China’s Campaign to Stabilize Lending

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For more than two years, there's been incessant talk of a massive credit bubble waiting to burst in China. These concerns aren’t completely unfounded. The world’s second-largest economy now shoulders more than $23 trillion of private domestic debt outstanding.

But the Chinese government is stepping up to the plate, by cracking down on the country's shadow banks and tightening monetary policy. Investors should find these remedial moves greatly reassuring.

China has a large, informal network of lenders such as off-balance sheet operations tied to local banks, insurance companies and a host of others. Many borrowers turn to non-traditional lenders for financing, because borrowing from official lenders is often difficult for small- and medium-sized business, thanks to tightening credit policies or the tendency of the Chinese banking system to favor state-owned enterprises.

Well aware of the financing challenges small businesses face, the government isn't eager to completely choke off more informal lending sources. In addition, nearly half of the debt carried by local governments in the country is owed to informal lenders. But with domestic debt now at 216 percent of gross domestic product, up from less than 130 percent five years ago, the government feels that it must intervene.

To that end, the government has been circulating draft rules for the People's Bank of China (PBOC) and other regulators to take a greater supervisory role over informal lending institutions. The goal is to institute greater internal controls and risk management procedures to minimize the chances of an event similar to the subprime lending crisis in the US.

As it stands now, there's virtually no transparency in the shadow market, but completely cutting ! it off could be equally damaging to the country's economy. With informal lending playing such a large role in Chinese financial life, all the way from individual borrowers to government entities, shutting the spigot on such loans could seriously damage China's growth prospects.

Given those challenges, it will likely be some time yet before a regulatory framework will be finalized.

In the meantime, the PBOC is trying to at least slow the pace of shadow lending by reducing the liquidity in the country's financial system. Last month, more than $200 billion in new loans was made by Chinese banks—a four-year high—and it is estimated that shadow loan issuance surged by 25 percent. The PBOC issued $7.9 billion in bond repurchase agreements earlier this month, a tool used to reduce systemic liquidity over the short term.

Such moves sparked sell-offs in Chinese equities in June and December of last year, exacerbated by growth concerns in the wake of monetary tightening. The tightening also resulted in higher interest rates, with the knock-on effect of soaring yields on Chinese government bonds. The first auction of those bonds this year saw the yield rise to almost 4.5 percent, the highest level in 16 years.

So far, the market response to the current round of tightening has been relatively muted, although it's likely offset by record lending last month.

Nonetheless, these moves indicate that the Chinese government is finally willing to rein in the shadow banking system, even if it is done in the government's usual deliberative way. The goal is to put the country onto a more sustainable growth track, less reliant on leverage and more dependent on spending. But the government also wants to inflict as little pain as possible on the wider economy, by forcing traditional banks to take loans onto their books and not pushing them into off-balance-sheet vehicles.

It will take years to formalize the current shadow banking system. But so far, the PBOC seems to have t! he situat! ion in hand, slowly draining liquidity from the system and stepping in as needed to stabilize troubled lenders. While the Chinese debt situation still bears close monitoring, it shouldn't be a panic inducer for investors.

Ignore the alarmist rhetoric from the chattering class about a debt bubble ready to burst in China. Officials there seem to have the situation in hand.