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As China’s banks pull back, shadow finance fills the gap

China has started the year with a spring in its step. Its incoming leadership, headed by Xi Jinping, exudes an air of bold reform. Industry has expanded for three straight months. Economic output seems to be is rebounding – it is expected to recover to 8 per cent for the fourth quarter. The result: The Shanghai composite has gained one-sixth since the start of December.

Investors should not get ahead of themselves, however. There are risks lurking beneath that rosy surface. Consider the growth in shadow financing, a sign that funding for companies and indebted local governments is becoming increasingly short term and less stable. Total social financing, or total credit growth in addition to bank loans, increased by more than one-fifth last year. But the proportion of credit in the form of bank loans has been falling.

Meanwhile, financing from less mature sources – corporate bonds and trust loans – has been rising to account for more than a fifth of total credit, double the proportion of 2011. Short-term corporate loans as a percentage of the total are also on the up.

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This is a problem for China's wealthy retail investors. They have been stocking up on wealth management products – 2.5 trillion yuan (about $400-billion) worth have been issued so far, according to China Confidential – that provide liquidity to the corporate bond market and trusts. Banks, meanwhile, have been reducing their exposure. Perhaps they fear that as companies and local governments become stretched, defaults will surface.

Hundreds of investors were caught out by a default on a wealth management product at Huaxia Bank last month. If spooked investors flee, there is the risk of collateral damage across the shadow banking sector. And if banks are forced to cover losses, their contingent liabilities will rise. China's financial system is still walking a tightrope. There will be booms, but there is still the risk of busts. Reform? Yes please, Mr Xi.

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