Shadow Banking and the Effect on the Economy of China

Shadow banks are institutions that engage in the activity of banking, just like other banking institutions, but are not themselves regulated like those institutions. While traditional banking institutions are subject to intense regulation, they have backup protection in the form of the discount window of the Federal Reserve as well as insured deposits protected by the Federal Deposit Insurance Corporation. Examples of shadow banking institutions can include investment trusts, hedge funds, and other nonbank entities that engage in credit, maturity, and liquidity transformation without insured deposit protection.

China, which is the second largest economy in the world, faces an economic dilemma that has been brewing for several years. Many assets that make up the Chinese economy are tied to property. For example, nearly sixty percent of the assets of urban households in China are in property. Additionally, forty percent of the fiscal revenue of local Chinese governments comes from land sale proceeds.

Developers in China were able to borrow generously from these shadow banking organizations, which circumvented certain limitations imposed on the largely state-owned banking industry.  Now that the developers are struggling to repay these massive debts, shadow banking organizations who have lent to them find themselves in dire financial straits.  Large property companies, such as Evergrande and Country Garden, have already struggled in repayment of their loans. While shadow banking organizations in China such as Zhongrong, which is one of China’s largest trusts, have been unable to repay investors on several products.

This repayment struggle has been attributed to regulation introduced by the Chinese government to crack down on increasing debt of developers. These regulations introduced in 2020 were intended to prevent a housing bubble much like what occurred in the United States in 2008. However, the cutting-off of easier to obtain funding led to short-term cash shortages for these developers. Who have since struggled to repay their debts. While the government was willing to step in regarding the amount of debt developers were acquiring, they have not had the same willingness to step in regarding defaults by these companies. The lack of a major response on behalf of the government has led to protests, for example in front of the Zhongrong offices after their missed payments.

While this may seem like a problem reserved for Chinese nationals, increasing globalization has allowed for western organizations to lend to shadow banks and invest in organizations that are at risk in the event of continuing repayment struggles. It is unknown how much the situation may escalate. Evergrande the Chinese developer has filed for bankruptcy protection in the United States as of August and the financial situation of other large and key members of that sector do not seem to be fairing much better.  As of August, stocks in some of China’s biggest companies listed in Hong Kong had plunged 21 percent from their peaks this year. How much this downturn will affect the overall Chinese economy remains to be seen. If this downturn continues and developers and the shadow banking institutions who funded them continue to run into issues with funding and repayment investment in China will continue to slow and the negative effects will likely continue to spread to other industries including traditional banking institutions that likely have financial ties to both struggling sectors. Investors and regulators throughout the world will need to continue to monitor the situation and hope for the best.

Article Written by James Cameron III

Sources:

What Is Shadow Banking? – Back to Basics – Finance & Development, June 2013 (imf.org) 

What’s going on with China’s shadow banking system? (msn.com) 

Federal Register :: Revisions of the Section 232 Steel and Aluminum Tariff Exclusions Process 

What is shadow banking? Unpacking the risks for China (cnbc.com) 

Dodd-Frank Act: What It Does, Major Components, and Criticisms (investopedia.com) 

Shadow Banking Regulation (annualreviews.org) 

China’s looming property crisis threatens economic stability | PIIE 

GDP Ranked by Country 2023 (worldpopulationreview.com) 

China Faces a Crisis in Its Real Estate Sector – The New York Times (nytimes.com)