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Enstrusted lending in China: a shadow banking primer

Enstrusted lending in China: a shadow banking primer

By Luke Deer


Entrusted lending became the second largest source of financing in China in 2013 after bank loans and the largest shadow lending channel. This article explains the entrusted lending channel, looks at why it grew and at how recent changes to inter-enterprise lending rules may impact on entrusted loans.



Entrusted lending is a unique feature of shadow banking in China.  The ‘entrusted loan’ (委托贷款) channel was set up after a 1996 People’s Central Bank regulation which prohibited direct lending between non-bank entities, primarily between enterprises but also by government entities.



The first decade and a half of reform and opening after 1979 opened up informal non-bank financing activity on a large scale.



Together with widespread capital and goods shortages, the effect of these reforms by the late 1980s was a stop-start inflationary growth cycle at the macro-level, a crisis in profitability in the state-owned enterprise system and a major non-performing loan problem in the bank system.



China’s authorities’ were therefore seeking to bring non-bank financing channels under control. But legally choking off direct all forms of non-bank lending posed a problem for ‘legitimate’ financing and liquidity management, particularly among corporate affiliates and from local government financing entities.



Thus the ‘entrusted loan’ channel was set up as an official work-around to allow non-bank institutions to lend to each other indirectly via the official banking system.



Moreover, until very recently, China’s central bank, the Peoples’ Bank of China (PBOC) had sought to conduct monetary policy by directly controlling monetary aggregates through lending targets–and the ‘entrusted loan’ channel allowed the the PBOC to account for non-bank lending activity via the banking system.



Under the ‘entrusted loan’ facility banks conduct an agency businesses to facilitate loans between corporate and other non-bank entities for a fee.



Formally, the non-bank enterprise lender retains the risk on the principal and interest of its loan to its designated borrower and the banks get the right to fee income from the ‘entrusted loan’. But banks and non-banks entities could also use the entrusted loan channel to circumvent regulatory restrictions.



Until September 2015 regulators had sought to manage bank balance sheet risk by enforcing a 75 percent loan to deposit ratio, which stipulated that banks could not loan more than 75 percent of their deposit base. Because ‘entrusted loans’ do not appear as loans on bank balance sheets’ and are treated as an ‘other investment asset’ banks could use ‘entrusted loans’ to circumvent the 75% loan to deposit ratio by using the ‘entrusted loan’ channel.



The attempt by China’s monetary authorities to reign in bank lending between 2010 and 2013 led to a sharp growth in alternative balance sheet lending strategies by the banks, primarily through entrusted lending but also through issuing bankers’ acceptances.



As Chen (2016) explain in a recent paper, monetary tightening between 2010 and 2013 led to a worsening LDR ratio for banks, especially for smaller second banks who were more easily squeezed by falling deposits.



It was these banks who turned aggressively to alternative lending strategies, such as ‘entrusted lending’ to mitigate regulatory risk of their worsening LDR ratio.



Banks could also trade ‘entrusted loan’ assets on the inter-bank market, and this provided further incentives for enterprising banks to build ‘entrusted loan’ businesses.



The result, according to Chen (2016), was that “the share of entrusted loans in the sum of entrusted lending and bank lending tripled during the monetary tightening period [from 2011 to 2013].”



While entrusted lending could provide corporate and other non-bank affiliates with a liquidity and investment facility, entrusted loans could be used to lend to non-affiliates at interest rates above the prime lending rate to restricted industries as well for purely speculative financial investments.



From 2005 to 2010 the China Banking Regulatory Commission and the State Council passed a series of increasingly stringent restrictions on bank lending to overcapacity, polluting and ‘risky’ industries – especially real estate related sectors.



However, ‘entrusted loans’ did not count as bank loans so they could be used to circumvent lending to restricted industries.



The entrusted loan channel could also be used by companies with good access to official credit channels, such as large publicly listed enterprises and local State Owned Enterprises, to borrow at low cost from the banks and to lend at high interest rates to non-affiliates in restricted sectors.



For mature firms facing slowing growth, increased credit during the stimulus failed to offset the declining returns on investment in their core businesses, and instead they turned to speculative investment through high interest rate lending, including financing positions in the stock market.



A recent paper by Yan (2015) found that speculative lending through the entrusted loan channel was more common among publicly listed mature firms with lower growth opportunities, particularly where their earning capacity was below the prime lending rate.



While the growth of entrusted lending has attracted scrutiny, there has been little firm evidence about the the extent of speculative lending through the entrusted loan channel.



However new data reported by Chen (2016) concludes that: “more than 60% of the total amount of entrusted loans was channelled to the risky industry between 2007 and 2013; out of these risky entrusted loans, 77% was facilitated by commercial banks.”



Recent policy moves may reduce ‘entrusted lending’

The entrusted loan channel was continued to grow in 2014 before eventually provoking a response from the authorities.



In January 2015, the CBRC brought in 5 restrictions on ‘entrusted loans’ designed to mitigate speculative investment though this channel by requiring that ‘entrusted loans’ only be used for lending to the ‘real economy’ purposes–and not for investing in stocks, bonds and other purely financial instruments.



Two further decisions in by the authorities in China may see a declining role for the entrusted loan channel.



First, as part of a wider shift in China’s monetary policy framework away from controlling credit aggregates, the loan-to-deposit restriction was removed by an amendment to the Law on Commercial Banks passed by the National People’s Congress Standing Committee in August 2015.



According to the CBRC spokesperson, the LDR ratio had been set up “to control liquidity risk” but it now longer fitted the reality of more diversified bank balance sheets and would instead be used as a ‘a liquidity monitoring indicator’.



The LDR ratio became a reason for banks to engage in regulatory arbitrage — and by removing the LDR ratio, banks would no longer be as constrained by the composition of the assets they could hold on their balance sheets.



Then, in October 2015, the Supreme People’s Court (SPC), ruled that direct inter-enterprise lending for ‘real-economy’ purposes would also be allowed between non-bank entities–removing the restriction on direct lending between non-banks which had been in place for nearly 20 years.



The SPC ruling on inter-enterprise lending was also subject the same 5 restrictions as had previously been applied to entrusted loans in January 2015, including the stipulation that loans must be for ‘real economy’ production and business activities.



The move towards an increased role for direct lending also fits the authorities desire for a more asset-based growth strategy.



Opening direct lending channels between enterprises will allow corporate affiliates to circulate working capital more easily, but it is not clear how the restrictions on types of allowed lending will be enforced by the courts.



Non-bank entities can go to the courts if their loan contract is breached, but they are unlikely to do so if the loan was used for investment in restricted industries or for purely speculative financial investments, which are explicitly prohibited loan use purposes under the SPC ruling.



The ‘entrusted lending’ channel will remain, but the incentives for using it are reduced because because corporate affiliates can now legally lend to each other directly and bank lending is not subject to the 75% loan-to-deposit restriction.



However, the extent to which the the ‘entrusted loan’ channel will be by-passed remains to be seen.



While enterprises can now legally engage in direct lending, finding partners and enforcing contracts can be costly and banks and other other financial institutions have an incentive to engage in the match-making inter-enterprise loans for fee income.



The opening of legal direct lending between enterprises also means we can expect more complex structured financing deals to be a growing feature of China’s financial system.





This article was originally published in Frontiers of Finance in China

Luke Deer is a post-doctoral researcher at the University of Sydney and a Research Associate with the University of Cambridge Centre for Alternative Finance and with the Cambridge Judge Business School. Luke researches alternative finance in China and the Asia Pacific--with a focus on peer-to-peer lending and crowdfunding, and on financial innovation and central banking in China.

The Asian Infrastructure Investment...

The Asian Infrastructure Investment Bank: Aim, structure & financing

Designed to provide financial support for infrastructure development and regional connectivity in Asia the bank is headquartered in Beijing, China. Its first President, Mr Jin Liqun was elected in January 2016. The purpose of the Bank is twofold: to foster sustainable economic development, create wealth and improve infrastructure connectivity in Asia by investing in infrastructure and other productive sectors; and secondly promote regional cooperation and partnership in addressing development challenges by working in close collaboration with other multilateral and bilateral development institutions.



Under its Articles of Agreement, the AIIB's functions include: (i) promoting public and private investment in the Asia region for development, in particular for infrastructure and other productive sectors; (ii) utilizing the resources at its disposal for financing such development in the region; and (iii) encouraging private investment  that contributes to economic development in the Asia region, in particular in infrastructure and other productive sectors, and supplementing private investment when private capital is not available on reasonable terms and conditions.



As of January 2016 the founding members are: Australia, Austria, Azerbaijan, Bangladesh, Brazil, Brunei Darussalam, Cambodia, China, Denmark, Egypt, Finland, France, Georgia, Germany, Iceland, India, Indonesia, Iran, Israel, Italy, Jordan, Kazakhstan, Korea, Kuwait, Kyrgyz Republic, Lao PDR, Luxembourg, Malaysia, Maldives, Malta, Mongolia, Myanmar, Nepal, Netherlands, New Zealand, Norway, Oman, Pakistan, Philippines, Poland, Portugal, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Tajikistan, Thailand, Turkey, the United Arab Emirates, the United Kingdom, Uzbekistan, and Vietnam.



Financing & Operations.

The authorized capital stock of the AIIB will be US$100 billion, divided into 1 million shares having a par value of US$100,000 each. The original authorized capital stock will be divided into 20% paid-in shares and 80% callable shares.


The basic parameter for allocation of capital stock to members is the relative share of the global economy of members (based on GDP) within the regional and non-regional groupings, with the understanding that the GDP share is indicative only for non-regional members.



What are AIIB's key financial instruments?
The AIIB will focus principally on financing specific projects or specific investment programs, equity investments; and guarantees. It may: (i) make, co-finance or participate in direct loans; (ii) invest in the equity capital of an institution or enterprise; (iii) guarantee loans for economic development; (iv) deploy Special Funds resources in accordance with the agreements determining their use; or (vi) provide other types of financing as may be determined by the Board of Governors.  Special Funds would be donor funds that are given to the Bank for use consistent with its purpose and functions.



Future Capital.

In addition to the capital subscribed by members, the AIIB will raise funds primarily through the issuance of bonds in financial markets as well as through the inter-bank market transactions and other financial instruments. The AIIB may raise funds, through borrowing or other means, in member countries or elsewhere, in accordance with relevant legal provisions.



China’s shrinking currency reserves:...

China’s shrinking currency reserves: really economic gains

Since mid-2014 Chinese currency reserves have shrunk by about 10 percent. This reduction culminated in August 2015 when the Chinese Central Bank responded to market pressure towards a weaker CNY and let the exchange rate fall by about 4 per cent in several steps. By following market sentiments, the Central Bank underlined its announcements to give market signals larger weight in exchange rate determination rather than to defend exchange rates, in particular not to defend a fixed single currency peg against the dollar.


However, both the timing and the sequencing of the Central Bank’s interventions were negatively perceived by markets in a situation when sizable corrections in Chinese stock markets occurred and when doubts about the sustainability of the medium-term growth path of the Chinese GDP of around seven percent shocked both traders and investors. To contain overshooting in currency markets and stabilize expectations that the Chinese economy is not facing a hard landing, the Chinese authorities leaned against further pressure of capital outflows and CNY exchange rate weakening and sold foreign currency denominated assets.


What appears a balance sheet loss, however, is in fact an economic gain.


More exchange rate flexibility in general and the exchange rate depreciation in particular helps Chinese authorities to ease the so-called currency mismatch.  Unlike many other emerging markets which are indebted in foreign currency and earn profits in local currency, China earns low profits in foreign-currency denominated interest-bearing assets and at the same time must foot the bill of eventually overindebted local investors, private and para-statals alike, all in local currency. Currency depreciation raises the value of currency reserves in local currency and helps to soften local budget constraints. In this respect, China is in a similar situation as Russia where the depreciation of the ruble has also helped to achieve balancing the local budget. Declining currency reserves (albeit from a record-high level) are the companion piece of reducing current account surpluses and stabilizing the Chinese current account surplus (as percentage of GDP) at a 3 percent level, much below pre-2010 levels.



Thus, the days are gone when the question whether Chinese-US trade were fair was answered sarcastically: yes, it is fair: China exports toxic toys and the US exports toxic papers.


In fact, while China now has sold some of the (non)-toxic papers, the structure of US (and other Western countries’) capital imports from China undergoes an important shift from interest bearing assets to equity assets, such as portfolio investment and foreign direct investment.


This shift decouples China somewhat from the sovereign risk of being exposed to possible debtor country defaults. At the same time, due to massive real wage increases in China over the last decade (equivalent to a real appreciation of the CNY) which was not at all compensated by recent nominal depreciation, Chinese companies for reasons of competitiveness were forced to substitute parts of direct exports for foreign production. Alternatively, China had to upgrade its export mix and thus to export more high-technology products such as commercial drones which are far from being discredited as “toxic”.  Hence, fewer currency reserves not only improve the quality of remaining reserves (in terms of reducing the share of non-performing claims on debtor countries). They also let China participate in risk-sharing of global equity investment in foreign currencies such as US-Dollar, Euro, Pound Sterling and Yen. A further depreciation of the CNY would improve the net foreign equity position of China measured in local currency as foreign equity investment of China is denominated in foreign currencies and therefore benefits from CNY depreciation.


In short, on both sides of the balance, the degree of toxicity of traded products and papers decreases with decreasing size of imbalances and decreasing currency reserve accumulation.  This is an important gain for the trading partners as well as for the world economy.


The decline of Chinese currency reserves has another politically important side effect. A country selling some of its foreign assets does the opposite of a country pursuing a “beggar thy neighbor” strategy of exchange rate undervaluation and currency manipulation. The suspicion that China manipulates its currency in order to defend jobs in the export industry is old. It is raised in the US quasi automatically when current imbalances rise and can gain momentum once nominal depreciation is identified as a political strategy rather than as a response following the markets. Chinese authorities would be well advised to act against this suspicion by beginning to swap external monetary anchors such as currency pegs for internal monetary anchors such as inflation targets.

Source Merics 2015


Coming to a bank near you: globalization...

Coming to a bank near you: globalization of the Renminbi.

It`s simply a question of when the renminbi (RMB) will become a global currency rather than if. The Internationalization of the RMB is an inevitable progression for an international economic power such as China. Its currency, which is still carefully managed by the government, has a market share well behind the US dollar and the euro and currently barely traded on foreign exchange markets. But volumes are climbing steadily and all the signs point towards the RMB gaining greater stature as a stable reserve currency of choice.


Late last year, as the world’s largest exporter and manufacturer, the RMB overtook the euro to become the second most used currency in global trade finance after the dollar, according to the Society for Worldwide Interbank Financial Telecommunication. And it also became the ninth most traded international currency.

China’s tight control on the nation’s capital account: the flow of funds both in and out of the country, seems to be the only outstanding issue in the RMB`s rise. Whilst international trade goes some way in redressing the balance, China needs a more efficient and most importantly, transparent, financial market.

The currencies of countries that play a major role in world trade have tended to become reserve currencies, i.e. held in significant quantities by national banks to protect nations against currency fluctuations. Central banks are now beginning to hold part of their foreign exchange reserves in RMB, albeit in small amounts, and the People’s Bank of China has set up 24 arrangements with international counterparts to allow it to swap the RMB in exchange for their own currencies.

China has begun to loosen its control over its financial markets and gradually open up access to its onshore markets. In 2007, the Chinese government began issuing RMB-denominated notes, bonds and funds, known as “dim sum bonds,” in Hong Kong. Since 2009, companies in Mainland China have been able to complete cross-border trade in RMB which allows companies to reduce transaction costs, better manage foreign exchange risks and speed up payments.

The reduced influence of the US dollar and diversification of currency reserves are key, if we are not to see a repeat of the 2008 financial crisis hit Asian Central banks again. More choices in international reserve currencies provide greater checks and balances to the international financial system worldwide.

While there are obvious benefits from the RMB challenging the dollar’s dominance, there are also numerous risks, predominantly the ability of Chinese policymakers to have total control of the economy, as has been the case for the last 30 years.  Secondly currency fluctuations can impinge significantly on China export sector which is already suffering from higher labour cost.

Countries are going to need to be able to trade in something besides dollars. It simply makes sense that if a large proportion of an emerging-market country's trade is with China, it should do its trades in RMB. However the key is stability in monetary policy and China`s need to make its currency reserves work on the international stage.


Is China’s Economy Crashing? The Immin...

Is China’s Economy Crashing? The Imminent Middle Income Trap.

China’s economy might indeed crash. Then again, it might not. Bearishness on China has gone viral. Two years ago, talk was of China’s economy saving the world. Today observers have swung to the opposite extreme, one expressed elegantly by Paul Krugman as “the Chinese model is about to hit its Great Wall, and the only question now is just how bad the crash will be.”



The following essay was written for the Boao Review by Professor Danny Quah of the LSE where he carefully dissects current predictions that the Chinese economy will either dramatically crash or else become ensnared in the ‘middle income trap’, please click here to open the full PDF.


Investments between China & BRICS countr...

Investments between China & BRICS countries on the up.

BRICS, grouping Brazil, Russia, India, China and South Africa, represented a gathering of important emerging economies which were playing an increasingly big role in world economy during last decade.Close economic ties among BRICS countries, especially after the New Delhi Summit, will most likely result in further cross-border merger and acquisition (M&A) deals driven by Chinese companies in other four economies.

"Chinese investment enthusiasm into the BRICS has remained strong as economic growth in these, and other emerging markets, has remained relatively intact despite global uncertainty,” said Lawrence Chia, co-chairman of Deloitte China’s global Chinese services group.

The aggregate GDP of the BRIC countries (before South Africa joined in late 2010) has almost quadrupled since 2001, from around $3 trillion to between $11-12 trillion in 2010.


The fourth BRICS Summit was held in New Delhi on March 28-29, under the theme of BRICS countries’ commitment to the partnership of stability, security and prosperity, where leaders of the five countries vowed to strengthen cooperation and boost inter-trade among the BRICS economies.

Deloitte forecast that emerging economies will grow by five percent in 2012, compared to a figure of 1.2 percent for developed countries.

As a co-writer of the report, namely “Lateral trades – Breathing fire into the BRICS”, China believed that cross-border investments between China and the other four BRICS countries will pick up over 2012 and beyond, as “comparatively more attractive growth fundamentals in the BRICS help encourage Chinese businesses to invest in those jurisdictions, as opposed to developed markets”.

The report also mentioned that “the desire to escape intense competitive pressures at home” is another reason that leads to Chinese companies’ increasing interest in acquiring in the BRICS.Statistics showed energy and resources sector accounted for 95 percent of the total deal value and 29 percent of the total deal volume in 2011.

Chinese consumer businesses, looking to expand into fast- growing overseas economies, became another power in the past acquisition activities.

Data showed that outbound consumer business and transportation investments into the four economies from 2009-2011 accounted for 4.5 percent of overall outbound M&A activity by value, while over the 2005-2008 period, this proportion just stood at 1.2 percent.


China key economic indicators for 1980...

China key economic indicators for 1980, 1990, 2000, 2011 and 2016.

Economic indicators for China 1980-2016.



Main indicators


Real GDP growth (annual %) 7.8 3.8 8.4    
Gross domestic product, current prices (US$, billions) 202.46 390.28 1198.48 6988.47 11779.98
Gross domestic product per capita, current prices (US$) 205.12 341.35 945.6 5183.86 8522.86
Industry, value added (% of GDP) 47.10 42.83 45.76 46.75  
Gross domestic product based on purchasing-power-parity (PPP) share of world total (%) 2.19 3.88 7.14 14.35 18.04
Total investment, (% of GDP) 52.41 36.14 35.12 48.65 46.23
Gross national savings, (% of GDP) 48.84 39.22 36.83 53.81 53.47
Inflation, average consumer prices 50.86 100 200.49 261.38 303.9
Inflation, average consumer prices (% change) 5.99 3.1 0.4 5.5 3
Volume of imports of goods and services (% change) 17.38 -16.88 24.8 16.52 14.78
Volume of exports of goods and services (% change) 23.03 12.84 25.22 15.56 14.97
Value of oil imports (US$, billions) 0.66 5.21 18.9 226.75 230.33
Value of oil exports (US$, billions) 3.55 3.68 4.63 27.48 26.29
Population, millions 987.05 1143.33 1267.43 1348.12 1382.16
General government revenue (% of GDP)   19.02 13.78 20.87 22.71
General government total expenditure (% of GDP)   20.98 17.05 22.44 22.56
General government gross debt , (% of GDP)   6.95 16.44 26.88 10.93
Current account balance (US$, billions) 0.29 12 20.52 360.54 852.22
Unemployment rate (as % of total labour force) 4.9 2.5 3.1 4 4
Gross domestic product based on purchasing-power-parity (PPP) valuation of country GDP (Current international dollar, billions) 247.89 910.93 3015.43 11316.22 18667.27




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