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UBS Investment Research Emerging Economic Comment

Chart of the Day: There's Nothing "Shadow" About It

Global Economics Research

Emerging Markets Hong Kong

25 April 2011

economics

Jonathan Anderson

Economist jonathan.anderson@

+852-2971 8515

Money can't buy everything. That's what credit cards are for. -- Ruby Wax

Chart 1. Flow "social" financing

% of GDP 45% 40% 35%

Corporate bonds and bill acceptances Designated/trust loans Local currency/FX loans

30%

25%

20%

15%

10%

5%

0% 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: IMF, UBS estimates

(See next page for discussion)

This report has been prepared by UBS Securities Asia Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 5.

Emerging Economic Comment 25 April 2011

What it means

For much of the past year investors have been regularly bombarded with two arguments on China ... one very true and the other essentially a myth.

The first (true) is that total financing in the mainland has been growing a good bit faster than the formal bank lending data suggest, and that tightening efforts have actually been less than meets the eye.

And the second (false) is that this is somehow due to a massive, unrecorded and unregulated "shadow" financial system in China, one that exists outside of banks and now accounts for up to half of all credit activity in the economy.

If the true/false labels above make good sense to you, then by all means stop reading here. If not, then allow us to explain what we mean.

All about social financing

As most readers are probably aware, last year the People's Bank of China began publishing new data showing broad "social" financing in the mainland ? an attempt to measure a wider set of intermediation channels for financial resources in the economy.

These include eight instruments: (i) "formal" local-currency bank loans, including discounted commercial bills, (ii) foreign-currency bank loans, (iii) trust loans, which include loans securitized and sold by banks, (iv) designated loans, (v) banker's acceptances, (vi) corporate notes and bonds, (vii) equity issuance and (viii) other minor forms of finance including some insurance-related transactions.

This is far from a comprehensive accounting, incidentally. As China economics head Tao Wang notes, if you really wanted to get a full list of funding from all sources you would need to include foreign direct investment, government fundraising, all manner of informal resources transfers ... and, most importantly, the internal use of corporate retained earnings, which is the single most important source of investment spending in China, as it is in virtually any economy.

On the other hand, the key point here is that even this incomplete view of "social" finance is still broader than the traditionally reported flow data that we've become used to working with, i.e., the first two standard bank loan items above.

What the data tell us

What do these broader data tell us? Tao went through the full numbers in How Much Liquidity Is Out There in China? (China Focus, 12 January 2011) and All About Money (China Economic Comment, 15 April 2011), but you can see a summary snapshot in Chart 1 above. What we did in the chart is to concentrate on the main "credit-like" components (i) to (vi) above ? i.e., ignoring equity issuance and the like, which are a very small part of the total in any case ? and then take annualized flows relative to underlying nominal GDP.

As you can see, as late as 2008 formal loans still accounted for 85% of all broad finance according to these metrics. By the beginning of this year, however, the share had collapsed to just over half.

So if you simply looked at the blue bars in the chart showing formal standard loan operations, you would conclude that there has been aggressive monetary tightening in China; by this measure, new lending has fallen all the way back to pre-crisis levels as a share of GDP. It isn't until you add in the remaining items that you suddenly find that total credit availability is still well above 2000s norms.

And where is all this additional credit coming from? Contrary to what you tend to read in the press, it's not securitized trust or designated loans (the orange bars in the chart); these are a visible part of the story today but

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Emerging Economic Comment 25 April 2011

have always been prevalent to some degree. Rather, it's the explosion in bank acceptances and corporate notes and bonds (shown in green) that really explains the rising gaps over the past two years.

Nothing "shadow" about it

So far, so good. Now, here's the crucial question for today's note: Where is the informal "shadow" financial system in all of this?

The answer is: absolutely nowhere.

If you go through the list of (i) through (vi) above you will find that every single category is almost fully originated and/or intermediated through the existing commercial banking system. In fact, only a couple of them can be called "off-balance sheet" to any significant degree ? and even in these cases, such as trust loans and acceptances, they are already regulated by the authorities and generally have standard risk-weightings applied under the current capital adequacy regime.

In other words, we're not talking about a proliferation of bizarre or extraordinarily levered credit operations that are occurring way off the radar screen. For the most part these are run-of-the-mill commercial bank transactions.

Goodhart's Law in action

So why the fuss? Well, more than anything else this is a perfect example of Goodhart's Law in action. Readers with an economics background will remember Charles Goodhart's maxim: Whenever a financial indicator or aggregate becomes a formal policy target, it tends to lose its efficacy over time.

In the case of China, it means that the more the PBC targets formal commercial loans as its tightening tool, the greater the incentive for banks to avoid making outright loans and provide credit through other instruments instead.

But again, it's still banks that are doing the lending. And the corollary to Goodhart's Law is that this tends to be a repeated game; the mainland regulators have already cracked down considerably on trust and designated loan transactions, for example, and you should expect further measures regarding acceptances and corporate paper as well.

I.e., this doesn't change our view that the authorities can control monetary aggregates in principle in the near term, and that they will continue to tighten going forward.

What happened to shadow banks?

Now, what about all those other institutions we keep reading about: trust companies, pawn shops, sidewalk markets, informal credit cooperatives, etc.?

The answer is that they are all there ? but that they simply don't matter that much in the grand scheme of things.

We say this for three reasons. The first is that the few studies we've seen on the topic put the size of the "alternative" financial sector (especially if we exclude, for example, trust companies' role in offshoring commercial bank loans and focus only on their capacity to provide true alternative finance) at perhaps 15% to 20% of GDP in stock terms ? not tiny, of course, but many orders of magnitude lower than the formal banking system.

This is supported by Chinese industrial data as well. China is relatively unique among EM countries in providing full quarterly balance sheet data for all medium and large industrial enterprises, and the figures for debt liabilities give no indication that corporate leverage has delinked at all from what the PBC reports in

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social finance statistics. The same is true for household surveys we have seen; the bulk of reported liabilities are for mortgages, auto finance and credit cards, all of which come from the formal banking sector. This still leaves a role for informal finance in meeting the needs of smaller companies and poorer household segments, but these are relatively minor users of credit in any economy. Third, and perhaps most important, every piece of "sidewalk" pricing data we've seen over the past 20 years suggests that informal interest rates are both high and extraordinarily volatile. These are not deposit-taking institutions by their nature and don't have a significant credit multiplier, so while they can "lend what they have" in any given period there is simply no ability to offset significant declines in formal credit with a comparable increase in alternative finance. I.e., the supply curve here is relatively vertical, which explains why demand fluctuations lead directly to volatile interest rate movements instead. The bottom line The bottom line is simple: If you want to get on top of monetary trends in China, stop reading the headlines and spend more time reading the work of China bank analysts. They spend their waking hours covering the institutions that (as we've shown) really matter in the mainland ? and most of them have been writing on nonstandard loan, acceptance, bill and bond trends for a good while now. Our own analyst is Sarah Wu, and for further information she can be reached at sarah-s.wu@.

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Q Analyst Certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.

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