviate the need for shadow banking, though he was sanguine on the systemic risks posed.

"The risks from shadow banking in China are controllable," Liu said, pointing to a number of recent policy initiatives by Beijing to curb local government debt and create a viable municipal bond market as evidence of reform currently in the works.

He added that shadow banking must be regarded by policymakers only as a short-term mechanism through which time can be bought to help finance small and medium-sized private enterprises until wholesale reform can be completed to liberalise access to capital markets and bank credit.

"Liberalisation will benefit China in the long run," Liu said. "I am cautiously optimistic about the pressures and outcomes for the domestic financial system."

Global investors and international credit ratings agencies broadly worry that huge credit bubble risks are building inside the Chinese economy that could explode with devastating domestic consequences and potentially spill over into the global economy.