Shadow Banking in Emerging Markets

When I first come to discuss potential thesis topics with my thesis advisor, the very first thing he suggested off his mind was shadow banking in China. My first thought was "Okay, that's very specific;" and since neither China nor shadow banking was of any interest to me at the time, I didn't look into it until today when I stumbled upon this data set from BIS.

The data set comprises of cross-sectional long series of credit to non-financial sector constructed collectively by the BIS and its member central banks; and perhaps more than 50% of this data set dates back way before 1990. Importantly, the data set provides a good breakdown by (1) borrowers (whether lending is to households or to corporations), and (2) lenders (whether lending was provided by domestic banks or other sources, i.e. domestic nonbanks and cross-border lending). I originally only wanted to see to what extent The Fragile Five (Brazil, India, Indonesia, South Africa, Turkey) is relying on non-traditional funding (i.e. funding not by domestic banks), though some compare-and-contrast surprisingly gives us a little peek inside shadow banking in China.

1 - What is Shadow Banking?

In a nutshell, shadow banking simply refers to non-bank institutions (e.g. private firms, investment banks, money market funds, securitization companies, etc.) whose activities essentially carry out the functions of a traditional commercial bank (i.e. creating liquidity via its own borrowing/lending). These institutions have been around for long, though they only caught attention after the 2008-2009 financial crisis, since many economists believe that it was the uncontrolled and unregulated activities of these institutions that generated great maturity mismatch and high leveraging, setting up the stage for the crisis.

Previously, researchers only focused on the shadow banking sector in advanced economies. Nonetheless, the spotlight is now shifting gradually to the emerging markets (EMs), as there have been evidences which point to a growing shadow banking system in these economies. For example, the Economist had an article about how companies are starting to lend to each other and earn profit, just like banks, in China. Borrowing the article's chart, we could see that other (non-bank) forms of lending are growing more and more rapidly, while the growth of traditional bank's lending (light blue bar) is slowing down.

Source: The Economist

2 - In what EMs is shadow banking significant?

So this is a little visualization I made from the BIS data set mentioned above:

Fraction of Lending to Private Non-financial Sector in Emerging Markets provided by Banks (green) and Non-banks/Cross-border Lending (Blue)
Source: BIS, own calculations.

The countries represented in the six charts are (from left to right, top to bottom) Brazil, China, Indonesia, India, Turkey, and South Africa. There are good and bad news. The good news is that all the Fragile Five countries (everyone except China (top-center), and maybe Turkey (bottom-center)) has a very solid domestic banking system which provides most of the credit to its non-financial sector. This has a very great implication: if capital flows is reversed (say, in a year or two), the direct impact on the real (which is non-financial) side of the economy will be relatively small. Let's not be all optimistic, however, since the domestic banks themselves have their own risks from borrowing abroad and from non-traditional sources; so the indirect impacts will still be there. Though, I must say, the levels of lending provided by domestic banks as above are still very impressive in my opinions.

Now we turn our attention to China, the only country among the six above that we can actually see a sizable blue area, which appeared at around 2005, and is gradually growing. In other words, Chinese households and private non-financial firms are getting funding from domestic non-banks and foreign sources. The BIS data set indicates that this funding gap amounts to 26261 billion yuan in December 2013, or around 4.25 trillion USD by today's exchange rate. Remember that this funding gap can come from two sources: (1) domestic non-banks (shadow banks) and (2) foreign lending. I made a quick search, and Chinese's state newspaper Xinhua reported that Chinese's foreign debt is approaching 1 trillion USD in early 2014. If we are to trust this source, that leaves us with roughly 3.25 trillion USD of shadow banks' funding! That's almost twice the US foreign debt, and accounts for 19% of total lending to private non-financial sector in China.

Why do we care?

Of course I personally find it very scary that 1/5 of lending to households and corporations in China comes from shadow banking. This sector provides what seems to be attractive funding during boom time, only to create serious liquidity problem during crisis period. Of course, the question of "to what extent does shadow banking impair the economy" requires formal modelling; though, for demonstration, if 50% of shadow banking funding in China dries up during crisis, that jeopardizes 10% funding to private households and nonbanks, i.e. real consumption and real production. I guess after the US-led crisis in 2008, it may still be too soon for another crisis at the world's biggest exporter and biggest lender.

Scary, isn't it?

BRICS' New Development Bank: Turning Tables?

The BRICS leaders early this week reached an agreement to establish a new development bank with an initial capital amount of $50bn, contributed equally by each of the five emerging markets - Brazil, Russia, India, China, and South Africa; as well as a currency exchange reserve of $100bn. This news has ignited hot debates all around, as people are taking sides in (1) whether the bank can effectively challenge the roles of the World Bank and IMF, institutions led primarily by the West, in international lending and (2) whether it can really aid better economic development and poverty reduction in developing countries.

In my opinions, question (1) is important because a success in replacing the West-led world financial system precedes the transfer of world power in the near future. Of course, it should not really matter if A runs the world's largest bank or B does, unless A and B have very different foreign (political) policies and abuse the financial system to enforce impose such policies on other countries, which, sadly, has always been and will always be the reality. However, after all, question (2) is what really matters.

CHALLENGE TO THE WEST?

Exactly around this month 70 years ago, world leaders met at the Bretton Woods Conference to establish both the World Bank (formally, the International Bank for Reconstruction and Development) and the IMF, in which the key players in this creation was the United States and the United Kingdom. Since then, the World Bank has always been led by a US-nominated president and the IMF a European. The creation of the BRICS Development Bank this time around is a clear adoption of the Bretton Woods-type international finance.

Challenge to the West or not, the creation of this bank and the reserve fund will definitely give the emerging markets more independence for their public finance and financial crisis prevention. Though not formally recognized, funding and loans from the World Bank and IMF are often subjective and not purely economic. Some claimed that the first loan ever of the World Bank, which was granted to France for post-war reconstruction purpose, came with the demand from the US that the France government must end its coalition with the Communist party. What can guarantee that the (US-influenced) World Bank or the (EU-led) IMF would nicely provide a helping hand, say, should Russia have a balance of payment crisis in midst of the Ukrainian chaos that is currently happening? Apparently not. Having its own bank and reserve fund clearly helps BRICS insulate their world affairs policies from economic risks.

There is no doubt that the BRICS bank and its reserve fund could never rival the West's counterparts in size, unless some of the top emerging markets maintain the kind of economic growth of China for 10-20 years. Currently the World Bank has ~$324bn worth of assets, and the IMF has $368bn in its reserve quotas, with additional pledged/committed resource of $1 trillion. So the World Bank has 6 times more capital and ratio of BRICS reserve fund to IMF fund stands at 1/10. Due to the fact that rich countries contribute a lot more to the WB and IMF, even if smaller countries switch sides, these two institutions would still have plenty of money available for lending. So, talking about sizes, the BRICS bank seems like a David in front of the Goliath World Bank; not to mention that the BRICS reserve fund might actually be ineffective. Remember that even an economy as small as Greece, when in crisis, requires a lot of capital assistance to get out. The EU and IMF had to provide joint support for this one country 110 billion euros in May 2010, and an extra package of 100 billion euros in July 2011. This number is almost triple the total fund that BRICS has in its new exchange reserve.

Of course no country in BRICS has economic fundamentals as bad as those of Greece (the highest level of public debt in BRICS is 54.9% of GDP in Brazil, compared to Greece's 161.3%, for example), there is still a little problem: systemic risk. Many of these countries are vulnerable to exchange rate and capital flight (sudden-stop) risk, which could and tend to happen to many of BRICS countries at the same time. We still remember when Fed first talk about tapering last summer, Brazil, India, and South Africa all saw huge depreciation of their currencies, which led them to be listed in the so-called "Fragile Five" - the five economies that are extremely sensitive to investors' mood. If these three need credit assistance all at once, that leave $33.3bn for each, perhaps not enough to solve a serious crisis.

Thus, even with their own reserve fund, I doubt that BRICS dare to stand up against the IMF any time soon.

BETTER DEVELOPMENT FUNDING?

As several newspapers point out, this development bank can win the hearts of many African countries which are in desperate need for international funding but could not borrow much due to potential fiscal and structural adjustments that the WB and IMF require as part of the loan packages, not to mention other conditions regarding  human rights, environmental, etc., the values that the West impose on their borrower. BRICS may not care about this, however. Therefore, the creation of BRICS' bank certainly makes credit more accessible to poor countries.

Considering the fact that several structural adjustments imposed by the IMF and WB have been harshly criticized and accused for impeding growth (e.g. worsening the Asian currency crisis 1997-1998), if BRICS choose to have more lenient lending conditions, it may be good news for developing countries. Or, maybe not. I'm simply afraid that imprudent lending would allow (fiscally irresponsible) governments to misspend. The worst scenario for a poor nation would be to spend easily borrowed money on the wrong public projects, since not only it would not bring about economic changes, it would also accumulate huge public debts for that country. Therefore, until the BRICS bank goes operational in 2016 and lays out clearly its lending platform, it is hard to conclude whether this new bank can aid better development for developing countries.

In the end, I don't care much about who leads the world's banking and reserve funds; what really matters is who can better boost growth in developing countries. All BRICS countries have impressive records of economic growth and poverty reduction. However, talking about sustainable growth, I'm a bit skeptical of China, so until it's proven otherwise, let me stay affirmative to the World Bank.

Creation of the ePerspective

Hi, my name is Vu T. Chau, an Economics student at Princeton University, class of 2015. My research interest includes macro theory, (international) monetary policies, and financial crises. These three aspects of Economics are of course very intertwined both in the literature and in practice, yet they are also quite distinctive in their own rights. This blog, therefore, will focus on the macroeconomic conditions of the United States, Europe, and emerging markets (in a narrow sense, BRICS + Turkey + Indonesia); as well as the interaction, monetary, and the resulting spillovers between them. Though, over time, there might be some posts on labor market/labor theory and developmental economics, as these are also part of my research interests.

Why did I create this blog?

This blog is created merely for personal objectives:

1) To improve my economic understanding: Two years ago, when I first read several economic newspapers and blogs, I was shocked by (1) how little knowledge I had of the real economic world, and (2) how unable I was to apply the textbook economics I learned into real world thinking. Over time, this has improved (luckily), though I still feel that there exists a gap between my economic theory and reality. Hence, this blog, first of all, is to complement economic understanding with real world analysis.

Also, last year I went to see a professor in my department to explain to him an idea for a theoretical that I planned on writing for my Junior Independent Work (required for all non-engineering students at Princeton). After listening to my explanation for 10 minutes, the professor simply said: "The idea is cute, but it's not true in practice at all." Thanks to him, I learned to look around for more real life evidence and ended up writing a better, more useful and applicable JIW than I would have if I had gone with the original cute idea. Now the professor has become my thesis advisor, and I am trying my best to understand the real economy before attempting to write anything.

2) To improve my critical writing: I realized an inconvenient truth last year that I cannot write very well, mostly due to my no-essay-class policy (that is, I avoid all courses that require the students to write essays). Though I definitely enjoy a more quantitative approach to everything, I think learning to express myself through concise and precise writing is also very important.

All in all, I hope this blog will be among the foundations that I need for my academic career and future economic thinking.

Why is this blog called "ePerspective"?
Well, first, the "perspective" part means this blog is a continuation in my blog series, alongside with "Just a thought" (EN) and "Suy nghĩ" (translation: "Thinking" - VI). The letter "e" at the beginning simply comes from the fact that there are many important concepts in Economics that start with "e": economics, equilibrium, equation, exchange (rate), export, efficiency, emerging markets, envelope theorem, etc. So I just thought, maybe this one "e" at the beginning could summarize all these essence of Economics.

So, welcome to ePerspective. :)