Sample Finance Essay on Shadow banking, the housing bubble and China’s financial system

Shadow banking, the housing bubble and China’s financial system

Introduction

The financial system is characterized by several factors which also control its success or failure in any country. Some of the sectors that play an important role in the financial system include the shadow banking sector and the property sector. Shadow banking is associated with the financial sector since it offers immense support to the primary financial systems and results in significant benefits in the system. Despite this, the shadow banking system is also wrought with as many challenges as the primary financial system changes. The size of shadow banking systems in the world depends on the size of the economies in which they operate. More advanced economies in the world have broader shadow banking systems (Valckx and others 66). In any economy, the growth of the shadow-banking sector is driven by factors such as the tightening of banking regulations, wide liquidity conditions and due to the demand from institutional investors. Shadow banking systems involve intermediation of credits outside the contemporary banking systems. The tightening of banking regulations results in this through diversion of potential investor attention to the conventional shadow banking systems available in the economy (Valckx and others 68). This is founded on the awareness that shadow banking operates on less stringent regulations.

Although the shadow banking and property market conditions affect the financial status of an economy to some extent, the overall status of the economy is in most cases affected much more by other factors i.e. the economic indicators in the country. In China, like in all other economies, shadow banking has undergone immense revolutions in the last decade, resulting in various impacts on the financial sector. The shadow banking system aims at complementing the primary banking system through provision of various services (Labes 2). First, shadow banking provides additional liquidity support for the financial market, transforms financial maturity, enables risk sharing with the traditional systems of banking and helps in the expansion of credit access from financial institutions. The property market similarly boosts the financial system through the provision of additional resources in the form of services such as mortgages. Consequently, the relationship between housing bubbles and the growth of the nation’s financial system can be drawn.

While it has been ascertained that shadow banking has benefits to the financial system, it is also important to note that it also poses significant challenges to the system, particularly in terms of destabilization of the financial system. The vulnerability to destabilization is however increased during financial crises. Shadow banking achieves this through the provision of high leveraging through the increase in holdings for illiquid assets during financial crises. Moreover, shadow banking increases risks associated with the banking sector such as run risks, problems with agency, spill over, and procyclicality and leveraging (Labes 4). The contribution of the property market to the financial system cannot be ignored nor divorced from the concept of shadow banking.

The discussion of the Chinese financial system encompasses the concepts of regulation, the shadow banking system in China and how shadow banking and the housing bubble contribute to the growth of the financial sector. Additional focus will also be on the impacts of the two concepts on the financial system and the potential harm these concepts could cause on the nation’s financial system. Currently the dearth of information available on the connection between the housing bubble, shadow banking system and the national financial system in China is limited. Consequently, the paper aims at carrying out an analysis of the financial system in China. The scope of the study will cover these three concepts in details. However, since all the three are significantly wide, it is impossible to cover all the details pertaining to the China financial system within the meager expanse of this paper. It is believed that this paper will contribute immensely in the provision of information about the economic status of the country. To achieve this objective, the study will be carried out based on an intensive literature review of materials relevant to the present study aims.

Research Objectives

In order to achieve the major purpose of the paper, the study will be guided by the following specific objectives.

  • To determine the nature of the regulations on the financial system in China
  • To find out the history and status of the shadow banking system in China
  • To establish the relationship between the property market, housing bubbles, shadow banking and the Chinese financial system in the contemporary times

Literature Review

Introduction

The role of shadow banking in the global financial sector has been effectively described by various authors as being both beneficial and vulnerable to risks. However, it is undeniable that the contribution this aspect has had on the financial sectors in the global context is immense. While being vulnerable to potential financial risks, this sector is also open to greater development and contribution to the nation’s GDP (Valckx and others 65). Similarly, the property sector has also contributed immensely to the expansion of countries’ financial systems. Shadow banking systems in China has been described as being based on mechanism different from other mechanisms that are applied in other economies such as the US. In China, Shadow banking is built on a guarantee system and operates within banks rather than in the capital markets (Dang and others 1). The contribution of the property market on the financial system has also been immense in China.

Shadow Banking in China

China’s economy in the recent years can only be described as robust based on the percentage growth that has been experienced in various sectors. This growth has made the nation’s economy to surpass the economies of several other countries, key of which is Japan in terms of its GDP. According to Dang and others (1), the Chinese economic growth has been driven by China’s robust financial system, which has led to the establishment of China as a major trading nation in the world. The impacts of this immense economic growth on the living conditions of the nation’s citizens has been positive over the years, resulting in the lifting of several people out of poverty. However, in recent years, the financial system of the country has relapsed in terms of growth. The system has been described as lacking in terms of diversity, intensive regulations and the influence of the government/ political system on the economy. Due to these factors, the shadow banking systems in China have also grown immensely. This is because factors such as stringent regulations in the financial sector contribute to the growth of the shadow banking system.

Shadow banking in China plays a very essential role in the expansion of China’s economy. In recent years, shadow banking has risen significantly in China, contributing a lot in terms of GDP improvements to the Chinese economy. For instance, in terms of intermediation in credits, the shadow banking system has played a critical role in the expansion of non- bank based loans such as entrusted and trust loans from fewer than 10 percent of all the loans in 2008 to more than 40 percent of the loans in 2013 (Valckx and others 68). This implies that as the benefits of shadow banking have been described to include expansion of access to credit and provision of alternative sources of financing, China already benefits from these and is more likely to expand in the application of shadow baking and in terms of gained benefits. Despite this growth in potential benefits of the shadow banking system, stringent regulations which have continued to be tightened in the financial sector have resulted   in the constraint of the economic expansion, particularly since 2012 (Valckx and others 66). This has in effect reduced the rate of expansion of the shadow banking system in the country. Various products are associated with shadow banking in China. These products range in form and conditions of availability depending on the type of shadow banking source and the size of the system.

One of the products that are offered by the shadow banking system in China is trust loans. Besides this, there is also entrusted loans which are provided by the same system. Trust loans and collective entrust programs are offered by the shadow banking systems. These loans are mainly aimed at providing assistance in banking wealth management programs. Consequently, these programs are mainly accessible to infrastructure and real estate projects that require funding. Other potential beneficiaries are local government entities and developers who may not be in a position to acquire funding through bonds (IOR and RMBISA 4). However, the main challenge faced by the shadow bankers is that these projects, which receive funding from the shadow banking system, are often incapable of generating income due to being over-invested. The implication is that without effective controls, the shadow banking system can incur losses due to the inability of the beneficiaries to make payments (Ma 1). This limits the capabilities of wealth management products in attaining the target revenue from the beneficiaries. The effect of this is that losses to the wealth management products such as trust loans result in subsequent losses in the entire shadow banking system.

The wealth management products (WMPs) are the core sources of revenue in the shadow banking system in China, with the registered income from these products being estimated at 1.2 trillion dollars in 2012. This income was however projected to increase due to the increase in demand for shadow banking products and services. The projected increase in WMP related income is said to be due to the increasing financial issuances in replacement of the expiring ones. This has already made a cycle to be developed whereby the continuous cycles of issuances and expiry leads to the continued expansion of the shadow banking system and subsequent increase in vulnerability to financial risks (IOR and RMBISA 4). The major concern that has been raised with regards to this increase in vulnerability is the relationship that exists between banks and the shadow banking system. This is because the shadow banking system in China operates on a traditional bank platform as opposed to other shadow banking systems which operate on the capital market platform. Due to this operational basis, the shadow banking system in China is characterized by a lack of transparency, which heightens the vulnerability to risks. The associated risks include the potential for causing financial instability across the entire region due to the minimal regulation that is also inherent in the shadow banking system in China. Moreover, the operation of the shadow banking system is even more complicated than the conventional banking system thus making potential risks to be higher than in other economies (IOR and RMBISA 4).

The risks associated with shadow banking in the country’s economy could also spill over to the global financial sector due to the interconnectivity between the financial sector and the shadow banks. According to Ma (1), the fast growth associated with China’s shadow banking system poses significant risks to the economy in terms of liabilities that could possibly find their way into the financial sector’s balance sheets. This implies that since the shadow banking system is dependent on the traditional banks platform, any liability that is due to the shadow banking sector has the potential of getting directly into the banking sector. Because of this, the non-financial/ shadow banking system in China is considered the weakest link in the financial sector of China’s economy. The impacts of the shadow banks on the financial sector are immense, particularly on the market stability (Ma 2). In research, it has been established that a destabilization of China’s finance market that may arise due to the uncontrolled expansion of the shadow banking sector could result in a destabilization of global finances. This is based on the argument that once China’s finance market is destabilized, the country has to import less and also export less (Dang and others 3). The implication of this is that countries dependent on China as a source of imports or destination for exports have to contend with lower supply or demand respectively. Besides the possible impacts on the country’s financial system and the growth of the shadow banking system in China has also raised significant concerns over the quality of services and products offered by these non-financial establishments.

Despite the regulations that have been tightened to control traditional lending practices used by the shadow banks in China, concerns persist about the quality of the products offered by these non-financial institutions. The possibility of a lending bubble coming about because of the shadow banks’ activities is controlled through the institution of policies which are aimed at controlling their practice. However, areas such as the quality of the credits associated with the shadow bank loans have had regulations put in place to reduce the potential for failure. The first measure that was put in place by the government’s regulatory authorities was to specify the maximum credit limits which can be issued by the non-financial institutions to potential clients. Secondly, yearly loan quotas were also established for application by the traditional banks to reduce the potential for inducing a credit bubble in the financial markets. These and many more other measures have been put in place to control the growth of shadow banking in China (Ma 2). The result has been amazing since in the past two years, the financial sector in China has attained a significant level of stability despite the growth of the shadow banking system. This means that while the shadow banks still play the complementary role for which they were designed, their potential for resulting in increased risks in the financial sector is significantly reduced.

The major beneficiaries of the shadow banking system in China have been identified as real estate and property developers and buyers who are incapable of obtaining funding through bonds. This implies that the success and growth of the shadow banking system in China is directly tied to the developments in China’s property market. The discussion of the shadow banking system in China can thus not be complete without the inclusion of a discussion of the property market.

 Housing Bubbles in China

The housing sector in China has been very dynamic in recent years. Changes in housing prices have been very robust in the recent past. The recent housing boom has made the impacts of the changes in the sector even more far reaching. The paradoxical relationship between the nation’s GDP and the prices of the housing in China can effectively be described as a housing boom. In the recent past, the housing prices in China have been increasing at rates higher than the GDP growth rates. This has made the housing sector to attain high capital return rates and similarly high vacancy rates.

This is a clear indication that as housing prices rise, their affordability reduces and subsequently demand for the houses reduces. As Chen and Wen (1) assert, the housing sector in China contributes expansively to the economic growth of the country. Real prices of housing in the last decade have grown by approximately 17 percent, while the GDP has grown by 10 percent (Barth and others 1). The significant growth in pricing has been associated with the growth in vacancy rates, which were recorded to be above 22.4 percent at the end of 2013. Although this indicates a high speculative housing demand rather than excessive supply, it also indicates the existence of a housing bubble. This is based on a comparison with the US, which shows that during the most intensive housing bubble experienced in 2006, the vacancy rates were only 6 percent (Chen and Wen 1). Interestingly, the returns that the housing sector has enjoyed in the same period have been significant.

The paradoxical combination of high housing prices, high vacancy rates and high returns brings to light the role of the investors in the development of the housing bubble. It is posited that the significant increase in housing prices creates an impression of housing as a potential store of value hence encouraging investment in the sector (Chen and Wen 2). The consequence of this is that most of the housing that are found vacant are those which have already been purchased by investors on the belief that there is a potential for future demand for housing. This subsequently creates a housing bubble in the economy such as that which is currently in existence. The high vacancy rates can be explained to be a result of the hiked housing prices.

In 2008, it was determined that at the rate of growth of the housing sector in China, there was the potential of a slow down after some time. This was based on the argument that with the increase in housing prices, more and more potential buyers would be forced to settle for less than they desired in terms of housing features (Barth and others 6). This fear was particularly escalated due to the fact that most of the house buyers depended on family finances for their house purchases. This implied that with the increase in housing prices, the access to funds was restricted. The assistance of shadow banks, which offered trust funds and housing development loans, therefore came at a time when it was needed immensely. This was especially important after banks tightened the lending rates due to pressurizing regulations. However, the shadow banks still provide funding to real estate development companies from the funds, they obtained from banks (Barth and others 9). This implies that with the continuing expansion of the housing sector and the projected decline in the sector has the potential of causing adverse effects in both the shadow banking system and the conventional banks in the country.

The Financial System in China

The financial system in China has been dominated by the banking sector for years now. The efficiency of the system is therefore in the hands of the banking sector, which has been striving towards the improvement of efficacy. This is through the reduction of the [number of unproductive loans issued through conventional banking products and improving the efficiency of credit products. Besides the banking sector, other sectors which take center place in the financial system in China are the stock markets and the alternative financial sectors. The stock market has been performing poorly in recent years despite efforts for improvement. From a study carried out by Allen and others, alternative financing channels comprise of the so called shadow banking systems which provide funding for sectors such as the real estate sector. The relationship between the alternative financing sector and the banking sector has been described as being interdependence, with the banking sector providing funding for the alternative financing sector which offers wealth management products to potential customers. It is thus imperative that for the economic growth in the country to be sustainable, the growth in the financial system has to be sustainable.

The government in China has found ways of improving sustainability in the financial systems of the coconut through implementation of policies which reduce the potential of collapse in any of the sectors that contrib.ute directly to the financial system growth. These sectors include the housing and general property sector, the stock market sector and the alternative financing sector. The reason for focusing on the properties and housing sector is probably based on the argument that since this sector is the major participant in the alternative financing sector, its collapse has the potential of resulting in a domino effect of negative impacts on the financial system. China’s major challenge in this regards is to avoid crises associated with the various sectors such as a financial crises in the banking sector due to sudden profit drops, a crash of the housing sector due to speculative bubbles such as that which has been in operation since the last two years, and twin crises (Allen and others 2).

One major objective of the government of China is thus to maintain the economic growth in the country through closure of gaps which are pertinent in the country’s financial systems. Gaps such as those associated with incremental lending to the housing sector even in the light of potential burst in the bubble. Measures have been put in place to ensure that these gaps are closed. The implementation of regulations and policies for the protection of the country’s financial sector began more than five years ago. This has included measures such as the introduction of market specific pricing for both risks and capital, expansion of the breadth of the financial markets, expansion of the liquidity and depth of the financial markets and improvement of the frameworks for stability in the financial sector (Hess 21). The implications of these regulatory measures are intended to sustain long terms financial stability and to improve the regional cooperation in terms of currency (Hess 21).

The financial system in China currently is ambitious about improving the status of the national currency so that it can be at a position commensurate to the country’s global position. In order to achieve this, the system has made regulations for the improvement of scalability, stability and liquidity. The future of the financial system in China is set to be based on exchange rates characterized by flexibility, liberalization of capital accounts and increased foreign reserve diversification. This cannot be achieved independently while the overall objective is to better regional collaboration in terms of currency. Consequently, the collaboration between various players in the Asian regions financial systems is imperative for the achievement of individual nations’ financial stability objectives. One important step that China has to take is the loosening of the restrictions in capital accounts (Walsh 21).

Discussion

Shadow banking, housing bubbles and the future of China’s financial system

The Financial system in China is currently facing challenges in terms of the participation of various players in the system. While the country’s financial system has regulations that have been put in place for the control of various activities, difficulties still arise due to the contribution of various sectors to the financial system. The major risks that have been associated with the country’s financial system include: the risk of collapse of the housing sector as a result of unprecedented bubbles, the risk of sudden reduction in banking sector profits, risk of collapse of alternative financing sector and the risk of twin crises, especially those involving the banking sector and the housing sector. Several regulations have been put in place to protect the financial system from these potential risks. These measures include regulation of lending rates, and control of loan quotas to the housing sector. While these measures have been instrumental in the regulation of the banking sector operations, difficulties still exist in terms of alternative financial sectors.

The main alternative financial sector that has resulted in immense strain on the financial system in China is the shadow banking sector. This system has undergone prolific growth in the last few years that can only be described as being exponential. Shadow banking in China is linked to various risks to the financial system in contemporary times. The first risk relates to the housing sector in the country. In the last few years, the housing sector has received financing from shadow banking even when banks regulated such financing to reduce the potential of realizing credit bubbles. This implies that as the extent of shadow banking increases in the Chinese economy, the amount of credit financing awarded to potential real estate and property. This, as explained in the literature resulted in a rise of speculative demands for housing. Despite the current status of the industry where the returns and vacancy rates are significantly high, this status quo is not likely to be maintained for long. It is expected that following inaffordability of housing due to their prices, the housing prices is most likely to go down as a result of the housing bubble. The implication of this would be a reduction in returns due to the shadow banking systems and subsequently to the banking systems since the shadow banks receive their funds from the banks. The combination of a housing bubble and the prolific growth of the shadow banking system therefore have the potential of shaking up the entire financial system in China. The future stability of the financial system in China therefore depends on the ability of the system to regulate the growth of shadow banking in the country.

The question is therefore posited as to whether China should do away with shadow banking completely. While this may sound as a viable solution to the challenges currently experienced in China’s financial system, the most appropriate solution would be to find ways of effectively containing the growth of the sector without complete annihilation of the system. This is based on the argument that despite the challenges posed by shadow banking, the benefits it has, particularly on the private investment systems cannot be ignored since these private investments contrib.ute immensely to the economic growth of the country. Moreover, control of their growth may also result in the control of access to property development financing hence reducing the impacts of the housing explosion.

Conclusion

The financial system of China depends on three major sectors, which include the banking sector, the stock market, and the alternative financing sector. The role played by the housing sector is tied to the contribution of the alternative to the development of the housing sector. This implies that while the financial sector may be stable currently, the combination of an imminent housing bubble and expanding shadow banking system may result in its destabilization. It is thus necessary for the financial system to provide regulations that may help to control the growth of the alternative financing sector such as shadow banks in addition to the regulations that control maximum credit limits and yearly loan quotas.

Works Cited

Allen, Franklin, Jun Qian, Meijun Qian and Mengxin Zhao. A review of China’s financial system and initiatives for the future. 2008.

Barth, James, Michael Lea and Tong Li. China’s housing market: is a bubble about to burst? Milken Institute. 2012.

Chen, Kaiji and Yi Wen. The great housing boom of China. Federal Reserve Bank of St. Lois. 2014.

Dang, Tri, Honglin Wang and Aidan Yao. Chinese shadow banking: bank-centric misperceptions. Hong Kong Institute for Monetary Research. 2014.

Hess, Patrick. ’China’s financial system: past reforms, future ambitions and current state’. In  F. Rövekamp and H. G. Hilpert (eds.), Currency Cooperation in East Asia. Financial and Monetary Policy Studies 38, 2014. DOI: 10.1007/978-3-319-03062-3_2.

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Labes, Sebastian. Shadow banking in China and its implications in the global financial recession. Alexandru Ioan Cuza university. 2014.

Ma, Maria. China: shadow banking and the global economy. Commentary. SEI. 2013.

Valckx, Niko et al. Shadow banking around the globe: how large and how risky? International Monetary Fund, 2014.

Walsh, James. The future of Asian Finance. Finance and Development. 2014.