China’s Shadow Menace

BEIJING – The US Federal Reserve’s decision to exit from so-called “quantitative easing” – its massive monthly purchases of long-term assets – is stoking fears of a hard economic landing in China. But China’s strong economic fundamentals mean that policymakers have the space to avoid such an outcome – as long as they bring the country’s shadow banking system under control.

As it stands, Chinese consumption and investment growth is expected to remain at roughly last year’s levels. Meanwhile, economic recovery in the advanced economies, especially the United States and Europe, is reinvigorating external demand, leading analysts to project annual Chinese export growth of more than 10% this year – 3-4 percentage points higher than in 2013. This would bring annual GDP growth in 2014 to a very healthy 7.5-8%.

The problem is that China’s financial sector has accumulated considerable risk in recent years, with broad money (M2) having ballooned to ¥110.7 trillion ($18 trillion) – almost twice the country’s GDP – at the end of last year. In an attempt to rein in M2, which could indicate that the economy is overleveraged, the central bank tightened conditions for commercial bank lending, so that, for any given increase in M2, less credit is extended.

But the move failed to contain M2 growth; on the contrary, M2 grew faster last year than in 2012. Worse, restricting commercial banks’ role as financial intermediaries and encouraging the growth of unregulated shadow banking has generated even more risks for China’s economy. Clearly, a new approach is needed – one that is based on a deeper understanding of the dangers inherent in China’s banking system.