Even though we have had a string of good economic reports out of China, I believe it's important not to lose sight of the challenges the nation still faces in keeping its economy healthy. The nation has a huge impact on the American markets and there are two particular struggles the nation continues to face that investors should keep aware of.
It wasn't long ago that analysts were afraid that China's economy was slowing down faster than expected. A recent string of strong data in August has analysts rethinking their thoughts on the country, and some have even listed their "full-year growth target" above the 7.5% the country has focused on.
Shadow Banking Practices
In late spring the government in China was bent on a shift in the economy toward "consumption led growth" and away from its dependency upon exports. One of the things that contributed to a slowdown was the country's curtailment of risky lending by banks. With the improving economic numbers, some are worried that the economy is again influenced by investments and property of what some call "shadow banking."
What is shadow banking? If you are unfamiliar with the concept of shadow banking, it is referring to unregulated activities by regulated institutions. This would include such things as hedge funds, on listed derivatives and credit default swaps. Since this "system" does not accept traditional banking deposits, it has escaped regulation. They get involved in higher credit and liquidity risk without having to meet capital requirements with those risks.
This risky lending has been at the forefront of Beijing's desire to reform the finance system. The People's Bank of China, the nation's central bank, refused to pump money into the system when banks needed it at the end of summer in an attempt to address this "shadow system." The message it was putting across to the mid-size state-run banks that were causing the problem was this: don't take for granted that whenever you need money it's easy to get.
This is how the lending worked in creating problems.
A state-owned company borrows from a state-owned bank at a low interest rate, let's say 5% as an example. The company turns around and lends that money out at a higher rate of return - 10% to a "private trust company." This is part of this shadow banking system. The trust company lends the money to a more speculative part of the economy like real estate.
With so much of this "shadow money" going in real estate, the government was fearful of a real estate bubble bursting, causing cascading loan defaults like we experienced here in America in 2008.
Not only is this "shadow banking" system a real threat to China's financial stability, but another threat the company is addressing has been industrial overproduction. This is one of the reasons that we may continue to see a slowdown in the Chinese economy over time.
Industrial Sector Overcapacity
One of the reasons that we may see even more slowdown in the economy is because of the enthusiasm at which industrial sectors are growing. Finding a happy production medium is the key here - sometimes too much is, well too much. Some level productions are so high they are leading to overcapacity and this includes such segments like steel, cement, plate glass and certain types of aluminum.
The government is aggressively addressing this problem while it designates certain companies to shut down for a period of time while more than 1,400 other companies from 19 industrial sectors are being "asked" to curb their production capacities. The era of "investment driven growth" that helped the economy to grow for so long is not sustainable. Reducing overcapacity is part of the plan to transform the economy.
If you think about it, this makes sense. For years the nation has grown by production and export. The sluggish world economy combined with weak domestic consumption naturally would lead to overproduction. A move away from this type of growth is important for China to be able to sustain economic growth in the long run.
It's important to be abreast of the financial situation and the manufacturing problems that the nation faces. There are other struggles that I haven't even mentioned, like the "real estate bubble," but these two will have a greater influence on the success of the Chinese economy in the short term. Even though the Chinese government is attempting to slow down and transform the economy, reining in "shadow banking" practices as well as continued overproduction will be important. It is no easy task for the government.