China Goes Cold Turkey on Shadow Banks

Beijing’s push to force most lending back onto bank balance sheets may put the economy at risk this year

By Nathaniel Taplin

China’s monthslong campaign against debt has raised more than a few red flags.
China’s monthslong campaign against debt has raised more than a few red flags. Photo: Reuters 

China has spent the past 18 months tightening the screws on risky funding practices, but growth has mostly kept chugging along. Total financing in the economy—including municipal and corporate bond issuance, equity sales and shadow banking—grew just 11.5% in May from a year earlier, the slowest pace in more than a decade. Even so, factory-gate price inflation accelerated again.

What exactly is going on?

China Goes Cold Turkey on Shadow Banks

A big factor is the convoluted way that China’s campaign against debt has unfolded—which implies that the real hit to growth could arrive soon.

Many of the risks lurking in China boil down to two problems. The first is small banks’ heavy dependence on short-term, high-cost funding. This is the risk regulators mainly targeted in 2017: pushing bank-to-bank lending rates up and slamming the gate on sales of high-interest, short-maturity “wealth management products” to mom-and-pop investors. 
But the second risk—the rapid growth of corporate financing channels outside the banking system—didn’t really get addressed until late last year. Total growth in nonbank borrowing, including through shadow banks and corporate bond issuance, had barely slowed before then.

It is slowing now—strip out traditional bank loans and local government bonds, and the growth in total financing was just 6% last month, less than half the level in October. That’s worrisome because small, private-sector companies—and some local state-owned ones—often have trouble getting reasonably priced bank loans in China, one reason shadow banking grew so quickly in the first place.

China Goes Cold Turkey on Shadow Banks

As it happens, key industrial indicators—and the bond market—have both started signaling trouble. The yield premium of low-rated six-month commercial paper over AA-rated debt has widened to 1.3%, from around 0.5% for much of last year, as investor concerns about corporate funding have grown. The recent rebound in producer price inflation— which ought to help struggling companies—hasn’t settled those nerves, likely because investors believe it’s a temporary rise caused by the easing of pollution controls in place over the winter.

China remains an investment-heavy economy despite progress on growing consumption over the past decade. Beijing is betting that top-down diktats telling banks to lend more to the private sector will be enough to keep the party going, as it attempts to scale back the shadow banking that has long supported companies hard up for cash. 
Investors will soon discover if they are right.

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