Traditional Banking System Now Less Than Half of Chinese Financial System; Consumers Win

Here's a good report from J.P. Morgan explaining the concept of social financing in China. China: the concept of total social financing (PDF)

What is TSF?

TSF is a relatively new concept constructed by the PBOC to reflect the magnitude of liquidity support from the entire financial system to the real economy. Traditionally, bank loans represented the most important funding source. However, with the growing diversity of financial institutions, financial instruments, and businesses, the appropriateness of bank loans in reflecting aggregate liquidity is being called into question. Accordingly, TSF has become a standard part of official data releases.

TSF refers to the total amount of financing that the real economy can access via the financial sector during a given period. It includes funding provided by financial institutions, such as banks, security firms, and insurance companies, and by markets, including the credit market, bond market, equity market, banks’ off-balance sheet items, and other intermediary markets. To be more specific, it includes bank loans (both CNY and foreign currency loans), trust and entrust loans, bank acceptance bills, corporate bond financing, nonfinancial enterprise equity financing, and other funding sources (e.g., insurance, micro lending, industry funds).

TSF is constructed as a “flow” concept, i.e., net increases in each component in given time period. The TSF data have been available since January 2002 on a monthly basis. However, the PBOC does not provide official data on the TSF “stock.” In practice, one could derive the TSF amount based on a simplified assumption that the nonbank financing component was close to zero prior to 2002 (nonbank financing was small prior to 2002). Based on this assumption, the TSF amount stood at 100 trillion yuan and rose 21.1%oya in January 2013.

In a breakdown, bank loans remain the biggest component of TSF, but the share has been declining in recent years. New bank loans accounted for 95.5% of TSF flows in 2002, but the share dropped to 57.9% in 2012 (46.1% in 4Q12), suggesting that nonbank financing has become increasingly important over the past decade.

The report is one year old; bank credit was below 50% in 2013.

This puts a different spin on Chinese monetary policy and interest rate liberalization. As trusts, WMPs and other shadow banking assets have grown rapidly, the traditional banking system and its fixed deposit rates has been shrinking. Interest rates on TSF have been moving higher for years and interest rate liberalization is inevitable because if the PBOC didn't allow banks to lift deposit rates, within the next year or two, most banks would probably have very little traditional deposits left.

China’s Shadow Banking Challenge

The main demand for shadow credit has come from companies and local government entities that were unable to access formal lending. The reasons may have included a lack of connections necessary to obtain bank loans; a lack of profitability so pronounced that banks were unwilling to lend even if connections were decent; restrictions on their sectors (especially for real estate, industries suffering from overcapacity, and dubious local government infrastructure projects) resulting from policy initiatives; or a lack of credit being available after other, better-connected or even government-guaranteed “safe” borrowers had used up lending quotas, particularly those operating in sectors identified as “strategic” in five-year plans.

For borrowers lacking political connections, the shadow banking system, in providing vital credit (even if sometimes at highly inflated interest rates), has sometimes been providing a valuable and helpful service. Many healthy, value-creating companies have been surviving even while paying “shadow” interest rates of over 30 percent.

On the other hand, companies suffering from restrictions on their sectors, or those that were un-creditworthy in general, including many local government financing platforms (LGFPs), have become hooked on shadow credit in order to stay in operation, rather than closing down and defaulting.

The risk from tackling the shadow banking system is that credit dries up for the marginal borrower. The subprime system was touted as a great way to reduce risk by breaking it up into pieces and selling it off to many lenders, but it also benefited borrowers with no ability to repay their loans. In China, the shadow banking system is playing a similarly crucial role in credit allocation, but it also fuels the excesses in the system.

Keeping these demand and supply factors in mind, it is easier to understand why we have seen (and will continue to) see apparently contradictory policies emanating from various central government sections with regard to shadow financing. Early 2013’s strict Document 9 from the CBRC was never fully implemented due to pragmatic concerns about the effects on economic growth and stability and the CBRC will continue trying to rein in risk without crushing the system.

It has recently emerged that the state council drew up a new policy in early December 2013 “Document 107”) that is more accommodating to shadow financing than Document 9, even while bringing in increased regulations. Language from the document describes shadow banks as “…a complement to the traditional banking system, shadow banks play a positive role in serving the real economy and enriching investment channels for ordinary citizens…”

Another interesting point: each time the PBOC constrains liquidity and drives up money market (and thus WMP) interest rates, the attractiveness of WMPs over normal deposits increases, drawing in more savers’ money. So far, the PBOC has been careful to prevent the cash crunches from causing a crisis – its return to providing liquidity each time is yet another policy contradiction for China’s financial markets. It is very difficult to sort out “bad” shadow borrowers from the “good” without risking the whole system, and the system does sometimes play its “positive role.”

It also makes Yu E Bao and other online money market funds more attractive than regular bank deposits.

China's policy makers are smart enough to thread the needle. Given the right conditions, I would bet on them pulling another rabbit out of their hat. However, they don't only need to be smart, they also need to be lucky because they have little room for error. Each year that passed without reform has raised the stakes. Social mood was positive, emerging markets were growing and the Fed was pumping up global liquidity. Now social mood is slipping, emerging market credit bubbles are bursting and the Federal Reserve is tightening monetary policy.

Effect on Consumers

Rising interest rates are a big win for Chinese consumers. Low deposit rates are a form of financial repression, used to help recapitalize the banks after the 1990s lending binge. It also benefits consumption because many Chinese people have the exact opposite mindset as many Americans. When interest rates rise in the U.S., individuals decide to save more money because the return on savings is higher. In China, when the interest rate rises, savers calculate that they can save less money and still achieve their goal. For example, the Yu E Bao app tells savers how much money they earn each day. My Chinese friend saw the yield going down and said he will have to save more in order to earn the same dollar amount each day. This is the average mindset of Chinese savers and why higher interest rates are a critical part of rebalancing the economy towards domestic consumption. Invest accordingly.