China's Shadow Banking And Liquidity Squeeze Explained

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Includes: FXI, PGJ
by: Marc Chandler

This great graphic was posted on the Financial Times' new news delivery service called fastFT. It in turn picked it up from BofA Merrill Lynch, who drew on data from China's central bank.

Click to enlarge

The orange-ish line is the yuan loans made by China's banks. The blue line is a broader measure. It depicts what China officials call "social financing," which, in addition to bank loans, includes the fund raising of other financial and non-financial firms, as well as households. The measure was introduced by the PBOC in 2011, so the economists that put the chart together must have projected the social financing prior for the earlier period.

Chinese officials devised this tool to help it monitor how the financial system evolved away from state-centric lending. This broad measure is of credit activity. It is the total funds in the real economy generated by the financial system.

The gap between the two lines is the growing role of non-bank actors in the financial system This has been dubbed "shadow banking." It is a nice moniker, but it is not very telling. It is simply the non-bank part of the financial system, which itself may be a function of the increasing complexity of the system. It is the dis-intermediation of banks.

Chinese officials do not have as much direct control over the shadow banking sector as they do the banking sector proper. Officials were able to slow bank lending, as they desired. However, credit creation in the shadow banking system was unchecked. The liquidity squeeze has seen rates rise sharply in China, and while they might not be rising further, remain at elevated levels, and is partly meant or tolerated to rein in the non-banking part of the financial system.

The falsified exports to conceal capital flows and practices around wealth management products were different, but similar ways to game and circumvent the system. Officials, in part, lost some control. The sale-and-buyback scheme that was banned last month was one of the ways in which smaller financial institutions dealt with the inherent maturity mismatch in wealth management products that were attractive and offered higher interest rates than deposits.

Around 85% of the wealth management products mature in 6 months or less. To get a higher yield, the proceeds were invested in bonds. This is the maturity mismatch and the sale-and-buyback scheme that was used to manage this is no longer available. Part of the increased interest rates in China may reflect the sales of those bonds in an illiquid market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.