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
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
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