4 Triggers That Could Cause A Meltdown In China's Enormous Shadow Banking System

China will release official reports on several economic indicators tonight. Chinese growth is slowing and fears of a hard landing for the Chinese economy are resurfacing.

Major undercurrents in China's financial system make a hard landing a real possibility. The shadow banking system, which is comprised of non-bank institutions that lend to high-risk borrowers, has the ability to send serious shockwaves through China if it collapses. This is partly due to its sheer size – at an estimated 14.5 trillion renminbi in outstanding loans, the shadow banking system in China is around 25 percent of all renminbi-denominated loans in the entire Chinese banking system.

BofA China strategist David Cui wrote recently in a note to clients that the risks emanating from the shadow banking system in China could be even bigger than that when you account for how the shadow banking system actually works:

Another issue we need to take into account is money velocity. Given that loans in the underground lending market often last only for days or weeks, it’s reasonable to assume that some of the shadow money may have a much higher velocity than commercial loans. As a result, the relative size of banks and shadow banks may underestimate the latter’s impact on the economy.

In other words, that credit is being recycled through the system at a much higher rate than loans on the books of traditional banks, which is part of its importance to the overall flow of credit in the Chinese economy.

Referring to the shadow banking system, Cui writes that "the risk of bad debt experience in this market over the next 12-18 months" is high, and that "if it materialises, the fallout could be severe."

Here are four triggers that Cui thinks could cause a full-blown run on the shadow banking system in China:

    (Illegal) Ponzi schemes falling apart: Cui notes that this has already started happening, writing that "since mid 2011, there are at least 14 reported cases of Rmb500mn+ Ponzi schemes gone bust, with eight occurring so far this year."
    A wave of defaults in highly-leveraged loans: Shadow banking entities make money by borrowing from the banking system at low interest rates and lending out at high interest rates to high-risk borrowers. Since most entities don't also take deposits to back these loans, what you have, according to Cui, is a "thin capital base [that] can be wiped out fairly quickly" when "loan demand starts to weaken and their investments (loans) go bad."
    More turbulence in the Chinese property market: Many of the borrowers from the shadow banking system, according to Cui, are "low-tier developers who have limited access to the official loan market." And the collateral being pledged against most of the loans from shadow banking entities: "probably property." So, if property prices tumble, that collateral quickly becomes worthless and causes loans to default.
    Shrinking corporate sector earnings: A host of Chinese financial products have guaranteed high returns lately due to high inflation rates. However, with the real economy weakening in China as demand disappears, profits are decreasing. Essentially, if earnings in the real economy can't support the investment returns that the shadow banking system has promised to investors, Cui says that "the divergence may become unsustainable, resulting in significant bad debts in the shadow system.

Cui's bottom line: "Many of the potential bad debts in the shadow banking sector may ultimately end up on banks’ balance sheet." And with worries over slowing growth in China as the crisis in Europe deepens and Europeans import less Chinese goods, a banking crisis is the last thing the Chinese economy needs.