Shadow banking, the housing bubble
and China’s financial system
Introduction
The
financial system is characterized by several factors which also control its success
or failure in any country. Some of the sectors that play an important role in the
financial system include the shadow banking sector and the property sector. Shadow
banking is associated with the financial sector since it offers immense support
to the primary financial systems and results in significant benefits in the system.
Despite this, the shadow banking system is also wrought with as many challenges
as the primary financial system changes. The size of shadow banking systems in the
world depends on the size of the economies in which they operate. More advanced
economies in the world have broader shadow banking systems (Valckx and others 66).
In any economy, the growth of the shadow-banking sector is driven by factors such
as the tightening of banking regulations, wide liquidity conditions and due to the
demand from institutional investors. Shadow banking systems involve intermediation
of credits outside the contemporary banking systems. The tightening of banking regulations
results in this through diversion of potential investor attention to the conventional
shadow banking systems available in the economy (Valckx and others 68). This is
founded on the awareness that shadow banking operates on less stringent regulations.
Although
the shadow banking and property market conditions affect the financial status of
an economy to some extent, the overall status of the economy is in most cases affected
much more by other factors i.e. the economic indicators in the country. In China,
like in all other economies, shadow banking has undergone immense revolutions in
the last decade, resulting in various impacts on the financial sector. The shadow
banking system aims at complementing the primary banking system through provision
of various services (Labes 2). First, shadow banking provides additional liquidity
support for the financial market, transforms financial maturity, enables risk sharing
with the traditional systems of banking and helps in the expansion of credit access
from financial institutions. The property market similarly boosts the financial
system through the provision of additional resources in the form of services such
as mortgages. Consequently, the relationship between housing bubbles and the growth
of the nation’s financial system can be drawn.
While
it has been ascertained that shadow banking has benefits to the financial system,
it is also important to note that it also poses significant challenges to the system,
particularly in terms of destabilization of the financial system. The vulnerability
to destabilization is however increased during financial crises. Shadow banking
achieves this through the provision of high leveraging through the increase in holdings
for illiquid assets during financial crises. Moreover, shadow banking increases
risks associated with the banking sector such as run risks, problems with agency,
spill over, and procyclicality and leveraging (Labes 4). The contribution of the
property market to the financial system cannot be ignored nor divorced from the
concept of shadow banking.
The
discussion of the Chinese financial system encompasses the concepts of regulation,
the shadow banking system in China and how shadow banking and the housing bubble
contribute to the growth of the financial sector. Additional focus will also be
on the impacts of the two concepts on the financial system and the potential harm
these concepts could cause on the nation’s financial system. Currently the dearth
of information available on the connection between the housing bubble, shadow banking
system and the national financial system in China is limited. Consequently, the
paper aims at carrying out an analysis of the financial system in China. The scope
of the study will cover these three concepts in details. However, since all the
three are significantly wide, it is impossible to cover all the details pertaining
to the China financial system within the meager expanse of this paper. It is believed
that this paper will contribute immensely in the provision of information about
the economic status of the country. To achieve this objective, the study will be
carried out based on an intensive literature review of materials relevant to the
present study aims.
Research
Objectives
In
order to achieve the major purpose of the paper, the study will be guided by the
following specific objectives.
To determine the nature of the regulations
on the financial system in China
To find out the history and status of the
shadow banking system in China
To establish the relationship between the
property market, housing bubbles, shadow banking and the Chinese financial system
in the contemporary times
Literature Review
Introduction
The
role of shadow banking in the global financial sector has been effectively described
by various authors as being both beneficial and vulnerable to risks. However, it
is undeniable that the contribution this aspect has had on the financial sectors
in the global context is immense. While being vulnerable to potential financial
risks, this sector is also open to greater development and contribution to the nation’s
GDP (Valckx and others 65). Similarly, the property sector has also contributed
immensely to the expansion of countries’ financial systems. Shadow banking systems
in China has been described as being based on mechanism different from other mechanisms
that are applied in other economies such as the US. In China, Shadow banking is
built on a guarantee system and operates within banks rather than in the capital
markets (Dang and others 1). The contribution of the property market on the financial
system has also been immense in China.
Shadow
Banking in China
China’s
economy in the recent years can only be described as robust based on the percentage
growth that has been experienced in various sectors. This growth has made the nation’s
economy to surpass the economies of several other countries, key of which is Japan
in terms of its GDP. According to Dang and others (1), the Chinese economic growth
has been driven by China’s robust financial system, which has led to the establishment
of China as a major trading nation in the world. The impacts of this immense economic
growth on the living conditions of the nation’s citizens has been positive over
the years, resulting in the lifting of several people out of poverty. However, in
recent years, the financial system of the country has relapsed in terms of growth.
The system has been described as lacking in terms of diversity, intensive regulations
and the influence of the government/ political system on the economy. Due to these
factors, the shadow banking systems in China have also grown immensely. This is
because factors such as stringent regulations in the financial sector contribute
to the growth of the shadow banking system.
Shadow
banking in China plays a very essential role in the expansion of China’s economy.
In recent years, shadow banking has risen significantly in China, contributing a
lot in terms of GDP improvements to the Chinese economy. For instance, in terms
of intermediation in credits, the shadow banking system has played a critical role
in the expansion of non- bank based loans such as entrusted and trust loans from
fewer than 10 percent of all the loans in 2008 to more than 40 percent of the loans
in 2013 (Valckx and others 68). This implies that as the benefits of shadow banking
have been described to include expansion of access to credit and provision of alternative
sources of financing, China already benefits from these and is more likely to expand
in the application of shadow baking and in terms of gained benefits. Despite this
growth in potential benefits of the shadow banking system, stringent regulations
which have continued to be tightened in the financial sector have resulted in the constraint
of the economic expansion, particularly since 2012 (Valckx and others 66). This
has in effect reduced the rate of expansion of the shadow banking system in the
country. Various products are associated with shadow banking in China. These products
range in form and conditions of availability depending on the type of shadow banking
source and the size of the system.
One
of the products that are offered by the shadow banking system in China is trust
loans. Besides this, there is also entrusted loans which are provided by the same
system. Trust loans and collective entrust programs are offered by the shadow banking
systems. These loans are mainly aimed at providing assistance in banking wealth
management programs. Consequently, these programs are mainly accessible to infrastructure
and real estate projects that require funding. Other potential beneficiaries are
local government entities and developers who may not be in a position to acquire
funding through bonds (IOR and RMBISA 4). However, the main challenge faced by the
shadow bankers is that these projects, which receive funding from the shadow
banking system, are often incapable of generating income due to being over-invested.
The implication is that without effective controls, the shadow banking system can
incur losses due to the inability of the beneficiaries to make payments (Ma 1).
This limits the capabilities of wealth management products in attaining the target
revenue from the beneficiaries. The effect of this is that losses to the wealth
management products such as trust loans result in subsequent losses in the entire
shadow banking system.
The
wealth management products (WMPs) are the core sources of revenue in the shadow
banking system in China, with the registered income from these products being estimated
at 1.2 trillion dollars in 2012. This income was however projected to increase due
to the increase in demand for shadow banking products and services. The projected
increase in WMP related income is said to be due to the increasing financial issuances
in replacement of the expiring ones. This has already made a cycle to be developed
whereby the continuous cycles of issuances and expiry leads to the continued expansion
of the shadow banking system and subsequent increase in vulnerability to financial
risks (IOR and RMBISA 4). The major concern that has been raised with regards to
this increase in vulnerability is the relationship that exists between banks and
the shadow banking system. This is because the shadow banking system in China operates
on a traditional bank platform as opposed to other shadow banking systems which
operate on the capital market platform. Due to this operational basis, the shadow
banking system in China is characterized by a lack of transparency, which heightens
the vulnerability to risks. The associated risks include the potential for causing
financial instability across the entire region due to the minimal regulation that
is also inherent in the shadow banking system in China. Moreover, the operation
of the shadow banking system is even more complicated than the conventional banking
system thus making potential risks to be higher than in other economies (IOR and
RMBISA 4).
The
risks associated with shadow banking in the country’s economy could also spill over
to the global financial sector due to the interconnectivity between the financial
sector and the shadow banks. According to Ma (1), the fast growth associated with
China’s shadow banking system poses significant risks to the economy in terms of
liabilities that could possibly find their way into the financial sector’s balance
sheets. This implies that since the shadow banking system is dependent on the traditional
banks platform, any liability that is due to the shadow banking sector has the potential
of getting directly into the banking sector. Because of this, the non-financial/
shadow banking system in China is considered the weakest link in the financial sector
of China’s economy. The impacts of the shadow banks on the financial sector are
immense, particularly on the market stability (Ma 2). In research, it has been established
that a destabilization of China’s finance market that may arise due to the uncontrolled
expansion of the shadow banking sector could result in a destabilization of global
finances. This is based on the argument that once China’s finance market is destabilized,
the country has to import less and also export less (Dang and others 3). The implication
of this is that countries dependent on China as a source of imports or destination
for exports have to contend with lower supply or demand respectively. Besides the
possible impacts on the country’s financial system and the growth of the shadow
banking system in China has also raised significant concerns over the quality of
services and products offered by these non-financial establishments.
Despite
the regulations that have been tightened to control traditional lending practices
used by the shadow banks in China, concerns persist about the quality of the products
offered by these non-financial institutions. The possibility of a lending bubble
coming about because of the shadow banks’ activities is controlled through the institution
of policies which are aimed at controlling their practice. However, areas such as
the quality of the credits associated with the shadow bank loans have had regulations
put in place to reduce the potential for failure. The first measure that was put
in place by the government’s regulatory authorities was to specify the maximum credit
limits which can be issued by the non-financial institutions to potential clients.
Secondly, yearly loan quotas were also established for application by the traditional
banks to reduce the potential for inducing a credit bubble in the financial markets.
These and many more other measures have been put in place to control the growth
of shadow banking in China (Ma 2). The result has been amazing since in the past
two years, the financial sector in China has attained a significant level of stability
despite the growth of the shadow banking system. This means that while the shadow
banks still play the complementary role for which they were designed, their potential
for resulting in increased risks in the financial sector is significantly reduced.
The
major beneficiaries of the shadow banking system in China have been identified as
real estate and property developers and buyers who are incapable of obtaining funding
through bonds. This implies that the success and growth of the shadow banking system
in China is directly tied to the developments in China’s property market. The discussion
of the shadow banking system in China can thus not be complete without the inclusion
of a discussion of the property market.
Housing Bubbles in China
The
housing sector in China has been very dynamic in recent years. Changes in housing
prices have been very robust in the recent past. The recent housing boom has made
the impacts of the changes in the sector even more far reaching. The paradoxical
relationship between the nation’s GDP and the prices of the housing in China can
effectively be described as a housing boom. In the recent past, the housing prices
in China have been increasing at rates higher than the GDP growth rates. This has
made the housing sector to attain high capital return rates and similarly high vacancy
rates.
This
is a clear indication that as housing prices rise, their affordability reduces and
subsequently demand for the houses reduces. As Chen and Wen (1) assert, the housing
sector in China contributes expansively to the economic growth of the country. Real
prices of housing in the last decade have grown by approximately 17 percent, while
the GDP has grown by 10 percent (Barth and others 1). The significant growth in
pricing has been associated with the growth in vacancy rates, which were recorded
to be above 22.4 percent at the end of 2013. Although this indicates a high speculative
housing demand rather than excessive supply, it also indicates the existence of
a housing bubble. This is based on a comparison with the US, which shows that
during the most intensive housing bubble experienced in 2006, the vacancy rates
were only 6 percent (Chen and Wen 1). Interestingly, the returns that the
housing sector has enjoyed in the same period have been significant.
The
paradoxical combination of high housing prices, high vacancy rates and high returns
brings to light the role of the investors in the development of the housing bubble.
It is posited that the significant increase in housing prices creates an impression
of housing as a potential store of value hence encouraging investment in the sector
(Chen and Wen 2). The consequence of this is that most of the housing that are found
vacant are those which have already been purchased by investors on the belief that
there is a potential for future demand for housing. This subsequently creates a
housing bubble in the economy such as that which is currently in existence. The
high vacancy rates can be explained to be a result of the hiked housing prices.
In
2008, it was determined that at the rate of growth of the housing sector in China,
there was the potential of a slow down after some time. This was based on the argument
that with the increase in housing prices, more and more potential buyers would be
forced to settle for less than they desired in terms of housing features (Barth
and others 6). This fear was particularly escalated due to the fact that most of
the house buyers depended on family finances for their house purchases. This implied
that with the increase in housing prices, the access to funds was restricted. The
assistance of shadow banks, which offered trust funds and housing development
loans, therefore came at a time when it was needed immensely. This was especially
important after banks tightened the lending rates due to pressurizing regulations.
However, the shadow banks still provide funding to real estate development
companies from the funds, they obtained from banks (Barth and others 9). This implies
that with the continuing expansion of the housing sector and the projected decline
in the sector has the potential of causing adverse effects in both the shadow banking
system and the conventional banks in the country.
The
Financial System in China
The
financial system in China has been dominated by the banking sector for years now.
The efficiency of the system is therefore in the hands of the banking sector, which
has been striving towards the improvement of efficacy. This is through the reduction
of the [number of unproductive loans issued through conventional banking products
and improving the efficiency of credit products. Besides the banking sector, other
sectors which take center place in the financial system in China are the stock markets
and the alternative financial sectors. The stock market has been performing poorly
in recent years despite efforts for improvement. From a study carried out by Allen
and others, alternative financing channels comprise of the so called shadow banking
systems which provide funding for sectors such as the real estate sector. The relationship
between the alternative financing sector and the banking sector has been described
as being interdependence, with the banking sector providing funding for the alternative
financing sector which offers wealth management products to potential customers.
It is thus imperative that for the economic growth in the country to be sustainable,
the growth in the financial system has to be sustainable.
The
government in China has found ways of improving sustainability in the financial
systems of the coconut through implementation of policies which reduce the potential
of collapse in any of the sectors that contrib.ute directly to the financial system
growth. These sectors include the housing and general property sector, the stock
market sector and the alternative financing sector. The reason for focusing on the
properties and housing sector is probably based on the argument that since this
sector is the major participant in the alternative financing sector, its collapse
has the potential of resulting in a domino effect of negative impacts on the financial
system. China’s major challenge in this regards is to avoid crises associated with
the various sectors such as a financial crises in the banking sector due to sudden
profit drops, a crash of the housing sector due to speculative bubbles such as that
which has been in operation since the last two years, and twin crises (Allen and
others 2).
One
major objective of the government of China is thus to maintain the economic growth
in the country through closure of gaps which are pertinent in the country’s financial
systems. Gaps such as those associated with incremental lending to the housing sector
even in the light of potential burst in the bubble. Measures have been put in place
to ensure that these gaps are closed. The implementation of regulations and policies
for the protection of the country’s financial sector began more than five years
ago. This has included measures such as the introduction of market specific pricing
for both risks and capital, expansion of the breadth of the financial markets, expansion
of the liquidity and depth of the financial markets and improvement of the frameworks
for stability in the financial sector (Hess 21). The implications of these regulatory
measures are intended to sustain long terms financial stability and to improve the
regional cooperation in terms of currency (Hess 21).
The
financial system in China currently is ambitious about improving the status of the
national currency so that it can be at a position commensurate to the country’s
global position. In order to achieve this, the system has made regulations for the
improvement of scalability, stability and liquidity. The future of the financial
system in China is set to be based on exchange rates characterized by flexibility,
liberalization of capital accounts and increased foreign reserve diversification.
This cannot be achieved independently while the overall objective is to better regional
collaboration in terms of currency. Consequently, the collaboration between various
players in the Asian regions financial systems is imperative for the achievement
of individual nations’ financial stability objectives. One important step that China
has to take is the loosening of the restrictions in capital accounts (Walsh 21).
Discussion
Shadow
banking, housing bubbles and the future of China’s financial system
The
Financial system in China is currently facing challenges in terms of the participation
of various players in the system. While the country’s financial system has regulations
that have been put in place for the control of various activities, difficulties
still arise due to the contribution of various sectors to the financial system.
The major risks that have been associated with the country’s financial system include:
the risk of collapse of the housing sector as a result of unprecedented bubbles,
the risk of sudden reduction in banking sector profits, risk of collapse of alternative
financing sector and the risk of twin crises, especially those involving the banking
sector and the housing sector. Several regulations have been put in place to protect
the financial system from these potential risks. These measures include regulation
of lending rates, and control of loan quotas to the housing sector. While these
measures have been instrumental in the regulation of the banking sector operations,
difficulties still exist in terms of alternative financial sectors.
The
main alternative financial sector that has resulted in immense strain on the financial
system in China is the shadow banking sector. This system has undergone prolific
growth in the last few years that can only be described as being exponential. Shadow
banking in China is linked to various risks to the financial system in contemporary
times. The first risk relates to the housing sector in the country. In the last
few years, the housing sector has received financing from shadow banking even when
banks regulated such financing to reduce the potential of realizing credit bubbles.
This implies that as the extent of shadow banking increases in the Chinese economy,
the amount of credit financing awarded to potential real estate and property. This,
as explained in the literature resulted in a rise of speculative demands for housing.
Despite the current status of the industry where the returns and vacancy rates are
significantly high, this status quo is not likely to be maintained for long. It
is expected that following inaffordability of housing due to their prices, the housing
prices is most likely to go down as a result of the housing bubble. The implication
of this would be a reduction in returns due to the shadow banking systems and subsequently
to the banking systems since the shadow banks receive their funds from the banks.
The combination of a housing bubble and the prolific growth of the shadow banking
system therefore have the potential of shaking up the entire financial system in
China. The future stability of the financial system in China therefore depends on
the ability of the system to regulate the growth of shadow banking in the country.
The
question is therefore posited as to whether China should do away with shadow banking
completely. While this may sound as a viable solution to the challenges currently
experienced in China’s financial system, the most appropriate solution would be
to find ways of effectively containing the growth of the sector without complete
annihilation of the system. This is based on the argument that despite the challenges
posed by shadow banking, the benefits it has, particularly on the private investment
systems cannot be ignored since these private investments contrib.ute immensely
to the economic growth of the country. Moreover, control of their growth may also
result in the control of access to property development financing hence reducing
the impacts of the housing explosion.
Conclusion
The
financial system of China depends on three major sectors, which include the banking
sector, the stock market, and the alternative financing sector. The role played
by the housing sector is tied to the contribution of the alternative to the development
of the housing sector. This implies that while the financial sector may be stable
currently, the combination of an imminent housing bubble and expanding shadow banking
system may result in its destabilization. It is thus necessary for the financial
system to provide regulations that may help to control the growth of the alternative
financing sector such as shadow banks in addition to the regulations that control
maximum credit limits and yearly loan quotas.
Works
Cited
Allen,
Franklin, Jun Qian, Meijun Qian and Mengxin Zhao. A review of China’s financial
system and initiatives for the future. 2008.
Barth,
James, Michael Lea and Tong Li. China’s housing market: is a bubble about to burst?
Milken Institute. 2012.
Chen,
Kaiji and Yi Wen. The great housing boom of China. Federal Reserve Bank of St. Lois.
2014.
Dang,
Tri, Honglin Wang and Aidan Yao. Chinese shadow banking: bank-centric misperceptions.
Hong Kong Institute for Monetary Research. 2014.
Hess,
Patrick. ’China’s financial system: past reforms, future ambitions and current state’.
In F. Rövekamp and H. G. Hilpert (eds.),Currency Cooperation in East Asia. Financial
and Monetary Policy Studies 38, 2014. DOI: 10.1007/978-3-319-03062-3_2.
IOR
and RMBISA. Chinese shadow banking: understanding KRIS and risk scenarios. Thomson
Reuters. 2014.
Labes,
Sebastian. Shadow banking in China and its implications in the global financial
recession. Alexandru Ioan Cuza university. 2014.
Ma,
Maria. China: shadow banking and the global economy. Commentary. SEI. 2013.
Valckx,
Niko et al. Shadow banking around the globe:
how large and how risky? International Monetary Fund, 2014.
Walsh,
James. The future of Asian Finance. Finance
and Development. 2014.
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