In 2008, I came up with a concept that I refer to as the “speculative spread,” which states that if the relationship between shadow banking (non bank financing) and production (GDP), on the one hand, and financial deepening (M3, or currency, small and large deposits at banks, and money market funds) and production (GDP), on the other, gets too far out of whack in the wrong direction, the financial economy becomes unstable. I had performed the calculations on the United States and the eurozone during the crisis, finding that the U.S. had an unstable financial economy, while the eurozone, for all of its debt disasters, had a relatively stable financial economy, with the exception of the period just leading up to the crisis in 2007.
Recently, I performed the same task for China, and found that somewhere between the end of 2010 and the beginning of 2011, the “speculative spread,” or gap between total social financing (comprised to a large degree by non bank financing) to GDP (F/P) and M3 to GDP (D/P) had become positive. It has continued to open up since. This means that speculation is now outstripping normal finance, and there appears to be no end in sight to its growth.
Intuitively, China financial scholars believe something like this has been happening—China’s shadow banking sector is out of control. The fact that shadow banking is greater than M3 is worrisome; this means that there is more liquidity in, say, “trust loans” to questionable entities like local government financing vehicles, than in both currency and bank deposits, money stocks that we know are relatively stable.
China financial scholars are eminently aware that something grim lies ahead and many are hopeful that the Third Plenum this weekend will resolve some of the negative financial outlook. To me, it’s not obvious that the Third Plenum will automatically resolve China’s financial instability—it seems the only way to really overcome this unstable “speculative spread” is to specifically target the shadow banking sector to curb its activity. It has been noted that monetary tightening will lead to a slowdown in credit growth and GDP, but it may not have the effect of curbing the shadow banking sector as opposed to M3, and could even exacerbate the speculative spread. Therefore policy aimed directly at the shadow banking sector is a far better idea—it could eliminate the threat of financial instability at its root.
China financial scholars are right in fearing the financial instability inherent in China’s current composition of financial flows. As “sexy” as it may be to study illicit financial flows—particularly for those who profit off of them—this is something that should not be overlooked and presents a real threat to the Chinese economy.
Sara Hsu is an assistant professor of economics at the State University of New York at New Paltz.
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