Shadow Banking Threatens China's Economy—but What Is It, Exactly?

Needed government reforms to the country's byzantine financial system may nonetheless upend China's growth.
zhouxiaochuanlinbanner.jpgZhou Xiaochuan (R), Governor of the People's Bank of China, is tasked with tackling excesses in China's shadow banking system.(Molly Riley/AP)

Last week, the Shanghai interbank offered rate (Shibor), China's once-anonymous version of London's LIBOR, made news around the world when it suddenly spiked at all time high. Expected to lower this rate by injecting cash into struggling Chinese banks, the People's Bank of China (the country's equivalent of the Fed) instead did nothing, leading to speculation that China's leaders were finally prepared to tackle the economy's overheating problem. In the process, the media appears to have finally taken notice of the potential dangers that lurk within the byzantine industry that is Chinese finance. Reviewing the headlines, a series of arcane, sinister terms leap out: Off-balance sheet lending. Inter-corporate finance. And, most prominently, shadow banking.

Such terms, nebulous as they may be, are keeping Chinese policy makers up at night: According to Fitch, China's shadow banking sector may be hiding as much as $2 trillion worth of risky assets in off-balance sheet lending. But what does that really mean? And, more importantly, how did China find itself in this situation? Before we can answer these questions, it's worth going back and having a look at what shadow banking really is, and how it presents a risk to China -- and the world economy as a whole.

Firstly, the concept of shadow banking has an unfortunate reputation and is in dire need of rebranding. Despite the macabre connotations its name conjures, it's not inherently a bad thing. Generally, shadow banking simply refers to the lending and borrowing -- basic financial activities -- that occur outside the traditional deposit and loan model; that is, anything other than putting money in the bank and occasionally borrowing for things like buying a house. In Western nations such as the U.S, hedge funds, venture capital firms and private equity -- all forms of shadow banking -- form a major part of economic life. In China, however, the structure of shadow banking is very different.

Until around 2007-8, conventional banks, in the form of loans, undertook the vast bulk of all lending in China, and because the Communist Party controls the vast majority of banks, this structure allowed the government to retain a handle over the economy at large. However, in the aftermath of the financial crisis, as export-oriented businesses -- the companies that form a major pillar of the Chinese economy -- saw markets shrink, two important things happened.

The Shibor rate hike and the government's refusal to step in with additional funds, then, is a not-so-subtle statement that the party's over and that it's time to solve debt addiction the old fashioned way -- cold turkey.

First, in response to the global financial crisis in 2008, the Chinese government enacted a stimulus package worth $586 billion, more than half of which was financed through new bank lending. This package won praise around the world for its speed and decisiveness and kept the country on track in the short term, in noted contrast to a similar plan implemented by the United States. But the stimulus also flooded the economy with cheap credit, thereby fuelling a speculative housing bubble, propping up inefficient state-owned enterprises (SOEs), and undoing years of work spent trying to instill China's banks with financial discipline.

In the two decades leading up to the financial crisis, a lot of hard and sincere work was done to try to teach profligate SOEs, local governments, and banks to live and work within their means, but that doesn't mean these institutions suddenly forgot how to take advantage of a free lunch. In fact, it probably heightened their appetite for it. As a result, much of the money was sunk -- almost literally -- into local government financing vehicles (LGFVs), which are municipal government-owned companies often responsible for infrastructure investment. These companies, for the most part, exist to keep local government debt off the books -- since local governments have a very limited capacity to borrow money directly -- by allowing them to borrow indirectly and finance construction projects through companies they own, built on land often acquired and sold below market price by them.

Surprisingly, this system constituted a huge source of revenue for cash-strapped local governments, which have few real sources of tax revenue. Less surprisingly, it is also an endemic, institutionalized form of corruption. A recent OECD report estimated that total public debt reached 57 percent of GDP by the end of 2010, with LGFVs accounting for about three quarters of this figure. Given that some people familiar with LGFVs see them as little more than holes in the ground into which seemingly endless amounts of perfectly good money are poured, it is likely this borrowing generated a wave of future defaults.


How, and why, was the money spent this way? To answer this question, it's important to understand the love affair between the Chinese government and infrastructure projects. Over the past two decades, Beijing has relied on building roads, power grids, and other fixed assets in order to facilitate the rapid expansion of the economy, but this method of growth inevitably leads to declining returns over time. As a result, Chinese policy makers understand that to decrease the economy's dependence on investment and export markets (which depend too much on the whims of the global economy) domestic consumption needs to pick up the slack. Unfortunately, however, this "rebalancing" is tricky.

Ryan Perkins, based in Beijing, is the editor-in-chief of

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