Despite its well founded reluctance to do so, the Chinese government may need to let shadow finance lenders off the leash if it wants to stabilise credit growth and shore up the economy. 

Fears about China’s economic health are once again stalking global markets after the government confirmed that growth slowed below the official 6.5 per cent target at the end of last year. China’s leadership is reportedly bracing for even slower growth in 2019 by lowering this year’s target to a range of 6 per cent to 6.5 per cent. 

Although this reflects a maturing economy and the government’s efforts to manage a structural slowdown, repeated warnings about downside risks coupled with intensifying stimulus efforts suggest there is concern among officials that they have lost control of the process. 

Measures taken so far have been insufficient because they fail to tackle a fundamental contradiction in Chinese policymaking. The government is committed to tackling financial risk, recognising this as a threat to national security. But clamping down on the sources of this risk — the opaque credit structures generally lumped under the category of shadow finance — has in turn starved key drivers of economic activity. 

Both  infrastructure and  real estate investment, and vast swaths of the  private sector, rely on off-balance sheet funding that is partially captured by the central bank’s monthly total social financing series. Total social finance — the official monthly measure of funding such as bank lending but also shadow finance channels like trust loans — continued to slow through the end of last year, dragging the economy with it. 

Financing growth may stabilise as early as the current quarter, helped by increased bond issuance. Local governments have this year been allowed to raise funds ahead of March budget approvals while companies with better credit ratings are taking advantage of relatively low rates. However, this funding is unlikely to be enough to significantly increase overall financing growth. 

Although the government has tried to incentivise banks to lend more to vulnerable sectors such as small and private companies, the growth of bank lending — by far the biggest component of total social finance — has remained flat, averaging 13 per cent over the past two years. Banks are not only undercapitalised, but are also under constant pressure to control risks and therefore constrained from increasing lending enough to compensate for the fall in shadow finance. 

This also explains why the term of bank loans has shortened in recent months. As a percentage of the monthly total, the share of medium to long-term loans to corporates — which tend to be used for investment purposes — fell to 18 per cent in December, the smallest amount in more than two years. That month, the purchasing managers' index distributed by Caixin fell below the 50 mark separating expansion from contraction for the first time in 19 months.

In its stead, a greater proportion of bank lending has been taken up by bill financing. This is short-term credit used by firms to meet working capital needs and alleviate liquidity shortages (at least some is probably also being used to roll over outstanding liabilities). Bill financing has the attraction of shielding loan officers from taking unnecessary risk while allowing banks to meet loan growth targets, in line with government directives. 

Rather than going towards productive loans that expand businesses and create jobs, this credit may also have fuelled sales of structured deposits, which emerged last year as higher-yielding alternatives to regular bank deposits after a clampdown on wealth management products

Banks have competed for business by offering bill financing to invest in higher-yielding structured deposits, which pay out based on the performance of an underlying asset, allowing clients to earn the spread between the two rates. 

A regulatory crackdown on shadow finance may have been  long overdue, but officials have also recognised the importance that this credit can play in an economy where small or non-state borrowers generally get short shrift from mainstream banks. 

Although PBoC governor Yi Gang has hinted that constraints will be loosened, the government is not ready to jump yet. Continued weakness in monthly shadow finance data suggests regulators are still wary about the potential impact that regulatory loosening could have on China’s debt profile. 

We expect the authorities to give partial way and ease some of the regulatory constraints on shadow lenders

Instead, the authorities have turned their attention to monetary policy transmission, focusing on the system’s plumbing rather than its liquidity levels. For example, banks have been allowed to issue perpetual bonds to recapitalise, and those bonds can be swapped for bills issued by the PBoC and used as collateral for loans from the central bank. 

It remains to be seen if this increases the flow and quality of lending. Certainly, last year’s targeted measures failed to do so. Eventually, we expect the authorities to give way partially and ease some of the regulatory constraints on shadow lenders. 

Although there is a risk that at least some of the revived lending may go towards rolling over old debt held by unworthy borrowers, it is a risk worth taking if the government wants to meet its growth targets.

— He Wei, Financial Researcher, FT Confidential Research

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and south-east Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.