Economy | Wu Jiangang

Although the Chinese shadow banking system is renowned for its opacity, the latest annual financial market report by the Chinese Academy of Social Sciences estimates the system had 20.5 trillion yuan ($3.3 trillion) in total assets - roughly 40 percent of China's GDP - in 2013.

As China is now the second-largest economy in the world, we need to examine the nature and risks in the shadow banking sector.

China's growth model has worked well for the last 30 years in terms of GDP growth, which is supported by government investment and exports. The funds for government investment were generated because of low expenditure on social welfare, high taxes and financial-sector monopoly. Exports rose because of low wages and generous incentives but at the expense of the environment.

But this growth model is becoming more and more unsustainable at a time when wages keep rising, real estate prices keep going up, pollution becomes more severe, the monopolistic finance sector becomes more and more unfeasible and government investments become more inefficient.

The turning point for China was 2008, when the export sector was hit by weak external demand caused by the subprime mortgage crisis. To prevent large-scale unemployment and potential social instability, the central government approved about 4 trillion yuan for infrastructure projects and mobilized the State-owned banking system to provide loans.

Lending leapt from 3.6 trillion yuan in 2007 to 9.6 trillion yuan in 2009. In addition, these projects needed subsequent funding.

Before 2008, the vast majority of lending in China was carried out by regular banking. But after 2008, as policymakers began to worry about the credit boom, inflation, a property bubble and overcapacity, they attempted to put the brakes on. The regulator imposed severe requirements on commercial banks in the form of deposit reserve requirements, loan ratios and capital adequacy ratios.

As the projects that had already started needed further funding and local governments secured loans implicitly guaranteed by the central government, commercial banks used many financial tools or innovations that are now classified as shadow banking to provide unregulated loans.

The main tools or innovations are wealth management products, loans through trust companies, entrusted loans, inter-bank repurchase agreements and bank guarantees. According to official statistics, wealth management products were worth only 530 billion yuan in 2007, but soared to 1.7 trillion yuan by the end of 2009 and 9.9 trillion yuan by the end of September of 2013. Total lending through trust companies was 340 billion yuan in 2007, rising to 680 billion yuan in 2009 and 2.6 trillion yuan in 2013. Total entrusted loans were 170 billion yuan in 2007 and grew to 440 billion yuan in 2009 and 1.8 trillion yuan in 2013.

It is hard to calculate how much commercial banks have used the inter-bank market to meet cash demand, but the liquidity crises in June and December last year vividly reflect the scale on which banks use inter-bank repurchase agreements in the money market to repay short-term debt.

Shadow banking in China can be regarded as the banks' shadows, since a major segment of shadow banking is the off-balance sheet business of commercial banks.

Two other main forms of shadow banking are monetary funds and private finance, which are expanding rapidly because of the Internet. .

Because shadow banking grows, it is outside of the purview of regulators and creates systemic risks.

As the main part of shadow banking is by regulated, systemically important banks, the risk is clear.

We don't really know where these off-balance sheet loans have gone, but from the fact that private enterprises have found it especially difficult to secure credit in recent years, we can surmise that these loans have flown to local government financing vehicles and real estate projects.

There is some evidence to back up this assumption. One is that the latest audit of local government debt tallied shadow banking at 17.9 trillion yuan by the end of last June, up 67 percent from the 10.7 trillion yuan at the end of 2010. Another is that real estate prices may have more than doubled in many cities since 2008.

As the real estate bubble in China poses a danger and a plunge in housing prices can cause problems, there is not much left for the government to choose from.

First, the government should bring shadow banking under regulation.

Second, the government should cautiously manage the expectation of housing and land prices to avoid sharp rises or falls.

Finally, the government should break the financial monopoly by allowing private capital to open banks and giving up interest rate management. The government must cede control in other industries, especially service sectors, for private enterprises so that they can create investment opportunities and lending demand.

The author is a lecturer at the Management School of Shanghai University and a research fellow at the China Europe International Business School Lujiazui International Finance Research Center. The views do not necessarily reflect those of China Daily.