By James Donald
Recent headlines often assign a negative connotation to shadow bank lending in China. However, significant lending outside traditional banking is not exclusive to China. For example, in developed markets such as the United States and the euro zone shadow banking represents a large share in relation to the total of other liabilities in the system.
At the start of 2013, by some estimates, shadow banking relative to total other liabilities represented close to 90% in the United States, 50% in the eurozone, and 20% in China.¹ However, President Xi Jinping’s administration appears to be undertaking efforts to curb the growth of shadow banking. Despite a long-term growth trend since the most recent transition of power in China, there has been an important deceleration in shadow banking growth.
Shadow banking serves a valuable purpose for many borrowers. Lending through traditional banking channels remains closed to many industries, only providing to those with the highest level of creditworthiness. As such, an overly tight clampdown on shadow banking runs the risks of slowing down credit and economic activity in many businesses. However, outsized growth is eventually a systemic risk. Last, China is a closed system with capital controls. While there are early hints for opening the capital account, once again, we believe this must be implemented cautiously to avoid potentially destabilising outflows.
The indebtedness of local governments in China has also been signalled as a concern. A particular characteristic of government finances in China is that most sources of tax revenue flow directly to the central government whereas spending remains the responsibility of the local governments. This mismatch has been acknowledged by the current administration and in our view the central government can be seen as a backstop in this respect.
Notably, government debt in China is manageable, with general government debt as a share of GDP at about 50%, which is lower than the ratio in other large emerging economies, and significantly below than that in developed countries. From this total, central government debt represents one-third and local government debt comprises the remainder (approximately 18% and 36% of GDP respectively). In addition, foreign-exchange reserves in China are about one-third of total global reserves, estimated to be about $4trn.
China has a favourable growth and inflation track record. The country’s massive investments in infrastructure mean that for many businesses fixed costs can remain low. With this backdrop, China is in its first credit cycle since the early 2000s when banks were re-capitalised. At that time, banks were mostly used as policy tools for directed loans controlled by the government. Today, as many bank entities have become listed, the scenery is different as institutions run more on market-based principles, which continue to be refined.
In our opinion, asset-quality risk for Chinese financials is largely contained by continued regulatory forbearance, reserve capital, and liquidity. Additionally, to understand the current challenges one must not lose sight that China is a top-down, centrally planned economic system. The largest capital allocator in China is its government, and local government debt and private sector lending (SOEs) are ultimately a claim on the Chinese central government. We believe that generally banks maintain adequate liquidity and are well positioned to withstand a stressed scenario; moreover, the Chinese government’s finances remain stable to address systemic risk.
James Donald is manager of the Lazard Emerging Market Equity fund
1 Source: Simon Ogus, DSG Asia. As of January 2013.
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