It is widely recognized that China has a very sizeable informal financial sector, which refers to financial intermediaries that are not registered with any regulatory agencies and therefore are not regulated. This informal sector is often lumped together with the wealth management products offered by regulated banks and trusts and referred to as the “shadow banking” sector, because they accept deposit-like funding and provide credit outside the traditional, and more highly regulated, banking model.
Technically, these financial intermediaries are often in violation of Chinese law. But local governments, knowing the existence of these financial intermediaries, usually allow them to continue operating unless there is evidence that they may have done harm to the local economy.
The composition and size of the Chinese informal financial sector, according to the IMF, is illustrated below:
Several reasons have been proposed by leading academic and business journals to explain the existence of a sizable informal financial sector. The first reason is the local government’s borrowing behaviour. Local governments have become the main competitor with local firms for bank loans. According to a recent report by the PBOC, one third of the outstanding loans in China were made to the local governments. Over the last several years, about 30 per cent to 40 per cent of total loans went into government infrastructure projects. This massive borrowing on the local government level crowded out private borrowing.
The second reason is the structure of the Chinese banking industry. As described above, several large banks dominate the banking industry in China. Large Chinese banks tend to lend to large firms. In other countries, such as the US, small local banks and other savings and loans companies fill the gap left by large banks. Also, large banks in those countries develop other financial instruments targeted at small private firms. This is not the case in China’s formal sector.
The third reason is the underdevelopment of the corporate bond market. This has made it very difficult for local private firms to issue corporate bonds to raise money. The fourth reason is the IPO regulatory frame work. As discussed above, the approval system poses further difficulties for local firms with no connections with the government to go public and raise money.
Fifth, the periods of negative real deposit rates, due to spurts of high inflation, while not the source of the shadow banking sector, certainly exacerbated its growth. Between February 2007 and October 2008, and from February 2010 to October 2011, the real one-year interest rate on deposits in Chinese banks was negative. During these periods, there was a consequent growth in the informal financial sector, as this sector avoids the government-mandated ceiling on deposit interest rates. The higher rate available to savers helps draw a lot of wealth into the informal sector, especially during these inflationary spells. To sum up, local private firms have very limited access to bank loans, the bond market and the stock market. Therefore they are almost forced to acquire funds from informal channels.
What is the situation of the informal financial sector in China? There is no official data or studies on the informal financial sector on a national level. The related area of wealth management products has been singled out as especially concerning by Xiao Gang, the chairman of the Bank of China. He has estimated there to be over 20,000 of these WMPs, reaching a total value of 12.14 trillion RMD by 2012. Xiao has characterized this ‘shadow banking’ sector as “a potential source of systemic financial risk,” whose model is “fundamentally a Ponzi scheme.”
A more conservative estimate places the value of these WMPs at only 7.1 trillion RMB, while other estimates agree that the value of these wealth management products is not much greater than 14 per cent of China’s GDP. This is still striking, given that they were only just above 4 per cent of GDP in 2010. The rapid growth of this shadow banking sector can be attributed to the period of negative real interest rates on bank deposits during the majority of 2010 and 2011.
Other informal financial flows, such as private lending, are even more difficult to account for, with analysts roughly estimating the later to amount to some 4 trillion RMB per year. Overall, the informal ‘shadow’ banking sector is estimated to account for just over 20 per cent of total bank assets (in 2012), an increase of about 33 per cent since 2010.
One way of evaluating the current situation of the Chinese informal financial sector is by taking a look at Wenzhou, which is one of the places that the informal financial sector has thrived over the past few years. Wenzhou is a city in Zhejiang Province, one of the most developed provinces along the east coast of China. Wenzhou is famous for its industrial output and at the beginning of the reform era generated a group of high net worth individuals.
It is reported that the GDP of Wenzhou reached RMB 243 billion in 2010, with per capita GDP being RMB 40 thousand, compared to a national average of RMB 30 thousand. About 300,000 small private firms produce more than 90 per cent of the local output, with about 70 per cent of them relying heavily on exports.
The informal financial sector went through two stages in Wenzhou. The first stage started in around 1995 and lasted until the global financial crisis. In this stage, the rapid development of the Chinese economy and, most importantly, export-driven economic growth, generated a large group of wealthy individuals in this area. The informal financial sector in this period mainly served as underground asset management firms providing alternative investment opportunities.
For example, it is claimed that about RMB 200 billion flew into the real estate market in Beijing and Shanghai, causing a boom in real estate prices. The informal financial sector was also accused of causing large swings in cotton prices, meat prices and many other commodity prices. The second stage started after the financial crisis and continues now. Since the Chinese economy has slowed down and the global financial crisis, combined with the ensuing euro crisis, has reduced foreign demand, many local firms have experienced a drying up of liquidity.
The local informal financial sector provided short-term liquidity for the local firms during this period. The liquidity provision was mainly done through very short- term but high-yield loans. For example a loan could be as short as three to five days, and the annualised yield could reach 70 per cent. It is estimated that the magnitude of the informal financial sector in Wenzhou reached RMB 700 billion.
The downturn of global trade as a result of the global financial crisis also caused a large scale default of local firms. Some owners of private firms, who had significant debt within the shadow banking system, went abroad to avoid debt collectors. This, in turn, affected the fragile local underground financial system, triggering defaults that harmed their investors.
In 2011, the local court sentenced one of the CEOs of the underground financial system to death, convicting her of “illegally gathering investors’ money”. This case was brought to national attention by some very prestigious economists, who insisted that “illegally gathering investors’ money” should either not be a violation of the law or should not receive such a severe sanction.
Prime Minister Wen Jiabao himself also asked the court to “recon sider carefully the accusation and the final verdict”. In the end the Supreme Court repealed the death sentence. This case is widely seen as providing an impetus for further financial reform in Wenzhou.
This article is an extract from the Brookings Institute's John L Thornton China Center paper The Chinese Financial System: An Introduction and Overview, published July 1.