‘One System, Two Shadows’: A local public finance perspective on China's shadow banking system

Why does shadow banking persist in China despite repeated policy efforts to contain it? While studies of informal finance have traditionally emphasized the credit needs of private businesses as a demand-side explanation, this study contends that China's local public finance also constitutes an important driver for shadow banking. Based on document research and administrative data, we find that China's shadow banking system has bifurcated into two segments since the Global Financial Crisis (GFC). One is the ‘entrepreneurial shadow’ that has long provided informal credit to the private sector, especially small- and medium-sized enterprises. The other is a ‘fiscal shadow’, which serves property developers and local government financing vehicles (LGFVs), the two pillars of China's land-based local public finance regime. Property developers are major contributors to local fiscal revenues through the land economy, while LGFVs function as off-balance sheet backdoor financing intermediaries for local governments.

Although localities have borrowed from unconventional sources throughout the reform era, the central government's GFC stimulus plan marked a turning point by fueling a debt-financed real estate and infrastructure construction boom. Property developers and LGFVs were launched onto a highly leveraged model of feverish expansion for over a decade. When the central government abruptly reversed its course by restricting the availability of formal credit, they became further entangled into the fiscal shadow for refinancing. Local public finance has thus become reliant on shadow banking, despite subsequent policy efforts to curb such activity. Our findings suggest the need for a more integrated analytic and regulatory framework that recognizes the mutual dependence between shadow banking and local debt – two major sources of systemic financial risks in China.