Shadow Banking and the Chinese Economy: A Micro to Macro Modelling Framework

The Chinese financial system has served the Chinese economy well in the early stages of development in channelling domestic savings to domestic investment. But, continued financial repression, along with a growing middle class and ageing population has created pressure on savings to 'search for yield'. At the same time, the dominance of lending to state-owned-enterprises, political constraints, inefficiencies and weak risk management practice by financial institutions (FI) have pushed SMEs to alternative sources of funding. The demand for yield from savers and funds from private investment has been met by the rapid growth in shadow banking.

This study encompasses two of the identified themes of the research call. The research theme 'alternative strategies for reform and liberalisation' covers the role of the Shadow Bank system in the credit intermediation process. This research is of critical importance because it informs the macroeconomic research necessary for investigating 'the role of the Chinese financial system in sustaining economic growth'. Addressing the first research theme we take a dual track approach to better understand the role of the financial system in sustaining in economic growth.The first track examines the role of bank and non-bank finance in promoting long-term economic growth at the regional level. The second track is aimed at the more short-term issue of identifying the potential frequency of macro-economic crises generated by a banking crisis.

The finance-growth nexus is a well-established area of economic development, however the China experience questions the supposition that financial development is a necessary precondition. The empirical findings are mixed. Part of the reason for this could be the failure to distinguish between the quality of financial institutions across regions, and the openness of the local environment in terms of the balance between private and public enterprises. Our research would build on the existing literature in two ways. First, it would utilise imperfect but available data on informal finance to examine direct and spill-over effects on medium term growth from contiguous provinces. Second, primary data on the geographic dimension in shadow bank lending gleaned from Theme 2 research will be used to design a weighting system to adjust financial flows for the quality of the local financial environment. The second prong will develop a small macroeconomic model of a hybrid DSGE type that incorporates a banking sector including shadow banks.

Such models have been developed for China in recent times but only a few have attempted to incorporate a banking sector.These models are mostly calibrated versions and make no attempt to test the structure against the data. Recent attempts to test a hybrid New Keynesian-RBC DSGE type model for the Chinese economy using the method of indirect inference have been successful and inclusion of a shadow banks have shown some success. The results of the Theme 2 study will inform the development of a fuller shadow banking sector in the macroeconomic model that will be used to estimate the frequency of economic crises generated by bank crises. Theme 2 research will examine the relationship between the banking system and the shadow banking system as complements or substitutes. It will aim to determine the variable interest rate on the P2P online lending platform on the basis of risk-return, the home bias in online investments, and the signalling and screening in the P2P online lending platform. Finally, it will aim to identify the impact of shadow banking on entrepreneurial activity, the industrial growth rate and regional housing investment and price differentials. These results would inform the theme 1 research on the interconnectedness of shadow banking with the mainstream and the fragility of the financial system to shocks and financial crises.

This research relates to two themes identified by the ESRC as strategic priorities. (1) 'Understanding the macro economy' and (2) 'productivity'. The global financial crisis has shown the impact that problems in the banking sector can have on the wider economy. In China, the non-State owned enterprises and Small and Medium-sized Enterprises have constituted the main growth engine and represent the backbone of China's economy. But direct funding from the state-dominated banking sector remains light creating avenues for shadow bank funding. The interconnectedness of shadow banking with the regular banking sector has increased the possibility of systemic risk. The insights of this research will therefore have relevance not just within the policy making circles of China but to the developed as well as emerging economies.

Who will benefit? There are five principal actors who will benefit from this research. They are
a) the credit providers of the shadow banking system,
b) the investors that are the recipients of shadow bank funds,
c) the savers who provide funds to the shadow banks,
d) the regulators that formulate policies that result in shadow bank activity, and
e) the commercial banks that fail to recognise the opportunities of the SME sector.

How will they benefit? The research will highlight best practice in risk management processes and governance that will improve development of the sector and greater likelihood of acceptance by the regulatory authorities. Borrowers will benefit from making informed judgements of borrowing costs from the efficient management practice of the shadow banks. The research will highlight the effect of misperceptions and imperfect information in the decision making process and will benefit from greater awareness of the risks associated with shadow bank savings vehicles. The research will also draw the link between regulation and the separation of funding avenues between state-owned enterprises and private sector and SMEs and will see how their activity generates the shadow banking system and the potential fragility to the banking system. Finally, commercial banks will be informed of the organizational impediments to the development of a robust SME lending practice.

The identified beneficiaries will be informed of the results of research in the following way. In the early stages of the project the team will be involved in a two-way engagement with the China Advisory Group (CAG). Policy seminars will be held with the CAG to keep them informed of research findings and highlights. A dedicated Chinese language website will be hosted by Fudan University to explain in non-technical terms the direction of research and findings. An international conference will be held in Shanghai that will be set out the research findings including keynote addresses by members of the International Advisory Board (IAB). The conference will invite senior members of the Peoples Bank of China, the China Bank Regulatory Commission and the Hong Kong Monetary Authority. A press conference on the findings and other media outlets will be sought by the China team. Press articles are expected to be placed by the research team in the China English language and Chinese language media. The interaction with the IAB and CAG is an important vehicle in the research dissemination process for impact. In the non-transparent system of decision making in China, impact involves the process of informing stakeholders as a means of influencing decision makers. The preliminary stage is to build trust and foster collaborative activity with the China research partners. The second stage is to inform stakeholders and the third stage is to influence through the channels created by the first two stages.