China’s war on shadow banking can’t last forever

Cause and effect. Action, reaction. As China cracks down on shadow finance, private companies and state giants alike are learning that the karmic wheel of money can come to a screeching halt.
In April 2018, China unveiled far-reaching rules for its financial industry as part of an effort to curb risk. Banks were asked to spin off their wealth-management arms, which had helped funnel credit to an overburdened private sector, and stick to traditional, boring loan books. They were given three years to adopt the new rules, ending in December 2020.
This was a declaration of war on shadow financing. The industry shrank by 1.6 trillion yuan ($229.1 billion) in 2019, after contracting by 2.9 trillion yuan a year earlier. The policy change has already inflicted some damage. Onshore bond defaults hit a record high for two straight years. In 2019, most of them came from private-sector borrowers struggling to refinance, while state-owned enterprises emerged largely unscathed. As we enter 2020, however, China’s draconian reforms could start to backfire on the state, too.
For starters, a shadow-banking crackdown has severely restricted Beijing’s fiscal prowess. To boost infrastructure spending, officials have been allowing local governments to issue special-purpose municipal bonds at a record pace, even bringing forward the quota for 2020. Yet infrastructure spending remains anaemic, growing even slower than the overall economy.
Why would this be? Since 2015, Beijing has been relying on public-private partnerships to build roads and railways. But private money has essentially evaporated after the new rules prevented wealth-management products, typically short-term instruments, from investing in longer-term projects. Meanwhile, China’s new municipal bond issues, at roughly 2 trillion yuan a year, can’t meet the nation’s annual infrastructure spending of 17 trillion yuan.
Beyond a few hiccups, faith in China’s public-sector bond issuers remained relatively unshaken in 2019. Every once in a while, a local government financing vehicle would be a few days late in its coupon repayment, but Beijing hasn’t allowed these municipally run, off-balance-sheet shell companies to default. As we witnessed in 2018 and 2019, private enterprises have no choice but to default when one of their key funding channels is cut off. Unless China takes a policy U-turn, the same phenomenon may repeat with municipals’ financing vehicles.
By now, the realisation that banks prefer state-linked entities has become deeply ingrained in China’s business community. So how do private businesses get cheap credit? By pretending to be affiliated with the government. Already, quite a few “fakes” have blown up in investors’ faces.
What’s missing in all this is why China’s biggest state-owned banks aren’t filling the void. One explanation is that they have little incentive. These lenders have remained profitable, with the big four earning almost 1 trillion yuan in net profit in the last year. Lending to private businesses requires grunt work, and credit officers simply aren’t interested. They’d rather write loans to state giants such as China Mobile Ltd. and go back into hibernation.
Meanwhile, Beijing has tweaked its credit statistics to appear friendlier to private businesses, all while lecturing China Inc. that allowing some defaults will help borrowers kick their debt addictions. While such advice is easy to dole out, it makes for bitter medicine when trouble starts brewing within state-run businesses. So, junk bond traders, rejoice! Those defaults you fear could dwindle in 2020. China’s war on shadow banking can’t last forever.

—Bloomberg