Helen Lam, CFA
Senior Portfolio Manager (Hong Kong)
Shadow banking should not be considered evil
Though there is no unified definition of the shadow banking system (SBS) in China, the market generally perceives it as primarily any financing activities outside of the regular banking system, including, but not limited to, banks’ wealth-management products, collective trust programs, entrust loans. Local Government Financing Vehicles (LGFV), in particular, are primarily being set up to source loans indirectly from banks to fund local government financing vehicles, such as infrastructure construction. From this perspective, the SBS actually provides alternative financing channels for the development of the real economy, if properly used. However, as these conduits may act to add leverage in the real economy or financial system, the potential mispricing of risk, misrepresentation of risk to end investors, together with the relatively low transparency, could potentially act to trigger some form of credit crunch, thereby indirectly and negatively impacting China’s financial system.
China’s shadow banking system is relatively smaller in size and simpler in structure.
That being said, we do not believe that the rolling over of existing LGFV debt through shadow banking conduits will act to destabilize China’s financial system at this time. While it is difficult to quantify the actual size of current shadow banking activities, which we see the market generally estimates to range from RMB 15 to 30 trillion (USD 2.4 trillion to 4.8 trillion), we are quite confident that it is significantly smaller and less complex than those of developed markets. For example, the US shadow banking system, which could theoretically include hedge funds, money market funds, and structured investment vehicles, was estimated by the Financial Stability Board in 2011 to be approximately USD 23 trillion, 10 to 20 times greater than that in China; while the euro area and UK were estimated to have shadow banking assets of USD 22 trillion and USD 9 trillion, respectively.
The risk characteristics of most shadow banking products in China are relatively low, with most debt instruments using a plain vanilla structure, as opposed to the embedded derivative structures commonly deployed in the developed markets. In view of the strong capitalization positions of China's banks, coupled with strong earnings and liquidity profiles, there appears to be a comfortable buffer to absorb the potential impact from the shadow banking risks in the Chinese economy.
China’s LGFV problem is fundamentally different from the European debt crisis
From an international investor’s perspective, the recent Fitch downgrade might have raised concerns for the potential systemic financial crisis in China, somewhat similar to what we have seen in Europe over the past two years. While we are cautious about the credit boom in China, we believe the chance for a nationwide financial crisis is very limited. The fundamental differences between China’s credit situation and that in Euro-land are the source and denomination currency of the debt and the government structure. While most European countries borrow in a currency over which they have no control, China’s local government bond debt is denominated in RMB with China government having autonomy over its currency. In addition, China’s local government debts are financed by the domestic markets. Under the current strict capital market control mechanism, we see minimal chance for a significant fund outflow that can be substantial relative to China’s capital market. In contrast, we generally observe international fund flight out of small and open economies when market sentiment turns south. Additionally, China’s fiscal situation is by far much better than the countries in the west, with a debt-to-GDP ratio standing at 45%. And even if we include the LGFV debt, it is still likely less than 70% debt-to-GDP. Currently, China’s central government transfers 38% of national fiscal revenue to local governments and it can always extend additional assistance to local governments when needed; thus making LGFVs a de facto form of extended borrowing from the central government. Due to the higher control of capital markets, and a healthier fiscal condition in China compared to most Western countries, we believe the risk of LGFVs in China is manageable.
China government has taken prompt actions
The China's Government, well aware of the severity of the shadow banking problem, has already started tightening regulations on wealth-management products and local government borrowing. For example, the China Banking Regulatory Commission (CBRC) has stepped up controls of rural banks' lending to LGFVs. Except for major national infrastructure projects, rural banks are not allowed to provide new funding to LGFVs. The CBRC also issued stricter guidelines on banks’ wealth management products.
The secular trends in RMB and RMB fixed income space remain intact
We believe the recent news flow and rating actions should have muted impacts on the Renminbi currency, as well as the RMB-denominated fixed income space. The China capital market, despite of the country’s significant and still rising economic power, is still poorly represented in the international portfolio, mainly due to the highly limited access to the onshore capital markets. As China continues with a gradual and controllable process in opening up its capital account, there will be incremental interest from international investors seeking to diversify portfolio exposure and to participate in China’s secular growth story on a long-term basis. Regarding RMB, we maintain our view that the currency will undergo a steady appreciation, underpinned by the sustainable RMB internationalization process, and the on-going economic rebalancing in China.
Investors should focus on quality and liquidity in China’s bond market
In view of China’s shadow banking risks, especially related to LGFVs, we believe a conservative approach with strong emphasis on quality and liquidity should be particularly important when investing in China’s onshore bond market.