A solution to a problem or a problem to a solution: The extraordinary Chinese debt problem
China has potentially found a solution to its extraordinary debt problem: regulating the shadow banking sector. However, one consequence of this is the ability of the shadow banking sector to migrate its activities back into the shadows.
Debt issues in China
China is now facing significant debt problems. According to statistics from the Bank for International Settlements (BIS), the credit-to-GDP ratio, an expression of total credit to the private non-financial sector which captures total borrowing from all domestic and foreign sources, was 208.7% in Q4 2017 in China. In comparison, the credit-to-GDP ratio during the same period was 220.9% in the Netherlands and 159.7% in the Euro Area. The International Monetary Fund (IMF) warned China that "[c]redit growth has outpaced GDP growth, leading to a large credit overhang", especially given that a high level of credit-to-GDP ratio can be associated with a high probability of financial distress. Markets have shown concern for China's ever growing debt, both domestically and internationally (Reuters, Financial Times, Forbes), resulting in Moody’s downgrading China's credit rating in 2017 as its debt continued to grow. Particularly worrisome is the accumulation of Non-performing Loans (NPLs) and possible massive defaults. On the other hand, some analysts take a positive attitude due to the high saving rate and interconnectedness between national commercial banks and the government, which implies a state guarantee. Nevertheless, the Chinese financial regulators, led by the central bank - the People’s Bank of China (PBC), are trying to mitigate systemic risk by attempting to “contain the country’s extraordinary debt problem”. The President and the Premier of China have both emphasised the importance of regulating the financial system and maintaining financial stability, which is now a central topic of the highest leadership.
Shadow banking sector
The debt problem might be even bigger than it seems, given the existence of the large shadow banking sector (SBS) in China. Indeed, the BIS estimated that at the end of 2016, the SBS in China had RMB 40.8 tn (54.8% of the GDP) at the ultimate borrower stage. Shadow banking, as explained here, is a term that relates to the parallel banking system, providing an alternative source of funding to traditional banking channels. For instance, retail investors may invest in investment funds, which will then extend loans as if they were traditional banks, only without the burdensome prudential oversight. Indeed, commentators argue that one reason why the SBS continues to grow is because it is not as tightly regulated as its traditional counterpart, and therefore allows for financial innovation to flourish that would otherwise be subject to prudential regulation. Yet China has tightened its grip on the SBS in recent years from a regulatory perspective, which has resulted in a sluggish growth period for the SBS. Commentators fear that this may inhibit financing channels and slow down economic growth.
The new asset management products rules
In order to manage the increasing debt in the SBS and to contain financial risks, on 27 April 2018, the PBC, together with other financial regulators, issued the 'Guiding Opinions on Regulating Asset Management Businesses of Financial Institutions' (关于规范金融机构资产管理业务的指导意见) (Yin Fa  No.106), with the aim to set a consistent regulatory standard for asset management products (AMPs), which is a component of the SBS in China.
Before the enactment of this new rule, Chinese banks, alongside other financial institutions, were allowed to set up and issue AMPs, which, in turn, invest in Non-Standard Credit Assets (NSCAs), including a majority of off-balance-sheet loans. These loans are usually granted to enterprises which do not meet the normal bank loan requirements. As a result, the enterprises could obtain funding through those opaque, low-disclosure-requirements and low-cost channels. The funding sources of these products are usually retail investors who rely on the implicit guarantee of (state-owned) banks. Under this implicit guarantee, investors expect protection by banks in the form of principal and interest when default occurs.
The new rules prohibit financial institutions, particularly deposit-taking institutions from issuing such AMPs. Those off-balance loans have to be brought back to the balance sheet. Consequently, the increase of bank assets would put more pressure on banks to deleverage, i.e. paying off debts, and raise capital, in order to comply with the rule on capital requirements.
A potential consequence?
The new rules only target AMPs, which are expected to be largely reduced in the near future. In a short period of time, financial risk in the Chinese SBS, at least those associated with AMPs, would be minimised. There is one caveat. While these new rules, on the face of it, appear to have “spurred a revival of traditional bank lending”, they could also have another implication – regulatory arbitrage. Regulatory arbitrage relates to the legal restructuring of financial activities to bypass the rules. The new rules on AMPs are in place to minimise risk. However, if the new rules also minimise benefits, thereby impeding profitability, this is problematic. Consequently, the new AMP rules may quickly become redundant given that “it takes roughly two hours to assemble a team of finance geeks and experts to devise a product or transaction” that will circumvent any new rules or regulation. It would, therefore, be unsurprising to find that, in the near future, the Chinese SBS may well have devised some form of financial innovation that will ultimately bypass these new rules. In fact, apart from AMPs, a variety of other types of SBS products remain lightly regulated, although AMPs take up a majority of the market. It is also not clear how the new rules would help ease the debt problem, since the regulation of the SBS, by default, creates a demand for market participants to develop and implement new financial products and innovations for the marketplace.