Views on improving the integrity of global capital markets
06 February 2015

How Service Sector Needs and Shadow Banking Are Reshaping Chinese Capital Markets

In my recent post on “The Impact of Population Dynamics on the Chinese Capital Markets,” we examined the effect of demographic shift on the Chinese economy and the likely problems it will pose. In this post, we will explore two other pressing issues within the Chinese economy — an underdeveloped service sector and the rise of shadow banking.

Service Sector Shortage

It is well known in China that its service sector is in a severe supply bottleneck. Individuals and businesses in China have difficulty obtaining services. For individuals these services include medical care and enrolling their kids in school; SMEs (small and medium enterprises) face such challenges as obtaining bank funding.

The culprit? A bureaucratic structure that ranks GDP (gross domestic product) above standard of living in its performance rating of government officers responsible for these measures in their jurisdiction. Traditionally, government officials at the provincial and county level serve a five-year term at a specific location. After their term is up, they are relocated to other posts. Where they land depends on their performance during their previous five years on the job. GDP is one of the most important performance indicators (KPIs). Needless to say, these officers, for their own career advancement and to support the country’s directive, deploy the bulk of their efforts to amplify this all-important KPI.

Let’s drill a bit deeper on the fastest way to enhance the regional GDP metric within a five-year span. The answer is simple: massive deployment of resources for the building of infrastructure and real estate because these are the things that are highly tangible and therefore rewarded during the eventual appraisal process. As for regions rich in specific resources, such as iron ore, aluminum, and forestry, the local government typically doles out many incentives to encourage both mining and wood-milling activities. And there have you a snapshot of how GDP can soar, and how in less than a government officer’s two terms, an era of huge demand for natural resources in China emerged, playing a big part in creating the global commodities boom of 2000 through 2008.

Predictably, important social issues that have longer-term implications on standard of living, such as education, traffic congestion, and pollution all took a back seat to GDP during the boom (and continue to take a back seat today). As a result, skyscrapers and massive infrastructure sprung up across major cities, generating an impression of near-full employment and economic prosperity. At the same time, excessive mining of resources led to oversupply of both raw materials and semi-finished products at the national level, not to mention the damage inflicted upon the environment.

Post-2008, the situation worsened due to the global financial crisis when international demand for Chinese-manufactured goods plunged. Inevitably, right after the crisis, governmental policy shifted its economic focus from export-driven demand to domestic consumption.

Going forward, this strategic shift, coupled with the lack of investment on resources required within the service lines, is expected to create an even wider divergence between demand and supply (the former outstripping the latter) within the affected industries. Examples of these industries include domestic consumer research, logistics, SME banking, medical services, and Internet financing. This ever-widening gap will continue until the government adjusts its performance rating structure of provincial and county officers to align with its newly established domestic consumption-based economy. Only then will government officers be motivated to implement concrete policy changes that will encourage the growth of the domestic service industry.

Rise of Shadow Banking

Based on 2013 data from the Shanghai Stock Exchange (SSE), 55% of the total profit of all listed companies originated from the financial sector. But as a percentage of the total number of listed companies on the Shanghai bourse, the financial sector represented less than 2%. In other words, the finance industry is most probably earning what economists call supernormal profit. The term stems from political economy pioneer Adam Smith’s theory of the “invisible hand,” which states that long-running supernormal profit is abnormal for any industry under efficient market conditions. For that to persist, some other stakeholders must have been paying the bills.

There are two primary reasons for the above-mentioned abnormal situation:

  • First, the Chinese capital market has always been a relatively closed market where only a handful of foreigners can invest via the QFII (Qualifying Foreign Institutional Investors) scheme. Similarly, only a handful of privileged domestic funds are allowed to invest overseas via the QDII (Qualifying Domestic Institutional Investors) scheme. As a result, the massive amount of wealth generated by the middle class during the past 40 years of great economic progress is kept within the Chinese capital market. When you combine that with the RMB 4 trillion worth of quantitative easing introduced after the global financial crisis, it does not take a rocket scientist to figure out that local banks and financial institutions are flooded with cheap money. The cost of funding for banks is, therefore, relatively low.
  • Second, given the oligopolistic structure of the local banking and finance industries, it is a common practice for banks and finance houses to direct loans to “big boys” that are deemed “too big to fail,” even if their projects or business models are unprofitable. These would be the state-owned enterprises (SOEs), state-related enterprises (SREs), and industry conglomerates. Banking revenue from these sources has a remote chance of default given the implicit governmental guarantee. Eventually, the low cost of funding successfully “marries” the stable flow of revenue to generate supernormal profits for banks.

Other stakeholders, such as SMEs, still get their bank loans albeit at a much higher cost of capital. Predictably, these SMEs turn to the shadow banking system to fulfill their funding needs. (For a first-hand account of my introduction to Chinese shadow banking, read my post here.) Hence, the Chinese financial industry, instead of fulfilling its primary role of enhancing the flow of capital from stakeholders that have excess money into the hands of those with brilliant investment opportunities, has largely evolved into an inefficient system that survives on paying out low-interest rates to depositors while lending out money to inefficient, but “too big to fail,” enterprises.

Now that we have a clear picture of the current economic situation in China, where the shift to a domestic-consumption economy and shadow banking are concerned, my next blog post will discuss what the government has done and may do, and the likely impact these actions will have on the various stakeholders within the Chinese capital markets.

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About the Author(s)
Alan Lok, CFA

Alan Lok, CFA, was a director of capital markets policy at CFA Institute. He was responsible for conducting research projects in the area of market instruments and market structures in the Asia-Pacific region. Mr. Lok worked with regulators, institutional investors, academics, and various other stakeholders within the financial industry to uphold investor protection and market integrity.

2 thoughts on “How Service Sector Needs and Shadow Banking Are Reshaping Chinese Capital Markets”

  1. Joshua Wu says:

    China’s Service sector or Tertiary Industry as some people like to call it actually contributes close to 50% of China’s GDP although it still pales behind countries like US and Japan where it can go up to a whopping 80%. I can see the focus for China shifting if it has not already, the recent numbers and outspoken comments by the top bodies of the party have indicated that they are more willing than not to adapt to the new normal which bodes well for the service sector.

    Sharing the below link which gives a rough idea of where China stands compared to the other countries in terms of GDP sector composition

  2. Alan Lok, CFA says:

    Thanks Joshua for your regular contribution to our vibrant blog community. And yes, you have just pointed us to another objective indicator. I will be publishing two more blog posts to showcase more examples of how serious the Chinese regulators are about restoring capital market integrity as well as giving some opinions on likely scenario within the Chinese capital markets in the foreseeable future. Before that, I shall look forward to constructive ideas from insightful readers like yourself. Cheers!

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