Shadow lending is not new in China. In an economy where access to official credit is typically limited to local governments and large state-owned corporations, smaller private enterprises have long relied on informal lending markets in times of need. Since 2009, shadow lending in China has undergone a dramatic transformation, both quantitative and qualitative.
Between 2005 and 2009, informal lending markets rarely accounted for more than a few percent of total credit in the Chinese economy, usually taking the form of the underground loan shark who charges 35 percent interest and ensures repayment by threat of physical violence.
Since 2009, however, and especially following Beijing's sudden clampdown on official lending to property markets in the second half of 2011, the shadow banking sector's share of total credit in the Chinese economy jumped to between 9 and 22 percent, depending on how "shadow" is defined. That means the sector is now worth anywhere from 17 to 40 percent of China's gross domestic product. Moreover, in the first two months of 2013, shadow lending products emerged as the top drivers of new credit creation in China for the first time.
More important than the sheer size of the shadow lending sector, however, is its shifting composition. The shift began with the rise of trusts, or formal non-bank entities that offered investors higher rates of return than ordinary savings accounts while providing a measure of security that truly informal lending markets could not. But after the second half of 2011, trusts were rapidly eclipsed as drivers of non-official bank credit creation by a new class of tools called wealth management products. These products promised investors even higher rates of return than trusts and they carried an important added bonus: they are for the most part operated, managed and theoretically backed by state-owned banks.
The popularity of wealth management products soared in 2012. Whereas at the end of 2011 they accounted for only around 1-2 percent of total lending, by the end of 2012 their value had reached over 9 trillion yuan ($1.4 trillion), or about 10 percent of total deposits. More important, their rise coincided perfectly with Beijing's imposition of strict controls on official state-owned bank lending to property developers starting in late 2011. This was not a coincidence.
Wealth management products emerged just as property developers, who are closely (if often informally) tied to local governments, saw their access to official state-backed credit dry up. This also occurred just as Beijing tightened restrictions on the number of properties speculators and investors could purchase. The products filled this void by creating a new credit source for indebted developers while offering investors, who after late 2011 could no longer put their money so readily or directly into property, a well-paying alternative. Finally, wealth management products served the interests of local governments and bank branches by simply keeping lending and economic activity high. From the central government's perspective, these products were at least tolerable insofar as they brought informal lending — however inherently risky — under the wing of the state sector.
This last point is critical. If shadow lending generally can be understood as a supplement to the state-owned banking sector, wealth management products offer a new twist: they technically belong to that sector. In this sense, their growing prominence represents the central government's effort to defuse the risks posed by informal lending by simply taking over as much of the sector as possible. This allows Beijing to simultaneously accomplish two important goals. First, it helps maintain growth for local governments, which rely heavily on land sales and thus lively property markets for revenue. Second, it shields state-owned banks' balance sheets from future property-related non-performing loans, since wealth management products are recorded separately from formal lending transactions.
The evolution of shadow lending is closely linked to the emergence of real estate construction as the key growth machine of the Chinese economy following the 2008-2009 financial crisis. In turn, the rise of wealth management products as a means for state-owned banks to gain a greater foothold in the sector reflects the central government's shifting efforts to manage the imbalances and risks inherent to a credit- and property-driven economy. Unless Beijing can shift the economy away from overreliance on lending and credit — a process that will likely require significantly boosting domestic consumption — these products, along with the imbalances they only temporarily hide, will continue to grow.