Wealth management products, underground finance and off-balance-sheet lending may affect health of credit flow

Shadow banking can broadly be described as the system of credit intermediation involving entities and activities outside the regular banking system. In developed countries, the biggest shadow banking players are usually hedge funds, venture capital and private equity funds.

However, in China, shadow banking has mainly taken the form of a large amount of wealth management products, or WMPs as they are known, underground finance and off-balance-sheet lending.

Chinese banks work closely with trust companies or other entities by packaging trust loans into WMPs, offering investors a higher yield than conventional bank deposits can. These products are mainly sold by commercial banks either at their branches or online. Many of the funds that were obtained through these channels went into real estate development, infrastructure projects, the manufacturing sector and local government financing vehicles. Banks are playing the role of "middlemen" between the recipients and investors.

It is difficult to measure the precise amount and value of WMPs. Fitch Ratings says that WMPs account for roughly 16 percent of all commercial bank deposits, while KPMG reports that trust companies will soon overtake insurance to become the second-largest sector in the Chinese financial industry. According to a report by CN Benefit, a Chinese wealth-management consultancy, sales of WMPs soared 43 percent in the first half of 2012 to 12.14 trillion yuan ($1.9 trillion).

There are more than 20,000 WMPs in circulation, a dramatic increase from only a few hundred just five years ago. Given that the number is so big and hard to manage, China's shadow banking sector has become a potential source of systemic financial risk over the next few years. Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations.

Moreover, many WMPs are not even linked to any specific asset, rather, just to a pool of assets, whose cash inflows may often not match the timing of scheduled WMP repayments.

China's shadow banking is contributing to a growing liquidity risk in the financial markets. Most WMPs carry tenures of less than a year, with many being as short as weeks or even days. Thus in some cases short-term financing has been invested in long-term projects, and in such situations there is a possibility of a liquidity crisis being triggered if the markets were to be abruptly squeezed.

In fact, when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme. Under certain conditions, the music may stop when investors lose confidence and reduce their buying or withdraw from WMPs. The rollover of a large share of WMPs could weigh heavily on formal banks' reputations, because many investors firmly believe that banks won't close down and they can always get their money back.

China's general banking stability is increasingly intertwined with the shadow banking system. In the past, Chinese depositors earned the same interest no matter which bank they placed their money with. Today they can shift their deposits to whatever entity offers the best WMP yields. As a result, money has flown out of banks' saving deposits, further eroding the capabilities for lending to the real economy, and could even lead to future cash pressures on banks.

Admittedly, shadow banking has its advantages. It gives an appealing return to depositors during periods when interest rates are very low or negative in real terms; it helps businesses that need credit but who are unable to access it from traditional bank loans. Meanwhile, shadow banking continues to provide funds that allow certain half-finished projects to remain in construction, which spur the GDP growth rate.

It is shadow banking activities that have allowed many projects to obtain fresh funds and hence avoid default. This could be one of the major reasons why the formal banking system in general is still enjoying declining non-performing loan ratios, despite the weakening repayment capabilities of some borrowers.

Unsurprisingly, although Chinese banks' non-performing loans are at a low level of 0.9 percent, the potential risks are worse than the official data suggest. Many industries have excessive capacity after years of aggressive expansion, and a lot of money has become involved in property speculation. Eventually, indebted companies may fall into default or hit severe cash flow problems.

Many Chinese companies, for instance in the iron and steel sectors and equipment manufacturing, are facing a "triangle debt" problem. That is, when a default occurs between one party and another because a third party cannot or will not pay the first.

Among 1,437 listed companies that published their 2012 interim results, account receivables stood at 803.9 billion yuan by the end of June, up by 45 percent year-on-year.

Chinese banks' overdue loans, an indicator of future non-performing loans, are increasing at a faster pace. By the end of June, the top 10 lenders' outstanding overdue loans reached 489 billion yuan, up 112.9 billion yuan from the beginning of this year. This indicates great pressure on banks' asset quality as economic growth slows.

Regular banking and shadow banking are not isolated from each other. Many activities in the two systems feed into each other, and could influence each other if things start to deteriorate.

Some countries' previous experiences of financial crises show that either rapid credit growth in the banking system or explosive shadow banking growth can pose threats to a financial system. Right now, the amount of shadow banking in the eurozone accounts for 210 percent of GDP, and is at 330 percent in the US, leaving their financial systems vulnerable amid the prolonged recovery.

China has recently released a flood of credit in responding to the global financial crisis, which not only helped its economy, but also helped some other members of the world economy. According to CLSA strategist Russell Napier, since 2007, China has accounted for 40 to 50 percent of broad money growth across the world's 16 largest economies. China's broad money now stands at $14.49 trillion, having jumped from $5.47 trillion in 2007.

In order to prevent China's financial systemic or regional risks from happening, it is imperative to pay more attention to shadow banking and to enhance supervision over shadow banking activities.

China's shadow banking system is complex, with a close yet opaque relationship to the regular banking system and the real economy. It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless.