SHANGHAI (Reuters) - China’s campaign to cut high debt levels in its economy is aiming this year to shrink the $3 trillion shadow banking sector, which could drain a critical source of income for the country’s banks and of funding for its fragile bond market.

Shadow banking, a term for financial agents that perform bank-like activity but are not regulated as banks, has boomed in China, the world’s second-largest economy, as a way of circumventing government’s tight controls on lending.

It has been a key driver of the breakneck growth in debt in the economy, which UBS says rose to 277 percent of GDP from 254 percent in 2016, and is now a target as Beijing tries to reduce that figure before it destabilizes the economy.

But with banks’ shadow banking business accounting for about a fifth of total outstanding loans, analysts fear that the unintended consequences of government efforts could trigger the fate it seeks to avoid.

“We see a policy-induced drastic deleveraging in shadow banking as a policy miscalculation that could trigger unexpected tail risks for the banking sector,” said Liao Qiang, credit analyst at S&P Global Ratings.

Investors’ concerns stem from new rules this month that put lenders’ wealth management products (WMPs), the biggest component of shadow banking, under the scrutiny of the People’s Bank of China (PBOC) for the first time and into its calculations on prudence, capital adequacy and loan growth guidelines.

According to the latest official data, WMPs jumped 42 percent year-on-year to 26 trillion yuan ($3.8 trillion) at the end of June, doubling in just two years.

WMPs are typically kept off banks’ balance sheets, making it difficult for regulators to assess the stability of a banking sector reliant upon them for growth.

And just as in the global financial crisis of 2008, banks’ interconnectedness amplifies the risks. Banks are increasingly buying into each other’s WMPs, such that interbank WMPs hit 4 trillion yuan in June, a doubling from two years ago.

Banking regulators are also seeking new rules that will require lenders to set aside adequate capital to absorb potential losses from WMPs.

The PBOC and China Banking Regulatory Commission have yet to respond to requests for comment.

VICIOUS CYCLE

Banks lure investors to WMPs with the promise of much higher returns than on bank deposits, then channel the cash into high-yielding bonds or other forms of disguised lending to sectors such as property on which there are official lending limits.

The specter of tighter monetary policy has already halted a three-year long rally in China bonds, and investors worry that the new WMP regulations could tip the bond market into crisis.

“Financial institutions, via WMPs, have invested a lot of money into credit products,” said Gu Weiyong, chief investment officer at Ucom Investment Co, a bond-focused fund house in Shanghai, and he said they don’t necessarily have sufficient capital to support those investments.

“It’s very possible that another scandal could erupt, maybe in the first half,” he said.

It is barely a month since Beijing tightened the rules on WMPs as part of a broader policy thrust at preventing price bubbles and reducing industrial overcapacity.

Bond prices have since fallen, sales of WMPs have slowed and money market mutual funds, also used by WMPs, are losing cash.

At the end of June, 41 percent of China’s 26 trillion yuan of WMPs was in bonds, with 16 percent in money market instruments.

Data from consultancy CNBenefit showed that Chinese banks sold 24,460 WMPs last quarter, compared with 25,980 the previous quarter, while money market funds shrank to 3.9 trillion yuan at end-November, the lowest in a year, from 4.2 trillion yuan in October, according to data from the Asset Management Association of China.

In addition, a year-end bond market rout wiped out all the gains this year in bond mutual funds, resulting in a combined loss of 21.6 billion yuan, according to the official Xinhua agency, raising the specter of losses in bond-linked WMPs.

“The big issue for financial stability in China is a combination of very high asset prices and also extremely high leverage,” said David Cui, analyst at Bank of America Merrill Lynch.

“The problem of this combination is that any drop in asset prices can quickly develop into a vicious selling circle,” Cui said, with falling bond prices leading to WMP losses, then to lower WMP sales, and back to more pressure on bonds.

For graphic on China's WMPs, click here