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The Growing Pains of China’s Shadow Banking System

Feb 14 , 2014

The just concluded World Economic Forum in Davos, Switzerland gave us an excellent window into the concerns that world leaders have about the global economy. One of the biggest regards the health of China’s economy and specifically of its shadow banking system. Concern about it is legitimate but I believe the expressed fear is overdone. 

Michael Justin Lee

Although ominous sounding, shadow banking exists in every country. In fact, the more thriving and capitalist a country’s economy, the more thriving its shadow banking system. 

What exactly is shadow banking? It is the totality of financial entities that don’t fall under direct bank regulation. So for example, if you have ever held a money market mutual fund or used a mortgage broker, you have been a participant in the U.S. shadow banking system. Not necessarily frightening, is it? 

In fact, this concern about China is nothing new. The creation of an efficient financial industry has been a difficult challenge at least since China embarked upon its capitalist road and I suspect since Marco Polo waltzed away with our idea for spaghetti. 

Since the capitalist road is unavoidably a winding and bumpy one, it should not be surprising that China’s shadow banking system, like the economy itself, will have its growing pains. Furthermore, in China, with rule of law still evolving, the road is bumpier still. Thus, quite uncharacteristically for me, I actually agree with the Davos intelligentsia up to this point. 

However, my agreement does not extend to their conclusion. The majority conclusion seems to be that China will implode from the weight of the shadow banking system’s problems, taking down first Asia with it, and then the rest of the world. Even after making full allowance for probable hyperbole at such a media event, I think the Davos grandees went too far. The worst of the possible outcomes can be ameliorated with simple openness and transparency and I think the Chinese know this. 

Market practitioners know that opacity and evasiveness about an economic problem makes it far worse. That’s a big no-no. Without open resources, the market has no chance to evaluate and discount the problem and therefore must assume the worst. 

China’s shadow banking problem has a bit of parallel with another topic discussed in Davos, Bitcoin. Bitcoin is a private market currency. It is not backed by the good faith and credit of the U.S. Treasury or of any other central bank. It is backed only by the trust that the market accords it. 

Actually, Bitcoin’s business model is not entirely new. Credit cards are also private market currencies. They are accepted for purchase because buying and selling parties trust their efficacy. The eventual success or failure of Bitcoin ultimately comes down to whether enough parties trust it, that is, accept it as a medium of exchange. The major credit card companies have earned that trust and therefore they are commonly accepted as currency despite not having been created by any sovereign authority. 

The same goes for China’s shadow banking system. Its success or failure also substantially depends on whether the market trusts it. There are other factors as well, but without the trust of the market, all of those other factors could not sustain it. Consider a run on a bank. If I distrust a bank, I would withdraw my money immediately. If everyone else does similarly, a bank run results even if the distrust is unfounded.

China needs to earn trust that is clearly absent right now and the first step would be a simple transparent admission of the troubling situation. Sweeping problems under the rug accomplishes nothing. Hoping that overall economic growth accelerates to such extent as to trivialize the problem also accomplishes nothing. Less than twenty years ago, some other countries right in China’s backyard experienced very great pain from trying that. China must surely have been watching. 

Chinese President Xi Jinping knows that his economic legacy will be very significantly determined by his handling of this particular problem. He seems a practical man and surely must know what any doctor would advise, that a clear and frank admission of an illness is a necessary first step to curing it. However politically painful it may be for President Xi to make such admission, the benefits are too great for him not to, which is why I doubt that the worst fears expressed in Davos will manifest. 

Michael Justin Lee, lecturer in the University of Maryland’s Department of Finance and Center for East Asian Studies, is the author of McGraw-Hill’s “The Chinese Way to Wealth and Prosperity” and Chief Snark at His email is

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