Interpreting China's Monetary Aggregates And Its Relation With Shadow Banking Business

by: Lincoln Li


M2 and social financing are two mirrors of Chinese money supply and each measurement reflects different aspects of the money flow.

Three items, namely trust loans, entrust loans, and Banker's Acceptance Bills, comprising social financing reflect the shadow banking business in China.

The historical numbers for these items reflect the back and forth between the regulator and banks, and investors should be careful in using them as inputs.

The Chinese economy is investment-driven and relies heavily on real estate and infrastructure projects. Bank credit accounts for a majority stake in overall financing activities; therefore, the money flows of banks are an important indicator for investors when gauging the condition of the Chinese economy. There are two series of data which are published by the People's Bank of China (PBOC) every month that investors should pay special attention to, specifically M2 and social financing. These are like two mirrors of China's money supply and each measurement reflects different aspects of the money flow.

M2 is the most popular measure of money supply in China. The PBOC defined M2 as M1+ Quasi-Money (Time Deposits + Saving Deposits + Other Deposits). M1 is defined as M0 + Demand Deposits where M0 is currency in circulation. By the end of June 2016, the central bank revealed that M2 reached RMB 146.17 trillion, M1 reached RMB 42.4 trillion, and M0 reached RMB 6.28 trillion. The growth chart of the money supply since 2010 is shown below.

When further reviewing the monthly YoY growth rate of M2, M1, and M0, we found out that the growth rate of M2 has been higher than M1 and M0 for most of the time since 2011. However, such trend reverted in October 2015 and since then M1 has been growing at a faster rate. In May 2016, the M1 growth rate reached 23.7% while the M2 growth rate was only 11.8%.

The growth rate gap between M2 and M1 is regarded as an indicator of the failure of current loose monetary policy. Excess liquidity failed to flow to the real economy and it was only held as cash by companies. The ANZ bank suggested that the rapid growth of M1 can be attributed to the quick increase of non-financial companies' demand deposits, which accounts for 95% of the M1 increase. On the other hand, the slow growth of non-financial firms' time deposits and residents' savings deposits pulled down the growth of M2. These two items account for 61% of M2 and 87% of the difference between M2 and M1. The excess liquidity served only to force the non-financing banks to purchase short-term financial products such as money market funds. The interest rates on time deposits are too low and therefore they are unattractive to non-financial firms.

The numbers for M2 and M1 provide investors with insights into the money stock allocation among deposit accounts, saving accounts, and demand accounts in Chinese banks. However, the numbers for M2 cannot reveal how these funds are being used. As a result, the central bank started to publish social financing data in 2002. The PBOC defined "social financing" as "the total amount of money (flows) the real economy draws from the financial system". It includes 10 items, namely lending in renminbi, lending in foreign currencies, entrusted loans, trust loans, banker's acceptance bills, corporate bonds, and shares issued in China by non-financial companies, insurance compensation, insurance property investment, and other financing. The PBOC published the first 7 of these numbers monthly and revealed the numbers for insurance compensation, insurance property investment, and other financing annually due to their lower importance.

In summary, M2 reflects the purchasing power of society and social financing shows the purchasing power allocated in society. The two numbers are like the two sides of a coin. Sheng Songcheng, the director of PBOC Survey and Statistics Department, suggested that M2 and social financing are highly correlated with a 0.99 correlation coefficient. However, the two numbers come from different sources, and social financing includes more non-bank financing activities which makes it a better predictor of the Chinese economy. The correlations between social financing and GDP, retail sales, CPI, and so on are higher than the correlations between M2 and these indicators.

The 10 items in social financing have different weights and the loans in local currency account for more than 65% of the total amount of social financing.

However, if we take a closer look at the data, the weight of loans in local currency has declined since 2008 and then it started to recover from June 2014.

The Chinese government announced a RMB 4 trillion stimulus plan at the end of 2008. Upon further checking the monthly increase in the amount of loans in local currency, we found that the loans in local currency reached a historical high in March 2009. This record high was refreshed in January 2016 when commercial banks reported a RMB 2.5 trillion increase in RMB loans. There are four reasons which have led to the most recent hike in loans. The first reason is that commercial banks wanted to secure their interest gains as early as possible. The regulator allocates a credit limit to each bank each year and banks can offer credit to clients at their own pace. If banks expect the economy to worsen, as in January, they have an incentive to compete with each other by using a large percentage of their quotas to finance a limited number of low-risk projects. The second reason for the increase in credit is the strong demand for mortgage loans and the third reason is the substitution of overseas loans for domestic loans. Before the PBOC depreciated the RMB last August, many companies borrowed overseas to leverage the low interest rate in the US. However, the depreciation of the RMB and a lift in interest rates by the Fed means that such transactions are no longer profitable and it forces most companies to seek loans from domestic banks. The forth reason for the increase in credit is the government's increased expenditure on infrastructure projects in order to stimulate the economy.

Other than the abnormally high increase in loans in 2009, by checking the year-to-date (ytd) increase in the amount of loans in local currency, we found that the annual increase in new loans in local currency has continued to grow since 2011; therefore, the decreasing share of loans must be due to the rapid growth of the other 6 items.

In order to check the gap between loans in local currency and social financing, we calculated the shares of each item in the gap at the end of May 2016 and their historical number. The results are as follows:

From the chart, we can see that bond financing and entrusted loans are two largest items, followed by trust loans, equity financing, banker's acceptance, and loans in foreign currency. Since 2006, all items have been growing. However, net corporate bond financing and entrusted loans are the only two items which have maintained a high growth rate all the time.

Bond financing, equity financing, and loans in foreign currency are straight forward. Banker's acceptance, entrusted loan, and trust loans are regarded as the major sources of shadow banking and their function in China is different from their definition in textbooks. In this report, we will examine Chinese banks' operations underlying these three numbers over the past few years in the hope that it will provide investors with an historical understanding of Chinese shadow banking operations and improve investors' understanding of the money survey numbers.

Shadow banking in China by definition is "credit intermediation involving entities and activities outside the regular banking system, with the functions of liquidity and credit transformation,which could potentially cause systemic risks or regulatory arbitrage." We understand that there are not only arbitrage operations behind these numbers but also much normal business. However, it is impossible to establish what percentage of the number is due to shadow banking activities and how much can be attributed to normal operations. However, we believe our examples were mainstream operation back then and banks' operations which fall within the 'grey area' should be a major component of the number.

Chinese banks used to be and still are under strict regulation. There are three rules commercial banks have to deal with constantly. 1. The 75% loan/deposit ratio which restricted banks' ability to lend at will and which policies were abolished in 2015. 2. The government's restriction on loans to certain high-risk industries such as real estate, steel, and coal firms. 3. Chinese banks are also facing similar-Basel III regulations and have to control the amount of risk-weighted assets. These three rules are bothering Chinese banks all the time and are the origin of the shadow banking system. In order to understand the Chinese banking system, we believe readers should keep another three rules in mind.

Rule #1: All things invented by Western countries will mutate in China

Rule #2: Chinese commercial banks fund the sources of shadow banking activities

Rule #3: Banks understand that the Chinese central government will be paid for the aggressive operations of banks in the end

Trust Loans

When discussing trust loans, it is common sense that they should be loans made by the trust companies and they should not have any relationship with commercial banks. However, strict banking regulations have forced a strange cooperation between commercial banks and trust firms.

In 2008, the Chinese government revealed a RMB 4 trillion investment stimulus plan after the global financial crisis. However, the central government provided only 30% of the funds, with local governments and banks contributing the remaining amount of money. As a result, commercial banks lend a significant amount of funds to infrastructure and real estate projects with long periods of investment. When the central government saw inflation increase and the massive amount of infrastructure projects, the government brutally required commercial banks to simply limit their loans to those projects which led to the cooperation between trust firms and commercial banks.

For the banks, they are facing a dilemma. Many real estate developers are small players and lack alternative sources of financing. If the banks stopped lending, it would threaten the liquidity of those firms and create an immediate default risk on the loans. In order to prevent an increase in non-performing loans and maintain relationships with developers, banks searched for trust companies to work with to move loans off banks' balance sheets.

The relationship between banks and trust companies works as follows:

The banks approached trust firms and asked the trust firms to work with real estate firms to establish a single trust plan. After such trust plan was established, the banks set up a wealth management product (WMP) to purchase the single trust plan. In such an operation, trust companies are acting as a conduit while the banks continue to take the risks of lending money to company A, but the loans successfully disappear from banks' balance sheets after the operation.

Wealth management investors literally should be the group who bear the risks. However, the banks stake their reputations on this operation, and therefore, there is little chance that the banks will not bail out the trust plan if there is a default. As a result, the China Banking Regulatory Commission (CBRC) has forbidden a direct purchase of a trust plan from a bank's wealth management product. However, the compliance teams in banks very quickly figured out a loophole and created a new term "trust beneficial right" to bypass the CBRC's new regulation.

The new operation introduced a new company B to purchase the trust loan and sell the newly created "trust beneficial right" instead of trust loan assets to the banks' wealth management products' buyer. But in essence, company B did not take any risks and only charges a small percentage of the conduit fees.

The battle between regulators and banks has intensified such that rules get longer and banks' operations become more complex. Finally, the CBRC issued "China Banking Regulatory Commission's Regulation Commercial Banks' investment operations and related issues", also known as No. 8 policy, in March 2013 which requires the non-tradable assets of banks' wealth management asset not to exceed 35% of the whole assets, nor 4% of banks' total assets, which ever is the lower. After the introduction of this policy, the banks could not figure out any new ways to bypass the rules and the cooperation between banks and trust firms has come to an end.

From the numbers showing the monthly increase in trust loans, we can see that new trust loans reached a record high on March 1, 2013 and started to fall thereafter.

Bankers' acceptance

Another tool for Chinese commercial banks to conduct shadow banking operations is Banker's Acceptance Bills. The number of undiscounted Banker's Acceptance Bills is regarded as another important statistic for the shadow banking business in China.

Banker's Acceptance, or BA, according to Wikipedia, is "a promised future payment, or time draft, which is accepted and guaranteed by a bank and drawn on a deposit at the bank." However, such definition does not reflect what happens in China. Chinese commercial banks have a special love for issuing Banker's Acceptance Bills for three reasons. First, issuing a Banker's Acceptance Bill is an off-balance sheet activity which means banks can issue them as quasi-loans to target companies without worrying about the 75% loan/deposit ratio. Second, in order to enable banks to issue Banker's Acceptance Bills, target companies have to first make deposits in the banks which increase the total amount of deposits. Third, there are several fees for issuing Banker's Acceptance Bills and these fees are considered to be intermediate income. Investors are paying greater attention to banks' intermediate income and consider it as an important gauge of banks' profitability, especially considering banks' traditional net interest margin income is shrinking.

At one time, issuing Banker's Acceptance Bill instead of offering loans was so popular among Chinese banks that banks even created new method to manipulate the tool. For example, one operation was to let a firm make a deposit amount, A, in a bank and then the bank issued a BA. Then the firm discounted the BA with another financial institution or private firm and obtained an amount of cash, B (B was larger than A). Then the firm made another deposit amount of B to the same bank and the bank issued a BA to an even larger amount. Such a process could go on indefinitely, and as a result, in some cases, the BA deposits became a major source of deposits for the bank.

On the other hand, Banker's Acceptance Bills should be based on trade activities and there is a need for related documents. As a result, banks usually work with companies on their applications and local media suggests that some banks seduce companies to file fraudulent applications.

After a Banker's Acceptance Bill is discounted by a bank, the bank has to book it as a loan and move it onto its balance sheet. Therefore, banks set a very high discount rate to discourage companies from discounting Banker's Acceptance Bills before they expire. On the other hand, many rural mutual credit cooperatives in poor provinces could not fully utilize their loan quotas and large amounts of Banker's Acceptance Bills, which were issued by commercial banks in coastal areas, were discounted in rural mutual credit cooperatives in poor provinces.

The amount of undiscounted Banker's Acceptance Bills is related to two factors, namely the amount of Banker's Acceptance Bills issued by the banks and the amount of BA being discounted. From the aggregate number of undiscounted amounts of Banker's Acceptance Bills, we can see that the number reached an historical high in June 2014 and then started falling. Standard Chartered suggested that lower interest rates encouraged companies to discount BA in advance after the central bank started lowering the policy lending rate in October 2014. The other reason that contributed to the declining amount of undiscounted Banker's Acceptance Bills is related to the slowing economy. The PBOC sets credit quotas for commercial banks, and if a bank can not fully utilize its quota, the bank faces the risk of receiving a lower quota in the following year. As a result, if banks find it hard to make loans to low-risk projects, banks tend to discount the bankers in advance in order to turn BA into loans to fully utilize their credit quotas. The third reason for decreasing BA is due to recent scandal. Many banks found their discounted Banker's Acceptance Bills were stolen from the vault by employees and those employees cashed out the same BA from other financial firms and used the money in high-risk short-term investment activities. After the scandal broke, banks started tightening their control systems and they feel reluctant to issue BA.

Entrust loans

The Chinese government forbids private companies from lending money to each other and it requires all lending actives to go through banks which in turn created entrusted loans. Banks, in theory, should take no risks with entrusted loans and they should only collect a small amount of fees. However, the strict regulations also make entrust loans a useful tool for banks to bypass regulations and lend to restricted clients.

When banks plan to make loans to credit-restricted companies such as real estate developers, they will approach another company and offer guarantee documents in order to encourage the company to make an entrust loan. When the regulator forbid any kind of guarantee activity and asked banks not to become involved in matching deals, the banks had no choice but to follow the rules and the entrust loan operation also evolved.

After the stock market bubble collapsed, the yields on all asset classes fell and large and public companies could issue bonds at a very cheap price. On the other hand, companies which need money would love to offer as high as 20% as an annual interest rate. As the return on operations of most public companies fell sharply during the slowing economy, many listed firms have come to rely heavily on entrust loans to boost profits. Although the regulator has forbidden the raising of funds publicly and then lending the money to other companies through entrust loans, large companies can always hide the true sources of the money through complex inner transactions. If we look at the volume of entrust loans, bond issuance, and equity issuance, we find that equity financing has grown at a decent pace, but bond financing and entrust loans have grown quickly.

The Chinese government has been concerned that indirect financing, mainly bank lending, accounts for a majority of China's total social financing and it plans to increase the percentage of direct financing, namely bond and equity financing. As a result, government officers have thought that a larger percentage of direct financing represents a healthier financing structure. However, shadow banking operations in the form of entrust loans might be proof of the irony that the Chinese government officer's beautiful vision has turned into a great tool for 'smart' market players to make money.

In terms of an alternative method to utilize the M2 or social financing number, a high profile Asian-focused hedge fund manager, Bei Lesi, who just funded his own fund, Lingfeng Capital, leveraged the Log-Periodic Power Law (LPPL) model to predict the collapse of the Chinese economy. Their model is based on the assumption that most of the credit is being used as funding for Ponzi financing, and therefore, it requires an exceptional growth rate to maintain the game.

Mr. Bei's model suggested that after June 2014, the growth of M2 in China has been maintained at a fast rate, but it has started to fall behind the exponential growth model, and in the third quarter of 2016, China has the greatest likelihood of experiencing market turmoil.

In summary, M2 and social financing are two mirrors of the Chinese money supply and each measurement reflects different aspects of the money flow. Three items, namely trust loans, entrust loans, and Banker's Acceptance Bills, comprising social financing reflect the shadow banking business in China. The historical numbers for these items reflect the back and forth between the regulator and banks, and investors should be careful in using them as inputs.

Disclosure: I/we 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.