Invisible Money: Rise and Fall of Shadow Banking in China

EMILY LIN chronicles the explosive growth and harrowing decline of shadow banking in China.

Lufax is one of mainland China’s largest online wealth management platforms. Photo: Reuters
Reuters | Stringer | File Photo

China’s shadow banking sector has developed rapidly since the Global Financial Crisis in 2008, sparking intense international debate over the potential financial risks that may arise in a largely unregulated private lending market. The scale of China’s shadow banking sector is estimated to encompass roughly 43% of China’s total GDP at RMB 25 trillion, growing over time to accommodate the credit demands of China’s private sector, which has encountered unequal access to credit when borrowing from traditional state-owned banks. Although shadow banking is a relatively recent phenomenon, the practice of private lending in China extends back to the era of reform and opening up in the 1980s, reflecting a larger credit constraint problem that is biased towards state-owned enterprises (SOEs) and large firms. Understanding the rise and fall of shadow banking in the last decade will give insight into a major policy initiative of the current Chinese administration to reform its financial and banking institutions in order to promote indigenous innovation and sustainable macroeconomic growth.

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Informal lending networks have existed for decades as a way to borrow interest-free money from relatives and friends. In the past, informal lending between relatives and rotating credit associations were small in scale, mostly confined to a single town, and used to finance costly life events such as weddings. These small scale networks expanded into larger rotating credit associations, trade credit, pawnshops, rural cooperatives, and other informal lending institutions in the 1980s due to the political and institutional constraints on private sector growth. While Deng Xiaoping prioritized economic growth over ideology, the central state still maintained a heavy hand in deciding where credit was allocated. The central bank implicitly guaranteed all loans, maintaining artificially low interest rates to ensure credit was accessible for highly inefficient and costly SOEs. Banks lacked a framework for evaluating credit risk, distributing resources based on central lending policies rather than profitability.

As China transitioned from having little to no banking institutions to developing a more modern and robust financial sector, credit constraints still permeated the banking sector. Private capital was not allowed to provide credit to borrowers without explicit permission from the state. Due to the continued monopolization of the banking sector, informal lending institutions evolved into a massive shadow banking sector. The shadow banking sector connected China’s numerous private savers, who sought higher returns, with small and medium enterprises (SMEs), which needed capital.

These private lending networks were often more formalized and sophisticated in the southern coastal regions, particularly in Wenzhou and Fujian, since local government officials were sympathetic to the growing private sector as a crucial source of tax revenue. In contrast, the inland regions were dominated by heavy industries established prior to China’s reform and opening up, directing the flow of credit to state-subsidized firms in steel, petroleum, railway, and telecommunications industries that were often less efficient and profitable compared to private enterprises.

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By the early 2000s, policy reforms focusing on marketization and private sector growth began to encourage indigenous innovation over manufacturing industries, but credit allocation for SMEs continued to be disproportionate to their contributions to China’s overall GDP. According to a paper by Justin Yifu Lin, an economist and former VP of the World Bank, SMEs accounted for 60% of GDP growth and 80% of employment, but less than 1% had access to bank loans. In addition, an ethnographic study done by Professor Kellee S. Tsai on the workings of informal credit institutions revealed that most individuals looking to start a small business didn’t even bother with the cumbersome and time-consuming application loan process in traditional banks and would immediately turn to shadow banking institutions that provided credit faster but at a higher cost.

The next stage of shadow banking growth came after the Global Financial Crisis of 2008. China’s economic growth slowed to an all time low of 6%, prompting the central government to pump out a stimulus package of RMB 4 trillion that indirectly fueled an expansion of the shadow banking sector. Most of this credit was allocated toward promoting infrastructure and real estate development and continued to be inaccessible to SMEs and individual households. However, the rapid expansion of monetary policy created large asset bubbles and entangled the shadow banking world with the traditional banking sector when state-controlled banks began selling wealth management products (WMPs) to investors and ordinary households. These financial assets were often uninsured but were treated as bank deposits with lenders promising high returns of 2-5% without disclosing much information about the quality of investments.

The government’s subsequent decision to tighten monetary policy precipitated the collapse of various Ponzi schemes, which were intricate pyramid hierarchies that lured investors in with promises of high returns but actually paid them using funds from new investors and not returns on sound investments. As a result, the shadow banking world experienced a series of crises in 2011 that occurred after a small section of the lending pyramid defaulted, creating massive losses for investors and ordinary households that had invested much of their lifetime savings. These severe defaults began in Wenzhou with disputes totaling roughly RMB 5 billion, placing intense pressure on China’s judicial system after private lending cases in courts increased by over 71% in one year. Later on, the collapse of other private lending schemes spread to Fujian, Guangdong, Sichuan, Henan, and other provinces, prompting the government to impose stricter regulations and prevent future systemic risk.

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In the past, China’s central government did not make serious efforts to crack down on the shadow banking sector since it was profitable for all parties involved, connecting potential investors with high savings to SMEs that needed the credit to finance their enterprises. On a macroeconomic level, shadow banking also helped to spur China’s rapid economic growth since it was responsible for providing credit to a growing body of domestic enterprises, promoting China’s goal of transitioning from an export-based economy to one driven by indigenous innovation and domestic consumption. However, the 2011 crisis revealed the urgency of the problem, prompting Xi Jinping and his administration to take concrete steps to stabilize China’s financial sectors.

In addition to deleveraging initiatives that targeted debts held by large, inefficient SOEs, the central government also increased regulations on WMPs that impacted roughly US$2 trillion worth of investments. By 2017, the new regulations included WMPs as part of required health checks for banks and established clear universal guidelines for lending policies. These initiatives were successful in drastically slowly WMP growth in 2018, helping to curb some of the imbalances in the shadow banking sector.

Future policy initiatives, however, will have to strike a delicate balancing act between protecting long-term financial stability through increased state regulation and expanding market-based allocation of credit through reduced state control. Additionally, creative polices are needed to regulate the increasingly popular P2P networks that have boomed with the rise of Internet finance platforms such as WeChat Pay and Alipay. These P2P networks overcome information asymmetry by acting as intermediaries between creditors and lenders, using big data to determine a borrower’s creditworthiness much faster than the traditional banking sector can. However, the fact that these networks can cross geographical boundaries and do not require physical locations may make them more difficult to regulate, creating a challenge for the central government that will have great implications in influencing China’s future growth trajectory. Recently, regulators in Shanghai ordered more than 40 P2P lenders to wind down their operations and exit the business, suggesting the Chinese government has no desire to court a repeat disaster.

Additional Resources

Geertz, Clifford. “The Rotating Credit Association: A “Middle Rung” in Development.” Economic Development and Cultural Change 10, no. 3 (1962): 241-63. doi:10.1086/449960.

Lu, Lerong. Private Lending in China: Practice, Law, and Regulation of Shadow Banking and Alternative Finance. Routledge, 2019.

Oi, Jean Chun., and Andrew G. Walder. Property Rights and Economic Reform in China. Stanford University Press, 2000.

Seo, Seok-Heung, and Jang-Hwan Min. “Private Lending Crisis in Wenzhou and Financial Reform.” Chinese Studies 52 (2015): 233-52. doi:10.14378/kacs.2015.52.52.15.

Tsai, Kellee S. Back-Alley Banking Private Entrepreneurs in China. Cornell University Press, 2018.


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