China's Shadow Banks

Ye

Sheng, who runs a luggage parts-manufacturing company in China's eastern Zhejiang province, is an unlikely looking banker. He doesn't wear three-piece suits, and his place of business rings with the shouts and banter of hundreds of workers who screw steel wheels to the bottom of satchels bound for department stores in South Korea. But Ye is a moneylender all the same. To keep his company in cash, he has taken in $10,000 in deposits from family and friends. He pays them interest, uses their money as working capital, and occasionally he extends loans to other private companies. "I give better returns than banks, and people trust me just as much," he says.

Although Ye's activities are technically illegal, they are an entrenched part of the economic ecology in China's capitalistic enclaves. Zhejiang, which has since the late 1980s been at the front line of free enterprise, is home to tens of thousands of private companies. Although these independents fuel most of the area's economic growth and provide most of the jobs, they usually are shut out from borrowing by China's four big state-owned banks, which typically ignore small private ventures. So when entrepreneurs need capital, they turn to "shadow" banks—China's vast, flourishing gray market of unregulated lenders, including companies run by people like Ye, associations made up of citizens who pool their savings to invest and to lend among themselves, and informal lending between firms.

It's difficult to ascertain how widespread shadow banking is throughout China. Beijing University economist Shen Minggao estimates that two-thirds of all financial activity in Zhejiang takes place outside the formal banking system. Local regulators do nothing to discourage informal lending because it funnels capital to vital, fast-growing businesses. But national economic conditions could now make it more difficult to look the other way. For one thing, China's inflation rate has crept above 5% while interest on savings deposits remains about 2%. In other words, Chinese lose money when they park cash in legitimate banks. It now appears that savers in Zhejiang, who have few legal investment options, are lending their cash directly to friends or are turning more of their nest eggs over to people like Ye, who pays higher interest rates than banks. Government figures show that depositors in Wenzhou—the financial heart of Zhejiang province—have withdrawn at least $1.2 billion in bank savings since February, according to the city's branch of the China Banking Regulatory Commission (CBRC).

These mass withdrawals pose a direct, albeit somewhat nebulous, threat to China's legitimate (but often poorly managed) lenders, which are burdened by bad loans to state enterprises and depend heavily on the deposits of ordinary Chinese to remain solvent. If the rest of the country follows Zhejiang's example, the deposit exodus could shake confidence in the entire system, sparking bank runs and a financial crisis. Arthur Kroeber, managing editor of the Beijing-based China Economic Quarterly, says the main reason the government increased interest rates last month by 0.27% for one-year loans and deposits—China's first rate hike in nine years—was to encourage people to keep their cash in banks. More interest-rate increases are expected, especially if inflation continues to gather steam.

A run on banks remains unlikely, but shadow banking poses another problem to Beijing. China's technocrats are trying to slow the country's unsustainably high growth rates partly by curtailing lending. But financial czars have no control over money sloshing around in unregulated banking networks, making it difficult to enforce curbs. Illegal funds have defied the government by investing in overheated sectors such as real estate. State-run media blamed "wandering ghouls" from Wenzhou for driving up property prices in Shanghai last summer.

In the past, Beijing might have responded by cracking down and throwing a few people in jail for loan sharking. That hasn't happened for the simple reason that the gray-market provides an efficient means of capital allocation in ways the country's socialist-era financial system cannot. The People's Bank of China, the central bank, discovered this recently when it started monitoring gray-market capital flows in Zhejiang. Expecting to find shadow bankers charging exorbitant rates, they instead discovered that underground interest rates were only marginally higher than what banks offer and repayment terms were better. This steady source of finance has given Zhejiang not only China's most vibrant private economy but also the lowest level of nonperforming bank loans in the country. Permitting informal lending allows state-run banks, which provide most of their loans to state-owned enterprises, to "focus on bigger, reliable companies, [while] smaller ones finance themselves in other ways," says Bao Sihu, head of the CBRC in Yuhuan county, home to dozens of private factories specializing in valves.