Inside China’s Shadow Banking

The Next Subprime Crisis?

Book by Joe Zhang

Article and Review by GlobalMacroForex

This book’s title is an ironic trick because it makes the reader think the problem is in China’s microcredit lending from non-bank groups (called Shadow Banking).  In actuality, author Joe Zhang works for one of these microcredit firms, and he argues that exact opposite — it’s China’s large mainstream banks that are the problem!  In this article, we’ll learn about China’s equity and real estate markets and what it means going forward.

We’ll cover topics including:

·      Interest rate controls

·      Loans being sold out

·      Shadow banking isn’t the problem

·      Chinese inflation

·      Stock and real estate bubbles

Let’s dig right in…

Interest Rate Controls

Author Zhang argues that China’s banking sector is too regulated, and that the regulations aren’t the right ones.  He points to the fact that there are 7 different Chinese ministries that regulate banking, that they often issue conflicting rules and that it’s a nightmare to navigate the bureaucracy.

The seven ministries:

1.                    China Banking Regulatory Commission

2.                    Central bank (PBoC)

3.                    Ministry of Industry and Information

4.                    National Development and Reform Commission

5.                    Ministry of Finance

6.                    Ministry of Commerce

7.                    General Administration of Industry and Commerce

Zhang’s central thesis is that China’s current interest rates and rate regulation need to be changed.  There are interest rate caps and floors on both deposits and loans.  This guarantees large profit margins for the well-connected banks, but deeply hurts the economy because it distorts the environment for loans and deprives certain underprivileged groups of credit.

“Limited credit is often fully taken up by privileged borrows so relatively weaker borrowers (on the financial and social ladders) have to go to more expensive shadow banks.  If the government really wants to reduce the cost of funding for SMEs and underprivileged consumers, it should raise interest rates for those “prime” borrowers.  So their demand in the market will decline, creating space for SMEs and underprivileged consumers.”

This graphic from the Wall St Journal illustrates the profit margin for banks at the current mandated rates.

Loans sold out

Zhang points out how by setting interest rates too low, it creates too much demand for loans, leading to banks filling up their possible loanable funds too quickly.  So banks look for new ways to get new deposits, but there are caps on the rates banks can pay depositors.  To get around the interest rate caps on deposits, banks are offering wealth management products, but these are really just new forms of trying to take deposits at a higher interest rate.

“Wealth products offered by banks are really just deposits in disguise”

Mr. Zhang argues that the birth of China’s microcredit shadow banking is a result of these artificially low rates.  Because the loans are “sold out,” the only place low income or unprivileged borrowers can go is the shadow banks.

“Where there are control of interest rates, [sic] there are underground financing channels”

So Zhang argues that it’s ironic that such low rates create such high rates for shadow banks, as everyone rushes to those alternative microcredit facilities.  This is the opposite of what should be happening because small businesses have the potential to create a lot of jobs and wealth but are being starved of capital.

“Paradoxically higher interest rates and lower demand in the privileged credit market will lead to lower interest rates in the underdog market and the improved availability of credit.”

The lower the mainstream bank rates, the higher the shadow bank rates will be.

Shadow Banking isn’t the problem

The author’s central thesis is that China’s low mainstream interest rates have created a situation whereby the only place most people can turn to for loans is the shadow banking sector.  While many foreign commentators think this is the riskiest and biggest problem area of the economy, Mr. Zhang is convinced it’s the cure, not the disease.

“Smaller loans are not only safer, but also more profitable, particularly when you are dealing with repeat customers.”

He argues that the shadow banking system is safer because the lender actually knows the customer and it’s done on a more personal level.  In addition, the shadow banking/microcredit sector is too small to really take down the larger overall economy.

 “The size of China’s shadow banking industry was RMB 22.9 trillion at the end of 2012, a number that is equivalent to 34% of the total outstanding loans in the banking sector, and 44% of the country’s GDP in 2012.”

While Zhang believes subprime microcredit has huge growth potential, especially to tap into China’s countryside demographics and neglected inner city population, he thinks mainstream banks still have the upper hand because subprime credit can’t make more risk-adjusted return-on-equity than regular banks because of the interest rate controls.  The main banks are guaranteed thick spreads.

Unfortunately, Zhang, who himself worked at China’s Central bank many years ago, doesn’t see change anytime soon.

“I believe that the central bank does not want to deregulate deposit rates in the next few years for fear of the banks’ irrational competition for deposits on the basis of interest rates.”

However he sees potential in some businesses such as the online retailer Alibaba, which is the eBay of China.  Alibaba is unique because it can provide loans to merchants and then securitize and sell those loans.  This gives the banks competition and could shake things up with interest rate liberalization.

Chinese inflation

Zoe Zhang argues the main problem is China’s explosion in the increase in its money supply.  He notes that the M2 has grown by 17.7% compounded annually for the past 12 years.  Inflation eats into savings of the everyday Chinese citizen and totally reduces their purchasing power.  This chart from paints a vivid picture.

Zhang points out how equity valuations tend to be much better when inflation is under control.  He cites the 2012 work of Carol Loomis, Tap Dancing to Work, which is a collection of essays from Warren Buffett.  In it, Carol demonstrates, using the US stock market, how the market moves in the opposite direction of interest rates (which are a reflection of inflation).

Dow Jones Industrial Average:

End of 1964: 874

End of 1981: 875

In 17 years it hardly changed, but in the next 17 years it went from 875 to 9,181.

Interest rate long term government bonds

End of 1964: 4.2%

End of 1981: 13.65%

End of 1998: 5.09%

Stock and Real Estate Bubbles

Author Zhang thinks there is a bubble in Chinese real estate, but he doesn’t know when it pop.  He points to a few reasons, including the artificially low interest rates, industrial overcapacity, unfair completion [HAS1] between borrowers based on politics, too much construction, too much vacancy, and prices being higher than most Chinese families can actually afford.  He argues that the physical real estate sector doesn’t offer any margin of safety due to over valuations and to the government actually wanting the price to come down (while actively working to achieve that end).

Zhang points to 10 to 12% interest rate loans being made to real estate developers as dangerous because they don’t have much room if margins start decreasing under such heavy leverage.  However, he sees promise in the Hong Kong equity market due to the lower interest rates.

“Given the huge differences in interest rates between Hong Kong and China in the next 5 to 10 years, it is natural that the stock valuations gap of these shares will become very significant.”

In Zhang’s opinion, Chinese domestic stocks will underperform their own H-shares in the future.  (This was written in 2013 and so far the opposite has been true.)  Overall though Zhang has mixed feelings about the Chinese mainland equity market because there’s so many distortions in the market.

“The only reason why China (except for banks) has low profitability is because they borrow too much.  When returns on invested capital are low, additional leverage only makes matters worse.”

This chart from gives a good picture of the state of China’s current equity markets.

With the real estate market, China’s government is actively trying to bring the price down.  With the equity markets, there’s the opposite problem.  Zhang says the China security regulatory commission talks up the stock market, when it should be doing the opposite — trying to prevent too much risk.  He believes regulators should stop doing artificial things to keep prices elevated, such as preventing controlling interest shares from being sold.

“A crisis will erupt in three possible ways:

1) Spreading economic unrest

2) Bursting housing bubble

3) Global economic slowdown that coincides with a domestic recession


Overall Zoe Zhang makes the case that China’s shadow banking microcredit sector can help alleviate some of the problems the country is experiencing caused by its interest rate caps and floors on ceilings and deposits.  He argues that the current shadow banking system is actually safer than the mainstream traditional banks and that the goal should be moving towards more free market interest rates.  Zhang thinks the real estate and stock markets are in a bubble and likely will underperform, especially if inflation comes in strong due to massive M2 growth by the central bank.  However, maybe if the microcredit sector can grow, China’s untapped countryside can finally achieve their dreams.