Shadow financing is banking reform gone wrong given that the key driver of growth has been banks circumventing regulations to protect margins. Shadow financing has grown rapidly, benefiting from implicit government guarantees despite being a channel for credit to higher-risk industries. We estimate the potential bad-debt loss for this segment at 3.7% of GDP on top of our estimated banking bad-debt ratio of 15% discussed in our May 2016, Bad-debt epidemic report. Bad debt has built-up as banking has remained one of the most strategic and protected industries where lending is driven more often by implicit guarantees than commercial decisions.
China’s high GDP targets have made the economy dependent on debt and banks are the major financiers. Banking remains a strategic industry operating amid slow reform, which helps explain how the banks have been able to get around so many regulations and how shadow financing has grown so fast. According to Brookings Institution, ‘Perhaps two-thirds of the flow of business into shadow financing is effectively “bank loans in disguise” . . .’
We estimate shadow financing reached Rmb54tn in-2015, or 79% of GDP, having experienced a 30% Cagr over 2011-15. It started in earnest in 2007 when the regulator allowed banks to invest in trust plans. It accelerated in 2010 when banks used wealth-management products (WMPs) to get around restrictions such as the loan-deposit ratio, and in 2012 when securities, insurance and mutual-fund companies entered the market with asset-management plans (AMPs). We estimate that bank-related shadow financing accounts for 64% of the total with Rmb22.7bn off balance sheet.
CLSA sees five key risks with shadow financing: 1) PBOC’s total social financing is outdated, understating China’s total debt; 2) transparency risk as retail investors do not have enough disclosure to evaluate risk; 3) implicit guarantee risk as middle-income families own 20% of wealth in WMPs; 4) maturity-mismatch risk which sparked the 2013 Shibor crisis; and 5) bad-debt risk. Our estimate of bad debt is based on bottom-up analysis applying the sector bad-debt ratio estimated from listed companies and applying it to individual sectors within WMPs, entrusted loans and other products.
Rotate into defensive growth and yield plays MSCI China has rallied sharply since the Brexit referendum, but the economy is slowing and the stimulus has faded. Use market strength to rotate into defensive growth and yield plays. We are overweight internet, telecoms, alternative energy, pharma and Hong Kong property and underweight cyclical sectors sensitive to the economy.