Watching the shadow banks

The Chinese trust company that nearly caused a "Lehman moment" for China earlier this year was in the news this month for another possible default - raising jitters once again about the world's second-largest economy's worrisome shadow banking sector.

One of China Credit Trust's wealth management products that matures next week is running into problems as a coal mining company has failed to make fee payments since the second quarter of last year. This is rattling investors as the trust company had averted a default in January at the eleventh hour only when an unnamed saviour stepped in to lend a hand. The fear then was that a default would trigger a chain effect similar to the one after the 2008 collapse of the Lehman Brothers investment bank in the United States that led to the sub-prime crisis there and global financial turmoil.

This was not being alarmist as China's huge shadow banking sector is considered by many to be a ticking time bomb. With a maturity peak likely next year for its US$1.9 trillion (S$2.4 trillion) trust fund industry alone, and defaults expected amid a slowing economy, it would be unwise to shrug off the threat. A rupture, if it happens, has serious implications not just for China but also for the global economy through its sheer size - at 46.7 trillion yuan (S$9.3 trillion) or about a third of the country's total credit. This means that 10 per cent of the world's corporate debt is exposed to the risk of a contraction in the sector, according to Standard and Poor's.

The unruliness of the lightly regulated sector and the difficulty in taming it add to the problem. Shadow banking in China, ironically, burgeoned in the aftermath of the US sub-prime crisis caused primarily by such banking. To weather the global financial crisis that followed, the Chinese government unleashed a huge stimulus programme in which new credit weighed heavy on the banks. The government then allowed alternative forms of credit to grow, including trusts, leasing firms, credit guarantee outfits and money market funds, which tend to lend to firms with higher credit risks, such as those in troubled industries like property and steel.

China has tried to rein in the sector with measures like curbs on interbank borrowing, which was one way of channelling funds to the shadow banking sector. But these have led to new forms of credit, including even online peer-to-peer lending. It is a conundrum Beijing needs to address squarely. Versatile capital markets must be encouraged and China has to also avoid a possible run on shadow banks. The consequences could be dire. Yet, looking the other way poses grave risks. It is a tricky task but for China and the world's sake, it must get the calibration right.