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Money Jun 24, 2013

Shadow banking threatens Shanghaied Chinese markets

By Arjun Parthasarathy

The term "Shanghaied" refers to a person being tricked into doing something that he or she did not want to do.

Financial markets are getting "Shanghaied" with the shadow banking crisis threatening the financial system stability of the second largest economy in the world. Emerging market currencies are facing the brunt of China's headwinds with currencies of South East Asian countries such as Indonesia, Philippines and Thailand down 2.3 percent, 5.7 percent and 8 percent over the last two months respectively. The Indian Rupee (INR) has lost around 10 percent in the same period.

China's Shanghai Composite index is down close to 10 percent over the last couple of months on the back of worries over China's economy. The fall in Chinese equity markets has had a spill over effect in Hong Kong with the benchmark equity index the Hangseng down close to 13 percent in a two month period. The Sensex and Nifty are down over 4 percent in the same period.

On shaky ground. Reuters

On shaky ground. Reuters

The weakness in the INR and the Sensex and Nifty has hit Indian bond yields that have risen by 35bps from lows over the last one month. Bond markets are taking out all rate cut hopes by the RBI leading to rising bond yields.

China's shadow banking and its issues

What are China's problems that are causing such nervousness in financial markets? The answer lies in what is called "Shadow Banking" in China. Shadow Banking can be loosely termed as unregulated borrowing and lending and this has reached proportions that are large enough to threaten China's financial system. The size of the Shadow Banking is estimated at $3.9 trillion (as of 2012), constituting 24 percent of total credit and 45 percent of GDP (Source: theasset.com).

Shadow Banking in China is dominated by trusts that are loosely regulated finance companies that cannot raise deposits. These trusts can give loans and make investments and they do so by collecting money from high net worth individuals in various forms such as wealth management products. The trusts lend money to small and medium businesses at high rates of interests and make investments in real estate and other speculative asset classes.

China's banks that are regulated use the trusts to float their own wealth management products. The fact that deposit rates in China are fully administered by the Central Bank makes the banks find that the trust route is a convenient way to raise quasi deposits.

The high risk lending and investments of the trusts have made China's financial system extremely susceptible to asset price declines and credit defaults due to a weakening economy. The Chinese government and the Central Bank are worried about the shadow banking size.

China in effect is facing what the US faced on the mortgage bubble. In the US, banks, finance companies, hedge funds and insurance companies over leveraged on US housing market through structured products and when home prices collapsed, the mortgage bubble burst. China can see a deep credit crisis in its economy if the shadow banking risks erupt.

What is China doing now to lower the shadow banking impact?

The PBOC (People's Bank of China) is squeezing liquidity from the system to prevent further flow of funds into shadow banking. The recent rise in overnight lending rates in China (rates shot up by 600bps over the last couple of weeks) as the Central Bank rejected bids for overnight funds from banks is reflecting the liquidity squeeze. It is similar to the call money and repo rates rising in India if RBI rejects bids for repo in the LAF (Liquidity Adjustment Facility) auctions.

The question is can the authorities prevent a shadow banking collapse? Bubbles formed will burst and no authority can prevent it. However authorities can reduce the impact of the bubble burst and that is what China will aim to do. The fact that China's financial system is not transparent will help mute the real impact of a shadow banking bubble burst. Shadow banking is largely internal and its fall will not result in direct spill over effects to other parts of the globe but any downturn in China's economy affects many other economies with strong ties to the country.

Financial markets will in the meanwhile fret and fume over the shadow banking issue in China and that would mean more volatility for the markets.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.

by Arjun Parthasarathy

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