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China to Allow up to 5 Privately Financed Banks, Tighten Reins on Shadow Banking

In a move surprising some analysts, China said it will allow the formation of up to five privately financed banks this year.

It also plans to focus more attention and regulation on its shadow banking sector. That, though by no means as significant as such sectors in other countries, has been growing at a rapid pace, in some years by as much as 50%.

According to the China Banking Regulatory Commission (CBRC), the new banks may be started from scratch, or may be existing banks restructured via private money, but they will "[bear] their own risks. Strict procedures and standards will be set for the pilots, with demanding setup criteria, limited licenses, enhanced supervision and a risk handling system,” according to the commission. It also said that it would look into making it easier for foreign banks to do business in the sector.

Private banks could be a way for China to boost competition in the sector and, it hopes, to spur growth. In addition, its concerns over the rise of shadow banking, along with soaring debt increases at local government levels, are spurring action to bring those institutions under closer scrutiny and control. Its banks have been ordered to publish their interbank liabilities, as well as their off-balance-sheet loans, in a nod to Basel Committee regulations issued last July.

Of the 19 Chinese banks that are publicly traded, the new orders apply to at least a dozen. Institutions whose assets amount to 1.6 trillion yuan ($264 billion) or more must publish 12 different indicators within four months of the end of each financial year, according to the CBRC. The indicators, which the CBRC said are not intended as evaluators of the banks' risk levels or management, instead are to provide data on derivatives and cross-border assets and liabilities.

Banks also must provide additional disclosure on trusts and wealth management products; in addition, brokerages and their place in shadow banking will be supervised more closely.

The growth of shadow banking, which was estimated by JPMorgan at approximately 69% of 2012's GDP, and the level of local government debt—which in less than three years has soared by 70% to nearly $3 trillion, 40% of which will be due by the end of this year—are causing Beijing to worry that the entire financial system's stability could be jeopardized. However, Chinese leadership is by no means shutting down the shadow banking system; in its statement about changes to come, the CBRC said, “The emergence of shadow banks is an inevitable result of financial development and innovation. As a complement to the traditional banking system, shadow banks play a positive role in serving the real economy and enriching investment channels for ordinary citizens.”

This is perhaps not surprising when considering that only five years ago, China's traditional banks dominated its financial sector, providing more than 90% of funding for the country's economy. Now, however, those banks only account for 50%, with nontraditional (for China) institutions accounting for the rest.

John Blank, chief equity strategist for Zacks, said that the Chinese have categorized their shadow banking industry into three areas: those with no operating license—he compared them to Internet finance companies in the U.S.; those with no licenses but that are partly regulated, such as credit guarantee companies, which Blank compared to factors; and licensed companies that are not sufficiently regulated, such as money market funds.

China has also said it will allow local governments to roll over their vast levels of debt by issuing bonds, rather than face default. That means the shadow bank loans that were taken out by those local governments to finance infrastructure projects will end up as bonds.

"Bridges, roads, apartment buildings [were] all funded by [shadow bank] loans, and will be rolled into bonds. Not general obligation bonds, but [bonds that are] attached to the projects themselves [and are] more transparent than loans. What's going to happen here is they will move from bank loans to bond markets. They had a shadow bank system, and now will have major bond markets,” Blank said.

The concern over potential default on all that debt has led to concern that China, as it seeks to quell burgeoning public sector debt, could end up stifling growth and throwing its economy into a tailspin. But as the country moves toward regulation of shadow banking, shunting shadow bank loans into bonds and allowing privately financed banks and even foreign banks into its financial sector, it is moving more toward a Western style of finance, according to Blank.

"[T]his is a typical pattern of Chinese development; to bring in an idea from somewhere else and [put it into practice]. These things have all been done,” Blank said. While they may not have been done in China before, they're commonplace elsewhere and thus signal China's intent to compete on the world financial market stage.

One might hope that, in replicating the financial sectors of developed countries, China does not also replicate their errors, something that no less a personage than George Soros feels they will. In a Project Syndicate op-ed, Soros said, “[T]here is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years."

Soros also said, "There are some eerie resemblances with the financial conditions that prevailed in the U.S. in the years preceding the crash of 2008. But there is a significant difference. In the U.S., financial markets tend to dominate politics; in China, the state owns the banks and the bulk of the economy, and the Communist Party controls the state-owned enterprises.... How and when this contradiction will be resolved will have profound consequences for China and the world."

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