BREAKINGVIEWS: Guest Column

(The author is a Reuters Breakingviews guest columnist. The opinions expressed are his own)

By Joe Zhang,

HONG KONG, July 8 (Reuters Breakingviews) - Few people sing the praises of China's shadow banking sector. Yet for all the misgivings of officials and economists, this enigmatic industry has doubled in size over the past three years - to an estimated $6 trillion. I would argue this has done China a world of good.

The loosely defined term “shadow banking” means two things in China. One is wealth management products (WMPs), short-term investments offered by banks to their customers, often including repackaged credit. The other is the diverse credit creation that takes place outside the banking system, involving trust companies, pawn shops, microcredit firms and kerbside lenders.

Important signals

Such activities may conjure up images of fly-by-night financiers. But there are several reasons to give shadow banking more respect. The first is that the industry is performing a valuable service for China’s savers.

Millions of savers (including me) have bought WMPs because they offer 4-6 percent returns, compared with the 2 percent or so on regular deposits. It’s taken for granted that banks would step in if these underlying investments fail. So as far as the buyers are concerned, WMPs are just deposits in disguise, pure and simple.

Why would banks shoot themselves in the foot by paying higher rates than they need to? It’s simple: to stop depositors leaving for better deals. The banks are effectively acknowledging that the officially regulated rates they offer are too low. WMPs reveal the true market price of deposits.

They also reveal the truth about China’s real rate of inflation. Let’s assume the real, inflation-adjusted return on deposits should be close to zero. The going 4 percent rate for wealth products suggests savers think prices are rising twice as fast as the latest official inflation figure of 2.1 percent.

This may all bring about the end to China’s financial repression. The government has kept the real interest rates negative for most of the past four decades. The consequences are severe: industrial overcapacity, persistent inflation, a real estate bubble, and worsening inequality. Since the 1980s, the government has promised but not delivered rate liberalisation. Now shadow banking may force its hand.

Bank regulators, meanwhile, can no longer claim the "conservative" regulatory loans-to-deposits cap of 75% keeps banks safe, since banks have already used WMPs to get around this restriction. The spike in interbank market rates in June shows that regulators need to take notice of assets both on and off the balance sheets.

The regulators may also need to be clearer about who is on the hook for what. That includes who must pay out if a WMP fails, but also what would happen to savings if a bank got into trouble. A long-debated deposit insurance plan is now back on the drawing board.

A division of labour

Despite these contributions, shadow banking still leaves a bad taste. Officials have never publicly welcomed pawn shops, microcredit firms or kerbside lenders. “High interest rates are immoral”, some warn. “They could destabilise the banks”, others protest.

The reality is that China needs these unloved stepchildren. They create millions of jobs by providing small and medium-sized enterprises with much-needed financing. Not only are they often the only place for SMEs and underprivileged consumers to go, but in many cases they are more nimble and efficient than the banks.

Take the products issued by China’s 67 trust companies, which had $1.4 trillion of asset under management at the end of the first quarter, according to the China Trustee Association. Like banks, trust companies may find themselves on the hook for products they sold. But trust companies are largely state-owned, and their loans mostly backed by hard assets.

Moreover, trust companies, despite being one of the least well understood parts of the shadow banking industry, serve the purpose of matching borrowers and lenders who don’t get what they need from the banking sector. I would argue that they serve a similar function to junk bond originators like Michael Milken's Drexel Burnham Lambert in the 1980s and 1990s.

Chinese banks remain little more than cashiers to state-owned businesses and well connected private-sector companies. Thanks to shadow banks, they now have formidable rivals – and SMEs have a source of finance that lets them compete with bloated state-owned companies. The end result is higher productivity and better services for all. That contribution shouldn’t be dismissed lightly.

• Joe Zhang, the author of "Inside China's Shadow Banking: The Next Subprime Crisis?", is chairman of Wansui Micro Credit in Guangzhou.