The People’s Money

THE TRANSFORMATION OF China within the context of a more integrated world economy has resulted in a substantial increase in annual income per capita. With approximately $8,500 per person in nominal terms, China is now a middle-income country. And, as people who have experienced deep poverty normally do, the Chinese save a lot. Over the years, the monetary authorities have channeled these savings toward the country’s industrial transformation, making sure, however, that the costs for borrowers have remained low. As savers began to feel squeezed, they started to look for better returns than those usually offered on bank deposits: first in the real estate market and then increasingly in so-called shadow banking instruments—unregulated borrowing and lending presented as wealth management products.

But better returns bring more risk and volatility. Many Chinese investors are not sufficiently acquainted with this trade-off, as is clear from the case of Shanxi Platinum Assemblage Investment, a small asset-management firm that collapsed at the end of 2014. In early December, following rumors that the company was in dire financial straits and executives had fled, angry investors gathered at its Taiyuan office, in northern China, to pressure the authorities to intervene and help them recover their money. Individuals and households had put their savings in Shanxi wealth management products that offered interest rates of 14–18 percent annually and were now at risk of losing a combined 100 million renminbi.

The pressure wasn’t enough. A few months earlier the People’s Bank of China and the Commerce Ministry had warned investors about “problems with chaotic business,” adding that “a large number of non-financial guarantee companies are not engaged in guarantee business. They even engage in illegal deposit-taking, illegal fundraising, illegal wealth management and high-interest loans.”¹ In the end, the authorities allowed Shanxi Platinum Assemblage to fail, making it clear that the central government would not be there to bail out financial institutions.

Episodes like this, along with the Chinese stock market’s steep downward adjustments in 2015 and 2016, brought international attention to the intrinsic contradiction between the state of the country’s financial and banking sector and its ambitions to develop the renminbi in one of the key international currencies. Shadow banking, of which Shanxi Platinum Assemblage was a part, is the result of the limited range of regulated savings products in China’s financial sector and savers’ quest for investments with higher returns than bank deposits provide. Poor options for savers are in stark contrast to the robust and growing array of financial resources that feed the country’s manufacturing sector and grow its economy, as described in the preceding chapters on trade and investment. And both these trends are the result of the distinctive feature of China’s model of development: financial repression.²

Under China’s system of financial repression, the government directs and controls where savers invest their money, and depositors don’t have many options other than local banks (they can’t, for instance, easily take their money out of the country). Typically, policies constrain the returns savers earn on their savings—notably, in bank deposits—so that banks can provide cheap loans to state-owned companies and to the private sector. Therefore, these policies result in a transfer of resources from depositors to borrowers. Financial repression occurs when “governments implement policies to channel themselves funds that in a deregulated market environment would go somewhere else.”³

The term financial repression was coined in the 1970s to indicate growth-inhibiting policies in developing countries, and in recent years, it has been extended to advanced countries. In the case of China, financial repression, instead of inhibiting growth, has for years provided ample financial resources to underpin economic activity. Policies include caps on interest rates, constraints on cross-border capital movements, and high reserve requirements.⁴ In this sense, financial repression has been an intrinsic component of China’s model of growth; it has enabled the country to move from plan to market, to transform the economy, and to become a global heavyweight within a single generation.

However, financial repression has created a massive misallocation of financial resources, with too many money-losing projects being funded while more promising projects in the private sector can’t raise capital. It has held down living standards, as many savers get poor returns for their money and thus are pushed to save more. It has inhibited the development of an efficient and transparent banking sector as well as liquid and diversified capital markets, leaving savers with limited options and thus fostering the expansion of shadow banking. It has also led to a paradoxical situation in which China is a nation of savers with large indebtedness. Ultimately, it has constrained the development of the renminbi as an international currency. To understand why, in this chapter, I take a closer look at financial repression and how it has operated over the course of China’s spectacular growth—notably, both creating and maintaining the link between state-owned enterprises and banks—and how it has allowed shadow banking to thrive.

Financial repression has been motivated by the need to have plenty of cheap capital that can be used to fund projects that are important to China’s economic development strategy or to dispense favor and “buy” consensus. The main organizing mechanism for financial repression in China is interest rates, which don’t function as a market mechanism to allocate savings to investments but to ensure plenty of cheap capital for state-owned enterprises.

For years, the authorities have controlled both the maximum deposit rate (the rate that banks offer to depositors) and the minimum lending rate (the rate that banks offer to borrowers), with the deposit rate set low enough to allow banks to make a profit by squeezing depositors—in particular, because rates have lagged behind inflation. This was a change from the years before 2004, when the People’s Bank of China used to adjust the nominal deposit rate to the rate of inflation.⁵ Setting rates centrally has ensured that banks do not compete with each other for deposits and that they can offer very favorable lending conditions (in addition, banks do not ask for stringent guarantees against the loans). The result has been a system in which depositors have subsidized borrowers, with the former effectively transferring a large share of resources to the latter. This has been reflected in a substantial decline in the cost of borrowing—especially after 2008, when interest rates were cut in response to the global financial crisis. Between 2004 and 2011, for example, the average real cost of borrowing was pushed down to only 3.2 percent, compared to 6.2 percent between 1997 and 2003. (It is currently 2.9 percent.⁶)

The pursuit of low interest rates as part of a system of financial repression has had serious consequences for the development of a market-oriented economy in China. First, for several years, China has had interest rates that were too low vis-à-vis the growth rate of its economy and fueled strong credit growth. In 2004, credit as a share of the country’s gross domestic product (GDP) was approximately 140 percent; in 2014, it was 170 percent.⁷ Household bank deposits expanded at a slower pace over the same period—they were approximately 75 percent of GDP in 2004 and 77 percent in 2015—but they are much higher than in other countries—both advanced economies and emerging markets.⁸ This system results in the paradox of generating excessive savings even though it penalizes returns on savings. Because savers have limited options, banks can rely on a “captive” group of depositors and thus can cut the interest income that savers receive without risk of losing depositors. At the same time, because of the poor returns that they get from deposits, individuals and households tend to increase their savings in order to achieve their financial goals—for instance, to pay for a child’s education or provide for comfortable retirement. So the pool of savings continues to expand—and continues to constrain household consumption growth.⁹

Low interest rates also create an abundant supply of cheap credit, leading to serious distortions in its allocation. Banks have found themselves saddled with excessive numbers of low-quality and nonperforming loans, making them vulnerable to insolvency or a liquidity crisis if the economy turns sour. To preserve their capital base, they shift the burden to savers by imposing low deposit rates—perpetuating this system.

Mao Zedong introduced central economic planning in the mid-1950s, and in the following decades, state-owned enterprises became a crucial component of China’s economic system. By 1978, state-owned enterprises accounted for 80 percent of the total industrial output, provided 70 percent of total industrial employment, controlled most industrial fixed assets, and dominated most components of the tertiary sector.¹⁰ These firms were inefficient and lost money, acting as a constant drag on public resources and keeping in place a dual-track price system that, among other problems, created enormous incentives for corruption. (A good sold outside the plan’s pricing system could fetch, for example, 50 to 100 percent more than the plan-determined price.¹¹) The firms had no financial autonomy and, in fact, had to remit most of their profits to the state treasury. In return, they received state budgetary grants to finance most of their fixed investment and to meet a significant portion of their working capital needs.

Reformers looking to transform China’s economy in the late 1970s faced the challenge of improving the efficiency of state firms, expanding the nonstate sector (urban collectives, private firms, and foreign-funded enterprises), and enhancing the role of the market without, however, significantly reducing state ownership; political, social, and institutional constraints—particularly the absence of property rights—prevented a full program of privatization. Forced to preserve state ownership as a major feature of the institutional landscape, their strategy was to substantially reduce the number of state-owned enterprises, curtailing the ones that were losing money and offering incentives to those that were performing well. Thus, while they were working to develop a group of giant, globally competitive firms to match those in developed countries, they were also ensuring that China’s key industries and firms remained firmly under state ownership.¹²

It was only in the early 1990s that Chinese policy makers came to recognize forms of ownership that did not feature the state. In 1993, the Third Plenum of the Fourteenth Chinese Communist Party Congress endorsed the creation of a modern enterprise system, paving the way for the privatization of small state firms and the transformation of medium and large ones into limited liability companies. This led to the elimination, the following year, of some 80,000 firms from the roster of state-owned enterprises. This shift marked the beginning of a critical transformation of China’s institutional setup into one in which private firms were not only authorized but also allowed to compete in the marketplace on equal terms with state-owned enterprises.

The Ninth Five-Year Plan (for the period 1996–2000) took a further step that led to the expansion of private firms. In 1997—faced with the increasing importance of the private sector in expanding economic activity, supporting growth, and creating new jobs—the authorities allowed banks to lend to private firms.¹³ (Eventually, in 2004, the Chinese constitution formally recognized, and thus legitimized, private ownership as an important component of China’s social market economy and one that was on an equal footing with public ownership.¹⁴) The next year Premier Zhu Rongji embarked on a bold effort to revitalize core state-owned enterprises, initiating a large-scale reorganization to make them more efficient and profitable.

Until then, these enterprises had been ranked at the ministry level and were under the direct leadership of the State Council. Zhu took a number of them—including Bank of China; China National Cereals, Oils, and Foodstuffs Corporation; and China Railway Engineering Corporation—out of the ministerial system. This was the first step toward formally making these firms more autonomous from the government. Many were then prepared for public listing, going through a substantial cleanup that consisted of moving viable commercial assets to what would become the publicly listed company and leaving money-losing operations in the original 100 percent state-owned company. This unlisted organization would serve as a holding company, controlling over 75 percent of the newly listed spin-off’s shares, ensuring that the state remained the majority owner by a huge margin. (Even today, when state firms are listed on the stock market, the state typically retains control because only a minority of the firm’s shares are sold.) By 1999, over 10,000 traditional state-owned industrial enterprises (about a fifth of the total) had become state-controlled shareholding companies in which the state was the majority or dominant shareholder. These new companies accounted for almost 40 percent of industrial output.

The way the authorities tackled privatization is paradigmatic of China’s approach to the overall reform process. They open to external pressure to bring in good practice, rules and regulations, and market discipline from abroad—but do so while retaining significant state control. In this way, China’s political leadership (former Premier Zhu, in particular) was able to indirectly, and almost by proxy, promote politically difficult reforms from within. Thus, “privatization” was achieved without giving up commanding state control over the economy.¹⁵ The state’s majority equity share also made it difficult for international firms to expand within China through mergers and acquisitions, as “national champions”—companies such as China Mobile, Sinopec, and Baosteel¹⁶—had privileged access to government-sponsored projects.¹⁷

Even today the governance of state-owned companies (and their private-sector spin-offs) remains firmly in the hands of the Communist Party. The Organization Department of the party appoints the top three executives (party secretary, chief executive officer, and chairman of the board) in most important state-owned enterprises,¹⁸ and approximately 80 percent of managers at state-owned companies are appointed by the party.¹⁹ There is also a “revolving door” that connects leadership roles in the government and in large state-owned companies. For instance, before taking up his current role, Finance Minister Lou Jiwei headed China Investment Corporation—China’s sovereign wealth fund, with assets worth approximately $600 billion. Similarly, Xiao Gang served as the chairman of Bank of China Limited and Bank of China (Hong Kong) Limited for almost ten years before being appointed chairman of the China Securities Regulatory Commission in 2013 (a position he held until January 2016).

By defining the governance of state-owned enterprises and big state banks, the leadership of the Communist Party has fostered a strong link between these two groups, with both serving various policy goals. This link has been, at the same time, a cause and a consequence of the Chinese system of financial repression.

In the late 1970s, China’s banking sector was a single, monolithic financial institution that served as both the central bank and the sole commercial bank, with a network of over 15,000 branches, subbranches, and offices.²⁰ Things started to shift in 1983, when the State Council separated the functions of central and commercial banking. It set up the People’s Bank of China (PBoC) as the central bank and established the Industrial and Commercial Bank of China (ICBC) to handle deposit taking and lending. By the mid-1980s, these functions had expanded to four state-owned banks that controlled almost four-fifths of all deposits, accounted for 99 percent of all bank assets, and were responsible for more than 90 percent of all loans.²¹

In the early days of Deng Xiaoping’s reforms, the four “specialized” banks—the ICBC as well as the Agricultural Bank of China, China Construction Bank, and Bank of China—were responsible for allocating credit within the economy. The ICBC lent mostly to state enterprises, operating as a subsidiary of the Ministry of Finance; the Agricultural Bank lent exclusively to support agriculture and rural industrial and commercial enterprises; and China Construction Bank was a principal source of funds for new investment projects. Bank of China, which until 1979 had been a subsidiary of the PBoC, carried out all types of foreign exchange transactions²² and had branches in Hong Kong, Singapore, and London. The London branch had been established in 1929, and during the Mao years, it played a critical role in managing China’s hard currency portfolio and arranging for short-term commercial credit. It also maintained correspondent relationships with many Western banks in order to settle financial aspects of trade contracts with noncommunist countries.²³ Even though China then had limited trade and commercial relations with the rest of the world—in 1974, its total trade was just 6 percent of that of the United States²⁴—it still needed international banking facilities to settle trade.

Starting in the mid-1980s, a series of policy measures eased regulatory barriers, helping to open up the banking sector and create a credit channel for private business. Influenced by Deng’s reformist zeal, the government began to exercise more tolerance toward private providers of capital and to envisage some degree of competition and openness in the financial sector. The idea was to use the state’s financial institutions as a channel to provide funding to private entrepreneurs—to rural entrepreneurs transitioning out of agriculture and even to private entrepreneurs who were trading overseas. This was a significant break with the past and was happening, incredibly, only a few years after the end of the Cultural Revolution.²⁵

Between 1980 and 1988, the Chinese financial system became increasingly flexible as the reformers directed banks and rural credit cooperatives (small, rural banks that provided loans and saving facilities to farming enterprises) to lend to the emerging private sector. The main elements of this financial liberalization were the adoption by state banks of an accommodating and supportive credit policy toward the private sector, the availability of financial instruments that were exclusively servicing the private sector, and the tacit permission for the use of these instruments. For example, in 1984, the Agricultural Bank authorized flexible interest rates for individual business owners—allowing it to adjust the costs of servicing the debt to the interest rates set by the central bank—and waived loan-guarantee requirements for those borrowers with a good credit history and a high self-funding ratio.²⁶ The reformers also proactively transformed a number of financial institutions by reducing state controls on rural credit cooperatives and permitting entry by private players. Through measures like these, the authorities ensured that there was plenty of credit for the rural economy in a way that was consistent with the political guidelines of China’s economic transformation. Similar measures were taken in cities, where the PBoC formally authorized networks of urban credit cooperatives.

Throughout the 1990s, the authorities increased the credit offerings by expanding the number and types of banks. A dozen new national joint-stock banks (including the China Minsheng Bank, the first private shareholding bank) were created. Shareholders for these banks ranged from private firms to state-owned enterprises. Urban credit cooperatives, which in the mid-1980s lent primarily to urban collective firms, merged to form urban cooperative banks and became the principal source of formal credit for small private companies. Their lending activity expanded rapidly, with 193 billion renminbi in total credit outstanding by the end of 1995.²⁷

In 1997, the Fifteenth Congress of the Chinese Communist Party unveiled measures that formally allowed banks to extend loans to the private sector, especially to small and medium-sized enterprises in fast-rising regions and urban areas. Banks were urged to base their lending decisions on the default risks and business prospects of the eligible borrowers. This spurred the creation of city commercial banks, such as the Bank of Shanghai and Bank of Beijing, which were spun out of urban cooperative banks. These banks steadily expanded, lending to private businesses that were too small for the state-owned banks.²⁸ By focusing on private-sector depositors—mostly individuals and nonstate enterprises—they were able to compete with the state-owned banks and their vast network of offices in almost every city. (In 1994, state-owned banks operated almost 150,000 branches, subbranches, and other offices of various types, mostly located in cities.²⁹)

On the whole, as the authorities developed the banking sector and removed some of the existing monopolies in the provision of credit, the approach and culture of Chinese banks also became more business friendly and more supportive of private-sector clients. In addition, the authorities increased private control of existing financial institutions and allowed private players more independence in providing financial intermediation services.

As a result, China’s banking sector (along with its economy) has shifted toward a more market-oriented system. But increasing the number and types of banks has not dented the dominant position of the big four commercial banks in the country’s domestic economy. They account for 44 percent of the banking system’s assets.³⁰ This share increases to approximately 48 percent if we include the Bank of Communications, which the Chinese now identify as the fifth of the large-scale commercial banks. As Nicholas Lardy points out, this share reflects a concentration that is similar to that of the top five banks in the United States—JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs.³¹

Thus, despite some deep transformation and restructuring that has shifted China’s banking sector toward a more market-oriented system,³² the country has not yet embraced full-scale financial liberalization. Financial repression remains, in the form of lending quotas and interest-rate caps. Even the measures that were introduced in late 2006, when China had to open its banking sector to foreign competition as part of joining the World Trade Organization, did not fundamentally transform the big banks. They remained a tool to support the government’s objectives rather than business entities operating on a purely commercial basis.

Amplifying this issue is the tendency of these state-owned enterprises to borrow more than they can afford and to borrow even for day-to-day operations, often using cheap money to keep businesses afloat that otherwise would need to close. Under considerable pressure from the government to support state-owned enterprises—even the money-losing ones—banks end up saddled with extensive and growing portfolios of nonperforming loans and solvency concerns. According to Dai Xianglong, former governor of the PBoC, a full 20 percent of state banks’ loans were nonperforming in 1994. That proportion increased to 25 percent in 1997 and then to 35 percent in 2000.³³ Lardy reckoned that as of 2013 the nonperforming loan share could have been as high as 25 percent of all loans outstanding, which would have placed the major banks dangerously close to insolvency.³⁴

The declining quality of state-owned banks’ assets as a consequence of nonperforming loans imposes a heavy tax burden, as the authorities often need to intervene and inject public funds to clean up the banks’ balance sheets. Between 2003 and 2005, Central Huijin, a state-owned investment company and subsidiary of China Investment Corporation, used foreign reserves to inject almost $80 billion into the big four banks before they went public: $22.5 billion each into Bank of China and China Construction Bank, $15 billion into the ICBC, and $19 billion into the Agriculture Bank of China.

The banking sector’s excessive focus on lending to state-owned enterprises also crowds out private enterprises, making it difficult for private companies and households to access financial resources. Of all bank loans outstanding, approximately 40 percent are to state-owned enterprises and 33 percent are to local governments, leaving less than one-third to private businesses and households.³⁵ With the banking sector thus unable to fully address their needs, many private entrepreneurs—especially in the rural areas—have shied away from banks and rely more heavily on informal finance. (I discuss this trend toward shadow banking more fully at the end of the chapter.) This has become something of a vicious circle, as neglect of nonstate enterprises has prevented banks from developing the skills necessary to assess the creditworthiness of potential borrowers. They are still figuring out how to correctly decide on loan allocation. In particular, they face the problem of acquiring reliable information on the borrowers’ ability to repay the loans, as they lack details about the quality of potential borrowers³⁶ and do not have the credit history records to back up their loan allocation decisions.

There has been some progress in recent years toward weakening the link between state-owned enterprises and the big banks, and commercial criteria increasingly inform Chinese banks’ decisions—including, for example, an assessment of a firm’s profitability as a criterion in resolving whether to grant a loan and in determining loan size.³⁷ As a result of these changes, Chinese private firms now enjoy better access to credit than in any previous period in the reform era. However, it is still the case, even if to a lesser extent, that having some state ownership helps firms gain access to bank finance. And political connections continue to carry weight in the decision to lend to the private sector. The banking sector’s bias toward state-owned companies continues to fundamentally distort the allocation of capital and to limit private firms’ access to capital. This impedes competition and efficiency, slowing down China’s transformation into a more market-oriented economy.

China’s bond market is similarly intertwined with the state. Although the domestic bond market has grown since 1990 (and is now, at about 30 trillion renminbi, the third largest in the world ³⁸), its development depends on, and is somewhat constrained by, the demand for funding, which comes mainly from the government and from government-related bodies. Because government debt is relatively small (just over 40 percent of GDP), the total stock of government bonds outstanding is only 10.7 trillion renminbi.³⁹ The market for corporate bonds has developed even more slowly and has remained almost exclusively the domain of state-owned and state-controlled companies. For instance, in the first half of 2015, the value of bonds issued by private nonfinancial enterprises in China’s domestic bond market had reached 529 billion renminbi—only about 0.8 percent of GDP.⁴⁰ This is insignificant in comparison with the U.S. corporate bond market, which currently stands at almost $10 trillion, or about 60 percent of U.S. GDP.

As in the stock market, banks are dominant in the bond market, where they play three roles: they are the key issuers of bonds, the largest buyers of bonds, and the intermediary institutions. The Agricultural Development Bank of China, China Development Bank, and Export-Import Bank of China were established in 1994 and are referred to as policy banks because of their role in financing economic development, trade, and state-led projects. Together with the Ministry of Finance and the PBoC, they issue about 78 percent of the bonds on the Chinese market. The policy banks do not have commercial banking functions and are not allowed to hold any private deposits. Issuing bonds is the only way for them to collect sufficient capital to provide loans.

The authorities’ intention is to develop capital markets and to ease the link between the banks and the bond market. For example, China’s interbank bond market has recently opened up to foreign central banks and some foreign financial institutions. But it will take a long time for the country’s capital market to reach the point of acting as a true alternative to the banking sector. The fundamental problem with developing and opening up the capital market is that this move inevitably collides with the need to preserve the current system. Although the authorities appreciate how important it is for a fast-growing economy like China’s to raise capital outside the banking sector, they fear that the development of the capital market will undermine the big banks (and thus the financial sustainability of many state firms) if households begin to withdraw funds from savings accounts and significantly increase their holdings of stocks and bonds. The risk is that banks will find themselves with less liquidity.

The limited availability of consumer credit forces families to accumulate savings in order to finance the purchase of consumer durables. Moreover, limited public provision for health care, retirement, and other social safety nets, as well as low wages, pushes families to accumulate savings in order to be self-insured.⁴² In 1978, the cumulative stock of household savings was about 21 billion renminbi, or 6 percent of GDP.⁴³ At the end of 2013, it was approximately 14 trillion renminbi, or about 23 percent of GDP.⁴⁴

Families have been actively accumulating savings over the years but so have corporate enterprises. The latter have been able to accumulate high levels of financial resources mainly thanks to the low-dividend policy—or the no-dividend policy, in the case of many state-owned enterprises. The large pool of savings that has been accumulating in the domestic banks since the early days of economic reforms has been instrumental in generating rapid economic and employment growth. But with interest rates kept artificially low, savers do not get much out of their money.

The limited offer of financial instruments other than bank deposits for savers and private firms has combined with China’s rapid credit growth to fuel the rapid expansion of unregulated borrowing and lending, referred to as shadow banking. Banks, trust companies, insurance firms, leasing companies, and, more recently, e-commerce companies like Alibaba and Internet platforms like Tencent are all part of China’s shadow banking, as are pawnbrokers and other informal lenders (including peer-to-peer lenders). Here, through questionable organizations like Shanxi Platinum Assemblage Investment, savers can get higher interest rates on so-called wealth management products than they get on bank deposits—approximately 6 percent on average, compared with 3 percent on bank deposits. Or they can put their savings directly into funds such as Yu’e Bao through Alipay—the online payment company that is part of Alibaba—or through the very popular mobile chatting app WeChat—which is run by Tencent. (With roughly 580 billion renminbi in 2015, Yu’e Bao is the largest money market fund in China and the third largest in the world.⁴⁵)

For banks outside the dominant big four, shadow banking is a way to access liquidity. Funds they raise through these wealth management schemes are then allocated to projects that do not normally qualify for loans with state banks—such as real estate, for example, which regulators deem to have grown too much.

These loans are often made off the balance sheet and therefore are outside the purview of bank regulators—hence the name shadow banking. As long as the borrower repays, everybody gains: the borrower, the bank, and the investors in the wealth management products. But if the borrower defaults on a payment to the bank, then the bank cannot pay the interest to the investors. This undermines investors’ confidence, making it difficult to attract new investors with fresh capital. Without that fresh money, the bank cannot return investors’ capital—shadow banking instruments tend to have a short duration, sometimes no more than three months—and the whole pyramid eventually collapses. As Xiao Gang, China’s former top securities regulator, said, shadow banking is “fundamentally a Ponzi scheme.”⁴⁶

Despite sentiments like this—and a name that suggests some kind of murky business—shadow banking entities very often are part of China’s main banks in organizational and managerial terms. Banks, for example, create and manage wealth management products and include them in their regular offers to their clients. Savers buy these products from their bank and redeem them through their bank, so they tend to think that the same bank guarantees these products and that they are therefore safe. But this is not the case; the ICBC recently made it clear that it would not protect investors to whom it had sold 3 billion renminbi worth of wealth management products. And yet shadow banking is a booming business, valued at $3 trillion in 2010 and twice that in 2012. In its 2014 report on China the IMF estimated the size of shadow banking as 53 percent of GDP.⁴⁷

The PBoC has been carefully monitoring the expansion of shadow banking—in 2014, before regulators stepped in, the issuance of wealth management products amounted to almost 14 trillion renminbi, or almost 10 percent of total bank deposits.⁴⁸ At the end of 2015 4.4 trillion renminbi, or 6.5 percent of GDP, were under management in the money market fund industry in China.⁴⁹

Because shadow banking is below the regulators’ radar, authorities are concerned that legitimate banks will use lightly regulated wealth management products to repackage old loans and prop up risky companies and projects that might not otherwise be able to borrow money. To remain solvent, banks need to continue to refinance enterprises and organizations that otherwise would go bust—which could bring banks down, too.

There is reason for the authorities to worry about debt. China’s total debt—including government debt as well as the debt of financial institutions, nonfinancial businesses, and households—has quadrupled since 2007 ⁵⁰ and is currently around 282 percent of GDP. This is in line with the debt-to-GDP ratios for G7 countries—total debt in the United States and Germany, for instance, is about 273 percent and 210 percent of GDP, respectively—but it is unprecedentedly high for a developing country.⁵¹ That debt has also been growing at an unprecedentedly high rate—it was only 130 percent of GDP in 2008, when, in the wake of the global financial crisis, the government introduced stimulus measures (including a large infrastructure spending program). As a result, businesses and provincial governments have been piling up debt—local government debt increased from 13 percent of GDP in 2005 to the current 33 percent.

No economy in history has experienced credit growth of such speed and scale without eventually suffering a financial crisis and a protracted period of low growth. Furthermore, private credit has risen to 180 percent of GDP, approximately two-thirds of which is corporate debt—these figures are similar to what the United States and Japan experienced before their most recent financial crises. State-owned enterprises and local governments have piled up so much debt that they increasingly need to resort to shadow banking in order to get enough credit to keep going. (On the other hand, firms with good credit ratings and a solid balance sheet do not need to rely on shadow banks for credit.)

Excessive credit growth, sub-prime investments (especially in real estate), and hence the increase of nonperforming loans provide the breeding ground for a banking crisis. As was the case for both the United States and Spain in the years before the 2007–2008 crisis, easy and cheap access to lending and excessive liquidity conjure a situation in which risk is underpriced, and, thus, imbalances build up. Unlike these countries, however, China can preserve its system by maintaining financial repression—and by carefully controlling capital movements and managing the exchange rate (the subject of the next chapter). Although managing the exchange rate has fueled the domestic economy by keeping exports cheap and competitive, it has also constrained the development of the renminbi as an international currency.