Are China’s Shadow Banking Regulations Contradicting Its Push for Common Prosperity?

China’s crackdown on the shadow banking sector may be undermining Beijing’s goal of building a more equitable financial system. As Chinese leadership attempts to solve the issue of predatory loans that have left the economy with dangerously high levels of credit risk, they are pushing shadow banks out of the market and severing financial access for a significant portion of the population.

From a policy perspective, Beijing’s decision to crackdown on privatized lending makes sense. By cutting down the interest rates shadow banks are allowed to charge, China is deleveraging a highly volatile industry while protecting individuals and small businesses from the predatory loans of unregulated financial firms. Ostensibly, these regulatory policies align well with Beijing’s broader domestic efforts to combat wealth disparity and create a more stable, inclusive economic system. However, China’s regulatory constraints on shadow banks seem to work better in theory than practice. Efforts to install debt guardrails that better protect Chinese citizens have instead cut off access to a vital source of financial relief for the very people Beijing seeks to protect.

Small-to-medium-sized enterprises (SME) are disproportionally impacted by China’s shadow banking regulations. This is largely a byproduct of Beijing’s financial policy decisions over the past two decades. Chinese SMEs have found it increasingly difficult to receive loans from traditional banks due to the systemic favoritism given to large, state-owned enterprises. This has forced smaller firms to find alternative methods of acquiring credit in the shadow banking industry.

As of 2009, shadow banking made up about 8 percent of the total market. As of 2016, shadow banking represented 32 percent of total financing in China. The drastic uptick in dependence on shadow banking is a side-effect of the inequitable loan acquisition process deeply ingrained in China’s banking system.

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SMEs’ reliance on shadow banks has climbed during the pandemic, creating additional challenges for China’s top economic advisors, given that small businesses are a major employer in China’s economy. A recent study conducted by Zhenghe Island Research Institute found that out of the small businesses surveyed, one out of every five took a private loan during the pandemic. Given that local firms have become embedded in the shadow banking economy, regulatory tightening is contradicting Beijing’s efforts to safeguard domestic firms – especially since this crackdown is happening in the backdrop of Xi Jinping’s “common prosperity” initiative, where domestic SME development has become a critical component of the overall strategy.

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As Chinese leadership looks to reel in the overstretched lines of credit that have given rise to the shadow banking sector, its draconian approach is harming the same sector of the economy that the current administration is hoping to grow. Beijing’s regulations have cut interest rates by so much that it is disincentivizing shadow banks from providing any financial services at all. As Zhang Min’an, a professor at Sun Yat-sen University, told the Financial Times, “Interest rate control ends up hurting the very group of borrowers it intends to protect as they are priced out of the market.”

Beijing is using its regulatory authority to drown out non-bank intermediaries by minimizing profits rather than providing a viable solution that encourages safe lending and borrowing practices. In doing so, Chinese citizens and local firms are left scrambling to find alternative means of financing.

Small business owners in China are stuck between a rock and a hard place when it comes to loan acquisition. They face overwhelming systemic disadvantages when obtaining loans from traditional banks, which pales in comparison to the relative ease with which large, state-owned enterprises can receive credit assistance. Moreover, the continual regulation of shadow banking has caused the industry’s assets to shrink by 11.5 trillion RMB from 2017 to 2020, leaving struggling firms with limited access to financial assistance. The socioeconomic implications of this are worrisome, given that China is unlikely to loosen its COVID-19 restrictions, perpetuating the need for pandemic-related loans.

In a speech given in September 2021, Xi Jinping emphasized the role of SME development in China’s future growth, stating that the Beijing Stock Exchange would become “the primary platform serving innovation-oriented SME.” If China truly sees SMEs as a critical pillar in its efforts to generate a more inclusive, domestic-focused economy, it will have to rethink its current policy toward shadow banking. Beijing must move away from the heavy-handed approach of pushing institutions out of the market and instead formulate a more nuanced strategy that focuses on mitigating credit risk while ensuring SMEs maintain vital access to lending partners.

Artmotion China

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