China, the world’s second largest economy, has seen an unprecedented explosion in its shadow financing industry over the last few years. According to estimates published by investment firm Credit Lyonnais Securities Asia (CLSA), unregulated financing activities or “shadow banking” currently accounts for 79% of China’s entire gross domestic product (GDP). Research conducted by the firm also concluded that between 2011 to 2015 the size of these activities grew at a rate of 30% each year. (For more, see also: The Rise and Fall of the Shadow Banking System.)

What's Driving This Growth

As a centrally planned economy, China’s government has placed a number of tight restrictions on the practices of its financial institutions such as banks. These restrictions include not being allowed to lend to businesses that operate in high-risk sectors and not being able to exceed a loan to deposit ratio of 75%.

In addition, up until recently, Chinese regulators once stipulated a ceiling and floor on the interest rates that banks could choose to pay their depositors and charge their borrowers. The Chinese government has begun to implement interest rate liberalization policies however as CLSA explains the reform is moving at a slow pace. As a result of all of this, financial institutions have been looking at alternative and less regulated channels that they can use to lend money.

In CLSA’s report, Francis Cheung, one of the company’s analysts, stated, “... the key driver of [shadow financing] growth has been the banks circumventing regulations to protect their margins." (For related reading, see: Wells Fargo Faces Probe for Fake Accounts.)

Potential Threat to the Economy

CLSA’s report also noted that bank-related shadow financing could wipe out as much as $379 billion from the Chinese economy. The firm estimates that potential bad-debt losses stand at 3.7% of all money lent through shadow channels.

Another research paper published by CLSA earlier this year echoed the fact that China is currently experiencing a bad loan epidemic. According to the firm’s analysis, in 2015 between 15% to 19% of all outstanding credit in the country was classified as non-performing debt.

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