China’s Shadow Lending Catch-22

While the world watched Greece and the EU fight to find a resolution to the debt crisis, China was having a financial crisis of its own.

Analysts are divided about China’s shadow lending sector. For years the industry was tolerated by local authorities because it provided small businesses and entrepreneurs with the funds they need to stay afloat. But losses are piling up, and as the economy faces greater stresses, many experts are beginning to shed light on the alternative lending market’s role.

Last year, China, the world’s second-largest economy, grew by a dismal 7.4 percent – its weakest rate in two decades, reports said. And just last week, more than half of companies listed on the local stock markets seized trading, placing trillions of dollars worth of shares at a standstill. IPOs were similarly blocked. According to reports, the majority of these freezes impacted smaller businesses trading on the Shenzhen exchange.

There is a slew of analysis and data to explain what happened – and what continues to happen – in China’s markets. Trading freezes were aimed to prevent an all-out stock market crash following share value nose-dives after rising 150 percent over the last year. As government officials scramble to safeguard the economy, and as foreign markets raise skepticism over the strength of the market, analysts are pointing a finger at a few main causes of this near-disaster – and one of them is the shadow banking industry.

Shadow Lending’s Role

The term “shadow lending” does not always have an exact definition. According to Bloomberg, “shadow banking” can refer to anything from risky investments, to P2P lending, to loan-sharks and even money-market funds or securities lending. “The common denominator,” Bloomberg said, “is that these activities flourish outside the regular banking system and often beyond the control of regulators and monetary policy.”

In China, the shadow lending market grew in response to state-run banks’ lack of funding to small- and medium-sized businesses, analysts say, fueled even further by bank lending caps.

According to reports at the International Business Times, about two-thirds of these lending deals are actually conducted by mainstream banks, but involve non-banks so the transactions can avoid regulatory burdens. Companies will also loan to each other using a bank as the intermediary, a tactic common for business buyers and suppliers.

Non-professional lenders began flooding the stock markets, largely leading to its volatilities, experts say, often at the support of government officials, who saw shadow lending as a way to meet financing demands that couldn’t be met by traditional banks.

A Long-Ignored Risk

The threat of shadow banking repercussions has been boiling for some time. But as recent as early July the World Bank published a highly critical report of China’s shadow banking sector in which the authors urged China to overhaul a system dominated by state-run banks with little support for SMEs.

Last March, the Financial Stability Board released its own research, finding that the world’s shadow banking industry is now worth $75 trillion and poses “systemic risks” – with China’s market growing at one of the globe’s fastest paces due to as many as 90 percent of SMEs in the nation being unable to access a bank loan.

In an interview with Bloomberg Business, Zhou Dewen, who heads the Wenzhou Small and Medium-Sized Enterprises Development Association, commented on his organization’s efforts to support its 1,000 SME members — efforts which thus far have had limited success in coming to fruition. “We made some efforts and progress, but we didn’t achieve any meaningful breakthroughs,” he said.

Today, the research found that China’s shadow banking industry accounts for 69 percent of its economy.

A Catch-22

In an interesting twist, China’s ongoing stock market crisis could actually help the shadow banking industry. With IPOs blocked, experts say companies that were on the verge of listing are now seeking alternative financing methods. Twenty-eight IPOs were halted by government officials this month alone, according to The Fiscal Times, meaning alternative lenders will be called to step in. Data suggests that alt-lenders could fill a gap as large as $17 billion for the second half of the year.

“Long-term capital providers such as sovereign wealth funds and family offices will have a constructive role in China should the IPO markets remain shut down for an extended period,” Mayooran Elalingam, head of M&A for the Asia-Pacific operations at Deutsch Bank, told The Fiscal Times.

So while shadow banking has largely caused these market failings, shadow banking will likely be seen as the remedy for businesses to survive the crisis. It’s a Catch-22 analysts say needs to be addressed by authorities — and soon.

The majority of the companies whose IPOs were blocked told reporters that they will use existing cash and bank loans to stay afloat for now. But for others, companies are still likely to turn to shadow bankers. According to Yahoo! Finance reports, many of these lenders are still earning interest and loan fees even with stock market and IPO freezes.

Without deterrence, shadow lending is likely to continue to thrive. The situation reveals just how important it is for businesses to be able to access financing even in a situation as dire as this. If Chinese regulators can pull this industry out of the shadows and introduce regulation to mitigate investment risk, SMEs may be able to find the working capital they need when a state-run bank turns its back.