BEIJING China must speed up market-based financial reforms to contain wild growth in shadow financing as well as the mounting risks stemming from the sector, a government think tank said in a report on Monday.
Shadow banking traditionally includes activities such as pawnbroking and peer-to-peer lending but now embraces vast off-balance sheet guarantees and loans in the banking system.
China needs a more liberalized interest rate regime and a unified bond market to prevent borrowers and investors from rushing to the opaque shadow banking system for new funding and higher returns, said the report made by the Chinese Academy of Social Sciences (CASS), a top government think tank.
"Chinese government must step up a series of financial reforms in the near future to crimp the incentives for the blind and explosive expansion of shadow banking system," said Zhang Ming, a researcher at CASS.
China had made the initial effort last June to ease its grip on bank deposit and lending rates, but there are rising calls for a more liberalized interest rate to fully reflect market forces.
Meanwhile, China's bond market is fragmented into three parts due to rivalry among ministerial bodies, which has reduced the financing efficiency of the regular capital market and led to swelling shadow banking activities.
The report said there is no evidence of a looming systemic risks in the shadow banking system, as the structures of those finance products are relatively simple and the leverage ratio being involved remains at a low level.
"So far, only some trust products show the premature shape of securitization and China's shadow financing is much less complicated compared to the western countries," Zhang added.
But it added that liquidity and default risks are indeed building up in the sector due to maturity mismatch between long-term assets of borrowers and short-term funding from investors.
Chinese banks and other financial institutions tend to sell short-term finance products to provide funding for longer-term projects, such as infrastructure and property assets, leaving issuers to sell new products to roll over the debt and increase delinquency risks, analysts said.
China's shadow credit channels have ballooned over the past years, in part for banks to skirt around lending rules and for investors to seek higher returns for their savings, with much of them going to regulator's unwanted sectors, such as local government financing vehicles and property developers.
The fast growth has fueled concern that some products may have been spun off from risky investments.
Despite the downside risks to the entire financial sector, the report also affirmed the positive role played by shadow banking system in supporting the growth of real economy, as it provides funding for cash-strapped smaller firms and upstart enterprises that banks usually try to avoid.
Li Yang, the vice president of CASS also said in a seminar last week that such a positive effect determined regulator's attitude to help guide a healthier development of shadow financing rather than to stifle it.
"The regulators' intention is to better govern the shadow banking system to enable it serve the real economy well but not to kill it," he added.
China's banking watchdog has unveiled a series of measures to improve supervision on the sprawling shadow banking system, including finance products sold through banks.
Global rating agencies have also warned of growing risks in the sector, considering the fast expansion and lack of transparency.
Ratings agency S&P estimated that outstanding Chinese shadow banking credit totaled $3.7 trillion by the end of 2012, equal to 34 percent of on-balance-sheet loans and 44 percent of GDP.
Fitch has cut China's long-term local currency credit rating to A-plus from AA-minus, citing risks from the rapid expansion of shadow banking activities.
(Reporting by Aileen Wang; editing by Ron Askew)