China's next financial crisis is lurking in the shadows...

of shadow banking.

It's like China stacked up 9 trillion dollars...

on the edge of a cliff.

Hi, welcome to China Uncensored.

I'm Matt Gnaizda.

I'm in today for Chris Chappell,

who's on vacation,

possibly in the South China Sea.

Today, we're going to talk about shadow banking.

It's like the evil twin of regular banking.

Shadow banking involves lots of money,

and lots of risk.

And it's tied to China's crazy investment boom.

China's economic boom

and its reliance on shadow banking

is similar in some ways

to the US economic boom in 2007.

Remember:

A lot of great things happened in 2007.

Apple released the iPhone 1.

The last Harry Potter book was published...

which Chris still has not read.

And the US economy had its last...good...year.

Because then this happened.

“Stocks all around the world are tanking

because of the crisis on Wall Street.”

“The stock market is now down 21%”

“We have armageddon.

In the fixed income markets we have armageddon.”

“No, but...”

“We have armageddon.”

“Armageddon”—thanks Jim Cramer—

happened after the failure

of a single investment bank had a domino effect

on the entire global financial system.

Trillions of dollars were lost,

and so were millions of jobs.

Well, it's been ten years since then.

These guys have recovered,

but these guys...not so much.

But now, this same kind of

boom and crash could happen in China—

and for the same reason.

As Bloomberg puts it,

China is playing a 9 trillion dollar game of chicken

called Shadow Banking.

And like a game of chicken,

some investors will get out in time.

But others will plunge off the cliff,

bursting into a ball of flames on the rocks below.

So what is this totally legit

and trustworthy sounding “shadow banking”?

To put it simply,

shadow banking is when banks—

or companies that are not banks—

lend money outside of the normal structure

of bank deposits and loans.

Here's a simplified explanation.

In the traditional banking system,

if a business owner wants to grow his business,

he goes to a bank, and that bank loans him money.

Over time,

he repays that money to the bank,

plus interest.

Let's say a single bank makes 100 loans.

It's pretty careful about who it loans to.

But even so,

some of the businesses will fail,

so Chinese regulations require

that the bank set aside money

to cover potential losses.

But shadow banking operates

outside that traditional system.

Let's say 100 businesses want loans.

A shadow bank packages those 100 potential loans

into what's called a Wealth Management Product.

Then it goes to investors and is like,

“Hey, buy our Wealth Management Product.

It has a high interest rate.”

When the businesses repay,

the investors will get their investment back

plus a lot of interest.

This is shadow banking.

It can also get more complicated.

Because sometimes the bank isn't a bank,

but just a regular company

that packages investments.

And sometimes the businesses

that want to borrow money

aren't regular businesses.

They might even be a local government

that wants money to build a bridge or whatever.

All these things can be packaged

into Wealth Management Products,

or other types of financial products,

and then sold to investors—

or sold to investment companies,

which then re-package them

before selling to individual investors.

A lot of times,

shadow bank loans get so complicated

that no one understands

exactly what the risk is.

According to this article,

“The repackaging of credit is so complex

that bankers often have to resort to

line drawings that look like schematic plans

for a Rube Goldberg device

to explain to clients what's going on.”

A Rube Goldberg device.

Like when you pull a lever,

that sets a wheel in motion,

that knocks down some dominoes,

that ends up destroying the economy.

But all this shadow banking

and Wealth Management whatevers

are so complicated!

Investors don't want to know details!

That's why companies involved in shadow banking

put out feel-good ads like this:

“Everyone holds sunshine at their hearts

Everbright your life

China Everbright Bank”

See?

Give us your money,

and you'll have sunshine in your heart!

That bank, Everbright,

is actually a legit commercial bank.

It makes regular loans, too.

But recently it's also been selling

a lot of shadow banking products to investors,

because that allows Everbright

to maximize profit without putting

so much of its own money on the line.

Basically, it sells the risk to investors.

But a lot of Chinese investors

don't think risk matters that much,

because the Chinese government will probably

bail everyone out if things go badly.

Like this investor in this Bloomberg article,

who explains that the Chinese government

would never let a big wealth management product fail,

because it's just not Chinese culture.

Sounds like wishful thinking, right?

But the Chinese government has

bailed out banks in the past.

Like the $45 billion dollar bailout in 2004.

So assuming they'll do it again seems reasonable.

Although if you've ever read the terms and conditions

on any investment product ever,

you've seen that “past performance

is no guarantee of future results.”

Sure, the Chinese government may have done

a small 45 billion dollar bailout in the past.

But it doesn't want to do a 9 trillion dollar bailout now.

Besides, back then,

there was almost no shadow banking in China.

It only started happening on a large scale

after the global financial crisis ten years ago.

Authorities tried to stimulate China's economy

by having banks lend more money.

But soon, demand for borrowing got so high

that banks didn't have enough money to lend people.

So banks started packaging loans

and selling them to investors to get the cash.

And it became such a big market,

other companies that aren't even banks

got into the game.

According to a 2016 report,

shadow bank loans now make up

57 percent all loans in China.

In other words,

more than half of all lending in China now

is actually done through shadow banking!

And this is a big problem

because shadow bank loans are usually

a lot riskier than traditional loans.

Once companies start packaging and repackaging,

it's easy to lose track of what the risk actually is.

It even starts to seem like a good idea,

like jumping out of a plane without a parachute.

The problem is,

it only works if you're you're Keanu Reeves, dude.

Oh, and there's another problem.

Shadow banking loans don't get recorded

on banks' balance sheets.

That makes banks look

healthier than they actually are—

and that also increases the risk.

And guess what?

That's exactly what happened in the US

leading up to the 2007 crisis.

Banks had been packaging

and repackaging home loans,

then selling and reselling the packages,

and eventually even the nerds at Lehman Brothers

had no idea how to calculate the risk anymore.

Shadow banking in the US was the lever

that set the global financial crisis in motion,

and ironically, its domino effect

is what led to the rise of

shadow banking in China.

And now Chinese authorities are getting worried

about what's coming next.

In fact,

“Zhou Xiaochuan, the head of China's central bank

has openly warned that authorities

need to curb financial risks

that might lead to a 'Minsky Moment'—

a sudden collapse of asset prices,

sparked by debt or currency pressures,

after a long period of growth.”

Basically, bad debt in shadow banking

could end up wrecking the Chinese economy.

And if the Chinese economy gets wrecked,

it could lead to serious consequences

for the Chinese Communist Party.

You know, because no one

believes in that communism stuff anymore,

so they tell people to go make money

and don't talk about politics.

But if people start losing their money

on a massive scale,

people might start talking about politics again—

like who's to blame.

That's why, at a top level conference in July,

Xi Jinping declared that financial security

was vital to national security.

“National security” is of course code for the CCP

securing its power over the nation.

But it's not 2007 anymore.

It's 2018.

We have iPhone 10s,

Johnny Depp is a Harry Potter villain,

and Chinese shadow banking has swelled

to more than $9 trillion.

The Chinese government can't afford

to bail everyone out

when things go south.

They're trying to rein in shadow banking.

But once you let the tiger out of the cage,

well, it...

I guess it runs around and eats people.

So what do you think of China's shadow banking?

Leave your comments below.

Once again I'm Matt Gnaizda.

Now it's time for that thing we do at the end.

You're still here?

Good.

Don't worry,

I haven't taken over China Uncensored.

Chris will be back soon.

In the meantime,

if you like this show,

we hope you can click on this orange button

and support us by pledging

a dollar or more per episode.

We'll invest it in a Chinese wealth management product.

Click to go to our fundraising website Patreon.