A massive contraction in shadow banking is the reason for slower growth in China, not the developing trade war with the US. Regulators everywhere should take note, writes Brian Caplen.

The Chinese authorities face the classic problem of the post-financial crisis era. Their banks are highly capitalised and well regulated but a massive amount of credit creation is taking place off balance sheet as a way of easing the regulatory burden.  

In 2017 shadow banking assets accounted for 70% of China’s GDP after the sector grew 40% a year for the five years from 2011 to 2016. This credit has been driving economic growth but authorities have been concerned for some time about the scale and leverage involved and how much the banks are still exposed. Even when banks are not the issuers of products that invest in high-yielding assets, funding may be provided by the banks.

With these concerns in mind, the authorities embarked on a deleveraging exercise in 2017 and early 2018 that included tightening the rules around these activities as well as the business of peer-to-peer lending platforms.

As a consequence, Fitch Ratings estimates there has been a 10% nominal GDP contraction in shadow banking assets bringing the total down to 60% of GDP and causing the well-publicised slowdown in economic growth.

In fact, the authorities seem to have been too successful in their efforts and are now pulling back “in an attempt to strike a balance between reining in excessive leverage and ensuring satisfactory economic growth in the face of potential economic headwinds”, according to Fitch in China: Shadow Financing on the Decline.

Where China has been travelling, others are headed. The latest Financial Stability Board report on shadow banking puts its narrow measure (for example, activities that involve credit intermediation with possible financial stability risks) at $52,000bn or 13.7% of total global financial assets. This is an 8.5% increase on the previous year.

Regulators everywhere need to understand that their focus must be as much on shadow banking as on mainstream banking. They also need to understand the links between the two sectors. In China they may need to take concrete actions to slow things down at the expense of economic growth if that is what is necessary to avert a crisis. Worryingly, outside of China there remains a reluctance of regulators to take such decisive action if it holds back growth – all of which runs the risk of a rerun of the financial crisis, this time led by non-banks. 

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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