On October 10, the Chinese government announced that it will increase its stakes in the four largest commercial banks, which are already largely public-owned. The move is designed to ''support the healthy operations and development of key state-owned financial institutions and stabilise the share prices of state-owned commercial banks''.

But why was this move considered necessary at all? Recently, investors have been dumping Chinese bank shares, anticipating a slowing down not just of the economy as a whole, but in particular the property market, which had experienced a bubble of massive proportions. But the underlying concern about the health of Chinese banks reflects a deeper concern, about the extent of entanglement of these commercial banks with the growing ''shadow banking sector''.

What exactly is shadow banking? Basically, this refers to non-depository banks and other financial entities like investment banks, mutual funds, hedge funds, money market funds and insurers, who typically do not fall under banking regulation. The growth of this sector has been explosive in the last decade: in the United States, in the run-up to the financial crisis, its size was estimated to be significantly bigger than that of the formal banking sector. In the aftermath of the crisis, many of these institutions, and banks that were exposed to them, had to be rescued.

UNCTAD’s Trade and Development Report 2011 noted that ''The shadow banking system depends on wholesale funding, which is extremely unstable and renders the system very fragile, as evidenced by the crisis.'' (page 94) It argued strongly in favour of bringing shadow banking under regulation not just money market mutual funds, but also the asset-backed securities market financed with repos.

Even at the IMF, a recent meeting of regulators held during the Autumn meetings called for greater regulatory focus on shadow banking. Participants noted that shadow banking operations, that firms doing these bank-like activities outside the banking system can pose systemic threats, and to have some effect regulators need more and different data to understand this fast-changing sector.

But China was known to have a much more regulated banking sector. Indeed, the ability of the Chinese authorities to control the four important commercial banks (Bank of China, Agricultural Bank of China, China Construction Bank and Industrial and Commercial Bank of China, which together were earlier estimated to control more than three quarters of total domestic credit) was seen as important macroeconomic tool in the hands of the state as well as an instrument of ensuring directed credit, both of which have been crucial to China’s economic success.

But this situation has been changing. The changes have been accelerated after 2008, when urge to provide more stimulus mean that the government allowed or encouraged more ''informal'' credit flows that went through new shadow banking intermediaries. As a result, the government’s control over actual flows of domestic liquidity is weaker than it has been for more than half a century. In addition to trust companies and private banks, which are not regulated but at least are registered businesses with established offices, there has been a proliferation of underground operators, usually no better than loan sharks operating in a world of largely unsecured loans. Such has been the profitability of these operations that even large local state-owned firms whose main business was not finance are now expanding into operating guarantee companies, pawnshops and trusts, arbitraging their own access to cheap loans to lend out at many multiples of the official interest rates.

The growing but opaque interlinkages between the formal credit system and the world of shadow banking are the real cause for concern. This is because the formal banks are also more attracted to indirect lending that generates at least double or triple the official 6.5 per cent one-year lending rate, and can even go up to 30-70 per cent in underground banks. In the first half of 2011, the most profitable activity of state-owned banks in the first half of this year was not lending to businesses but funding trusts and underground banks.

Much of that went into the overheated housing market, associated not just with a construction boom but with urban real estate prices that are now the highest in the world for cities like Shanghai and Beijing. Since official curbs on lending to this sector were tightened, this market has expanded even further. But recently the market has wobbled and real estate prices have finally started falling.

The bursting of this bubble could be painful. In an attempt to provide some protection, the government has encouraged the growth of credit guarantee companies – but many of these are also highly leveraged and themselves far from creditworthy.

Societe Generale has pointed out that China’s shadow banking sector could amount to as much as RMB 14 to 15 trillion. This has also increased the correlation between lending curbs on formal banks, corporate bankruptcies and the occurrence of macroeconomic difficulties in China.

For a very long time, China’s ability to control finance was an important (some would say essential) ingredient of its macroeconomic success. Now that this control looks more tenuous, the future of the overall growth strategy also looks that much less rosy.

* This article was originally published in the Triple Crisis Blog http://triplecrisis.com/the-dragons-shadow-chinas-banking-system/

October 13, 2011.