
China’s economy is straining to keep up a semblance of its former growth rate. The surest sign is the way a shadow market in bank paper has evolved to substitute the commodity that China is increasingly running short of: cash.

Bankers are passing around their own ersatz currency, stimulating trade with what, in effect, are off-the-books loans. As in the wildcat currency era of the United States, the antebellum period before America had a national currency, this paper trades at a discount from province to province. It is increasingly used for speculative purposes, is potentially inflationary, and is hard to regulate. The People’s Bank of China (PBOC) has been unable or unwilling to crack down, lest it provoke a serious slowdown. But when the world’s second largest economy must resort to passing around IOUs, the financial community should take note.

Bankers acceptance notes (BANs) are nothing more than a post-dated check with a bank guarantee. For example, a buyer in Chongqing might have a hard time passing checks to vendors in Shanghai. But if the purchaser gets his paper signed by, say, Bank of China, his check now has the guarantee of a major financial institution: it is money good. BANs facilitate trade by obviating the need for vendors to assess the creditworthiness of purchasers. But in China, this prosaic instrument of commerce has become a kind of shadow currency that allows under-reserved banks to purchase deposits, fuels speculation, and undermines the central bank’s control over the money supply.

“From the bank’s point of view, Banker’s Acceptance Notes are all about getting deposits,” explains a banker in Zhengzhou. In a typical transaction, a customer with cash in his pocket can put down 100 RMB as a security deposit and walk away with double that amount in BANs. The bank is pleased because it receives hard currency in return for its own funny money. The customer is delighted: he has turned 100 RMB in cash into 200 RMB in something almost as good. In effect, the bank has given the customer a 200 RMB loan without using a cent of cash.

The transaction harkens back to U.S. banking in the era before fiat currency, when banks used their own banknotes to purchase reserves of everything from gold bullion to national bank notes, British pounds, and bushels of wheat. Chinese banks print their own scrip to purchase “reserves” of cash, i.e., deposits. If the bank paper is accepted, it functions as currency and banks get to hold onto their reserves. But if people worry about the bank’s credit, or need cash (perhaps during a crisis) the bank will be forced to redeem its paper, possibly in a hurry.

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In theory, all BANs are issued to support trade. When a customer is issued BANs, he must show proof of an underlying transaction. And to the extent the notes truly are backed by trade – by televisions shipments to Chongqing, say, or refrigerator exports to Seattle – there is very little risk. The notes get paid down as transactions are settled, and the bank need not worry about them. But to the extent BANs are not used for trade – to the extent they are merely rolled over and circulate as a secondary currency – they represent a constant, outstanding bank liability to high-risk industries.

“The truth is, most BANs are not used to support real transactions,” says a grinning shadow banker in Shenzhen. His company is one of many Chinese conglomerates whose business tentacles seem to span every industry from mining to tourism. But nearly half of its transactions are unprofitable: they are formalities, conducted solely for the purpose of acquiring BANs. “BANs are supposed to be issued only to support trade. But the rules are very flexible, and there are ways around them,” he continues. For example, trading partners can coordinate so that transactions net out. Party A sells Party B 100 RMB of widgets and Party B sells Party A 100 RMB of widgets. They both walk away with the same widgets they started with, and an extra 100 RMB of BANs each. As if by magic, the transaction has generated 200 RMB of highly liquid, bank-guaranteed financial assets.

BANs without underlying trade are used to finance speculation. Shadow bankers sell the BANs at a discount of about 5 percent – a process known as “discounting” – in return for cash. The seller of the note needs walking-around cash and is willing to dump his paper at a loss. After all, the seller is likely a speculator. He only loses 5 percent on the sale of the BAN, but his cash is invested in trust products or lent into the grey market at yields well in excess of 10 percent. The buyer of the note is likely to be a grey market BAN broker. As far as he’s concerned, he’s earning a risk free 5 percent by purchasing bank-guaranteed paper at a discount. In other words, a piece of paper – an IOU – is being passed around on which first a speculator and then a bank gives a guarantee. In this way, credit flows from the banks through shadow bankers and into property and other high-yield, high-risk industries such as mining or infrastructure. What looks to a banker like a purchase of televisions or washing machines in Shanghai could easily end up financing condominiums in Jiangsu or rolling over coal debt in Inner Mongolia. Most worrisome is that banks account for BANs as guarantees; guarantees are obligations that, a la Fannie-Mae, do not appear on a balance sheet.


The banks find the off-balance sheet accounting treatment of BANs particularly useful. Onerous statutory requirements force Chinese banks to keep a loan to deposit ratio (LDR) of 75 percent or less. BAN issuance simultaneously decreases loan balances while increasing deposits; it relieves LDR pressure on both sides of the vinculum. Of course, the change in LDR is a purely cosmetic change: the risk – and leverage – in the bank is just as high as if it had extended a plain vanilla loan, but the leverage is moved off balance sheet. Hence, to the extent BANs are used for speculation, they represent bank exposure to high-risk activities that is invisible to regulators, investors and even bankers themselves.

Not surprisingly, China’s local governments, themselves heavily involved in project and commercial finance, have become a huge market for BANs. Since 2008, local governments across China have been diligently at work on grand infrastructure and “urbanization” projects, of which ensuring an adequate supply of ghost cities seems to rank highest in priority. In the process, local government financing vehicles (LGFVs), the corporate subsidiaries that local governments use to fund infrastructure projects, have racked up an estimated 19 trillion RMB in debt according to the National Audit Office. Because LGFV investment has been so unremunerative – ghost inhabitants don’t pay taxes – the fiscal burden on local governments is crushing. For cities and counties that are short of cash, there is scarcely a more appealing solution to printing their own.

“There is a risk of banks and LGFVs colluding to fake security deposits and print BANs with no underlying trade,” warns a Ministry of Finance discussion document. Local governments up to their eyeballs in debt have the advantage of control – often of ownership – of banks within their territories, and can order up BANS at will. LGFVs turn to sister banks as a makeshift printing press, printing pseudo-currency virtually on demand. LGFVs use BANs to pay suppliers and obscure the truth about their overburdened balance sheets. A jaded banker in Tianjin complains, “When a borrower uses a BAN, they are supposed to record it on their balance sheet as a liability. But it’s kind of an unspoken rule that they don’t. To be honest, a lot of people see this is a major advantage of using BANs; they can pretend they have lower debt than they really do.” And the LGFVs never have to worry about principal repayments because banks are happy to roll over BANs as they come due. In short, LGFVs have nearly unrestricted access to notes that allow them to make payments, do not get recorded as debt, and never have to be paid down – i.e., their very own money.

Local governments printing their own money has led to a partial fracturing of the monetary system. A BAN issued by a local bank is likely to be accepted within its province, but its credit might not be honored – or honored only at a punitive discount – across provincial borders. An employee at an LGFV in Jiangsu engaged in contract work for infrastructure projects said his company routinely accepts BANs from Jiangsu banks. However, it refuses scrip from neighboring Anhui; out-of-province banks must pay in cash.

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“A lot of smaller, local banks print more BANs than their balance sheet can support; in fact the reason they print BANs in the first place is because they don’t have the cash to make loans,” explains a banker at the Zhuhai branch of a major commercial bank, “Their BANs won’t be accepted outside of that province. It’s kind of like in international currency markets. The U.S. dollar is accepted in every country as the reserve currency. Similarly, RMB are accepted anywhere in China. But provincial BANs can only be used within their native province.” It’s almost as if the non-consumer part of the Chinese economy had reverted to the 1930s, when each province issued its own legal tender.

It is impossible to estimate how much of China’s outstanding BANs were issued to LGFVs, but it is meaningful enough for the Guangdong Audit Bureau to list BANs as a new financing channel available to local governments. If China is to maintain a coherent fiscal and monetary regime, sooner or later its LGFV debt will have to be digested, either by paying it or writing it down. When regulators attempt to do so, they will find the National Audit Office’s estimate of 19 trillion RMB in LGFV debt understated, in part owing to BANs issued to LGFVs.

According to the People’s Bank of China, almost nine trillion RMB of BANs are circulating in an economy with a monetary base of 107 trillion RMB. This huge economic underground is a measure of the extent to which highly speculative investment is outpacing the ability of Chinese banks to finance through deposits. If LGFVs and property developers had sufficient cash flows they would not need to resort to BAN funding. If returns on invested capital were sufficient, banks would see their deposits grow organically and not be reduced to purchasing RMB with this strange breed of banknote. These notes may behave like money, but their use is constricted; they cannot be used to purchase groceries or pay wages and will never be acceptable internationally. The BAN economy is thus separate, unable to be integrated with the rest of China’s economy. How long can it be sustained?

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Matthew Lowenstein is an Analyst at J Capital Research.