Professor Acharya on the Impacts of Shadow Banking in China
—
The following is an excerpt from a Foreign Policy interview titled "Shadow Banking Is Killing China’s Stock Markets" by NYU Stern Professor Daniel Altman:
Why can’t China’s government stop the plunge in share prices on its stock exchanges? This week I spoke to Viral Acharya, a colleague at New York University’s Stern School of Business, about the causes of China’s share price bubble and the consequences we’re seeing today. He’s part of a research team studying how the growth of shadow banking — the creation of bank-like deposits outside the regulated part of China’s banking system — turned a simple correction into a crisis. And he says the worst isn’t over yet.
The reason has to do with the involvement of China’s shadow banking industry in the recent run-up of share prices. Because rates in China’s regular banking industry are heavily regulated, banks have been offering high-yield alternatives to regular deposits. By promising high fixed returns, they attracted billions of dollars from Chinese savers, and much of this money went into the stock markets. But in the process, the banks created a huge amount of leverage that has made the post-bubble markets uncontrollable.
Below are some excerpts from our conversation. You can also read more about the research here.
Foreign Policy: How do we know that there was a bubble in China’s stock markets?
Viral Acharya: Especially over the last year, the stock market appreciation was out of sync with the fundamentals of the economy. The collapse of the recent few months has pretty much wiped out the gains since January, but if you take the 12 months August to August, you still have about 35 percent to go. You basically had a 100 percent return in 12 months. Something phenomenal would have to happen in order to see that price appreciation. If there were some underlying economic boom, then it would be easier to rationalize what happened. But all the signs have been at best tepid.
FP: So what did cause prices to rise so quickly?
VA: It can be attributed to leverage, including margin-based lending that got put into the stock market.
FP: The margin-based lending has been a big story, but your research suggests that another source of leverage is the shadow banking system. How did that happen?
VA: Shadow banking in China has grown tremendously in dollar terms, to more than $2 trillion. It is made up of attempts by regulated banks to issue deposit-like products — but not actual deposits — and offer higher interest rates to investors, given that deposit rates are regulated and suppressed. Banks float wealth management products as trusts, their own special purpose vehicles, marketing them as relatively safe paper and offering higher rates than regulated deposit rates. Of course, the higher rates have to be generated in some way, so they often find their way into riskier projects. The bulk of this was going into real estate and infrastructure built by municipalities.
FP: How did that money eventually make it into the stock market?
VA: The shadow banking paper that banks were floating could no longer go into real estate and infrastructure projects, because those were slowing down. They basically put the money into the stock market. They did it in a very leveraged fashion, similar to what happened in the United States with mortgages up to 2007. From one underlying pool of risk, you created a safer and a riskier tranche. And they’ve done something very similar in China. They make an equity investment, but they convert it into a structured product. The idea is that up to a certain return of the underlying stock, that becomes a fixed-return product, and anything above that is a variable-return product.
Read the full article here.
Why can’t China’s government stop the plunge in share prices on its stock exchanges? This week I spoke to Viral Acharya, a colleague at New York University’s Stern School of Business, about the causes of China’s share price bubble and the consequences we’re seeing today. He’s part of a research team studying how the growth of shadow banking — the creation of bank-like deposits outside the regulated part of China’s banking system — turned a simple correction into a crisis. And he says the worst isn’t over yet.
The reason has to do with the involvement of China’s shadow banking industry in the recent run-up of share prices. Because rates in China’s regular banking industry are heavily regulated, banks have been offering high-yield alternatives to regular deposits. By promising high fixed returns, they attracted billions of dollars from Chinese savers, and much of this money went into the stock markets. But in the process, the banks created a huge amount of leverage that has made the post-bubble markets uncontrollable.
Below are some excerpts from our conversation. You can also read more about the research here.
Foreign Policy: How do we know that there was a bubble in China’s stock markets?
Viral Acharya: Especially over the last year, the stock market appreciation was out of sync with the fundamentals of the economy. The collapse of the recent few months has pretty much wiped out the gains since January, but if you take the 12 months August to August, you still have about 35 percent to go. You basically had a 100 percent return in 12 months. Something phenomenal would have to happen in order to see that price appreciation. If there were some underlying economic boom, then it would be easier to rationalize what happened. But all the signs have been at best tepid.
FP: So what did cause prices to rise so quickly?
VA: It can be attributed to leverage, including margin-based lending that got put into the stock market.
FP: The margin-based lending has been a big story, but your research suggests that another source of leverage is the shadow banking system. How did that happen?
VA: Shadow banking in China has grown tremendously in dollar terms, to more than $2 trillion. It is made up of attempts by regulated banks to issue deposit-like products — but not actual deposits — and offer higher interest rates to investors, given that deposit rates are regulated and suppressed. Banks float wealth management products as trusts, their own special purpose vehicles, marketing them as relatively safe paper and offering higher rates than regulated deposit rates. Of course, the higher rates have to be generated in some way, so they often find their way into riskier projects. The bulk of this was going into real estate and infrastructure built by municipalities.
FP: How did that money eventually make it into the stock market?
VA: The shadow banking paper that banks were floating could no longer go into real estate and infrastructure projects, because those were slowing down. They basically put the money into the stock market. They did it in a very leveraged fashion, similar to what happened in the United States with mortgages up to 2007. From one underlying pool of risk, you created a safer and a riskier tranche. And they’ve done something very similar in China. They make an equity investment, but they convert it into a structured product. The idea is that up to a certain return of the underlying stock, that becomes a fixed-return product, and anything above that is a variable-return product.
Read the full article here.