Starting in 2012, the relatively light regulatory touch also coincided with key macroeconomic
developments that allowed off-balance sheet “shadow” banking activities to take off. The strong growth of informal financing channels and off-balance sheet assets encouraged regulatory arbitrage—borrowers and lenders shopping around for the most permissive and risk-tolerant new product categories with lenient rules and lighter capital requirements—and ended up changing the foundations of China’s financial system as well as jeopardizing China’s traditional macroeconomic policy tools. Before 2012, China’s banking system may have been inefficient, making extensive loans to state-owned enterprises and local
government companies, but it was relatively stable. That stability came from its funding base, which relied primarily on traditional bank deposits, overwhelmingly from household savers. Even if China’s banks were making bad loans, household depositors were unlikely to pull their money from the banks, primarily because they had no other viable domestic investment options and because controls on capital outflows were reasonably effective.
China’s banks continued to see significant inflows of deposits every year from both domestic and foreign sources. Starting in 2003, China began running large trade surpluses, which brought more foreign currency (primarily U.S. dollars) into China where it was exchanged for yuan (and in earlier years involuntarily surrendered). China also ran significant surpluses in net foreign direct investment as foreign companies piled into China, bringing in more foreign currency that was converted into yuan. The central bank ended up acquiring most of these U.S. dollars by intervening in the foreign exchange market, creating the yuan necessary to facilitate export and investment transactions while limiting the appreciation of the currency that would have occurred had the foreign exchange market been allowed to clear. Naturally this increased the money supply in China, so the central bank limited the risk of inflation by freezing some of those funds at the central bank via hikes in the required reserve ratio, raising interest rates, and imposing credit quotas.
Figure 2-1: Components of China’s Balance of Payments, 2003-2017 Billion USD
Source: State Administration of Foreign Exchange.
Fundamentally, the process produced still more deposits in China’s banking system. Exporters and investors were confident that the PBOC would buy any and all foreign currency that they brought onshore in exchange for yuan. From 2003 to 2011, these net foreign inflows, producing new deposits in China’s banking system, averaged around $30 billion per month, despite the intervening global financial crisis. As a result, the key policy challenge facing China’s financial technocrats was how to manage the
consequences of excess deposit inflows and the concern that these deposits would allow banks to create too many new loans, despite a restriction limiting a bank’s loans to 75 percent of its deposits. Deposit growth had typically outpaced loan growth until 2011.
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Figure 2-2: Growth of Deposits and Loans in China’s Banking System, 2001-2017 Percent YoY
Source: People’s Bank of China, Bloomberg.
In late 2011, however, this situation changed suddenly, sparked by developments that had little to do with China. Given rising market concerns about the sustainability of European sovereign debt growth, European banks began to reduce risk on their own balance sheets by pulling back on lending in Asia, including to banks that had lent to Chinese firms in foreign currency. The net result was that China suddenly faced a capital and financial account deficit that was larger than its current account surplus. The result was a balance of payments deficit, which caused China’s currency to begin depreciating in late 2011, requiring more foreign currency to be purchased by Chinese banks and companies onshore to repay offshore foreign-currency obligations.
More significantly for China’s banks, they suddenly found themselves missing a previously abundant funding source—deposits from external sources. In a more market-oriented banking system, a sudden shortfall in funding would have produced a slowdown in lending growth, but local governments still had strong incentives to keep credit flowing. This created a problem for banks, particularly smaller banks tied to localities, which were already struggling with local governments that could not repay existing loans and needed new funds to maintain the level of investment activity. However, simply extending new loans would often place the banks below the capital requirements imposed by the CBRC.
The sudden change in China’s external funding conditions that began in late 2011 and early 2012 created two new challenges for banks: they needed to compete for funding, which was suddenly scarce, and they needed to keep extending new loans even though they did not have enough space on their balance sheets or enough capital to do so. These challenges then altered the fundamentals of China’s banking system in two ways. First, banks began to rely far more heavily on non-deposit forms of funding, including WMPs and borrowing directly from other banks and the central bank, rather than traditional deposits. Second, banks began to restructure their assets in ways that looked less like loans and more like investments.
These assets bore many different labels, including “trust beneficiary rights” (TBRs), “directional asset
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management plans” (DAMPs), “investment receivables,” and “interbank entrusted payments,” but what they had in common was that they bore lower capital requirements than traditional loans and required lower loan-loss provisions. Regulatory arbitrage quickly gained momentum on both the liability and asset sides of banks’ balance sheets.