Market Analysis

China’s Private Lending Steps Out of the Shadows

China’s incremental financial system reforms are small steps in the right direction, but there’s much further to go.

If you blinked, you may have missed it. Over roughly the past month, China’s taken baby steps toward loosening its death grip on capital controls. The benefits, if any, will depend on how much China commits to this liberalizing move.

As we’ve written before, China prevents much cross-border capital flow, preferring greater control over monetary policy and its currency. (This is known as the impossible trinity—you can’t simultaneously have a fixed exchange rate, as China has, discretionary monetary policy and free capital flows.) As a result, foreign investors are excluded from investing directly in the domestic Chinese stock markets (A-shares). Additionally, capital flow restrictions mean China’s private citizens’ investments are corralled mostly into domestic vehicles—like low-yielding bank deposits and the housing market.

Still, China can’t keep out all foreign money—some enters via trade and foreign direct investment. So China has found loan quotas a powerful, though crude, tool for controlling the economy and inflation. Chinese banks prefer exhausting their loan quotas by lending to the perceived lower-risk, larger, government-backed companies—hence, though illegal, “shadow lending” is prevalent among small, private Chinese businesses. Recently, the case of Wu Ying (aka, “Rich Sister”) garnered a great deal of media attention. Wu, a 28-year-old Chinese billionaire, was initially sentenced to death for financial fraud (essentially, shadow lending). Though her sentence has since been reduced, the case does illustrate a broader issue—at least 16 others are currently on death row for illegal fundraising.

But a prolonged stay in a Chinese prison isn’t shadow banking’s only risk. Last year, a localized run on shadow banks created a liquidity crunch in Zhejiang province , causing many borrowers, mostly owners of small- to medium-sized enterprises, to file for bankruptcy or outright flee town. Considering the illegality of the practice, private investors had limited legal options to recoup their funds—layering on additional risk.

The Chinese government finally seems to be acknowledging the importance of the shadow banking system, which is estimated at over US $1 trillion. At the end of March, plans were unveiled to make the city of Wenzhou a “special financial zone.” Under this new designation, shadow lenders can register as private institutions and operate legally. Furthermore, Wenzhou’s citizens will be allowed to invest up to $3 million in non-banking entities abroad—previously only possible through government intermediaries. This offers an alternative to real estate investments and paltry deposit rates. And for entrepreneurs, an influx of legitimized funding could promote organic growth within China’s economy.

Foreign investors wishing to invest directly in Chinese A-shares also stand to benefit from loosening controls: A separate announcement in early April increased the Foreign Institutional Investor program (QFII) from $30 billion to $80 billion. QFII is the quota set by the Chinese government on the amount that may be invested in Chinese equities. While many Chinese companies dual-list on the Chinese and Hong Kong stock exchanges (H-Shares, which are open to foreign investors), increasing the flow into the A-shares market offers a larger investable universe and potentially more efficient pricing among shares.

These are good steps, but let’s put the QFII increase and the Wenzhou experiment in perspective: The current QFII fund accounts for only about 1% of A-shares market capitalization, and the current $30 billion quota isn’t even fully used. Although Premier Wen Jiabao has hinted the Wenzhou policy changes could expand nationally, there are still concerns it’s either primarily a symbolic move to placate the masses or merely a near-term move to stimulate the economy.

Accordingly, the stock market had a muted reaction to these events. The true economic benefits of these reforms remain to be seen, but however small, they’re seemingly small steps toward what is hopefully China’s ongoing economic liberalization—a move that would benefit China most of all.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.