China's financial system is increasingly at risk from the growth of domestic shadow banking, impulsive local government financing vehicles (LGFV) and non-performing commercial bank assets. We need to be alert to the situation, pay more attention to Western quantitative easing monetary policies and be prepared for possible changes.

Research indicates that China's shadow banking sector has total assets of 30 trillion yuan (USD $18.6 trillion). Statistics released by China's central bank show that bank loans soared by 8.2 trillion yuan (USD $1.32 trillion) nationwide in 2012, the second highest increase in recorded history; social financing came in at a record-high 15.7 trillion yuan (USD $2.52 trillion). The ratio of bank loans compared to social financing has plummeted from 92 percent in 2002 to 52 percent in 2012. Domestic trust assets have increased sharply from 1 trillion yuan (USD $160 billion) in 2007 to nearly 7 trillion yuan (USD $1.13 trillion) last year.

China's regulatory authorities suspended operations between trusts and the banking sector last August in a response to the risks posed by shadow banking. But cooperation between securities and banking sectors was in full swing during the second half of 2012. The total value of wealth management products held by stock brokers rose from 300 billion yuan (USD $48.2 billion) in 2011 to almost 1 trillion yuan (USD$ 160 billion) in 2012. It is cause for worry that many Chinese people think that shadow banking is a simple economic activity that operates outside the financial system. The truth is that shadow banks function as banks without the framework and regulations of traditional banks.

Shadow banking includes entities such as hedge funds, private equity funds, money market funds, bond insurers, structured investment vehicles, as well as non-bank financial institutions like trusts, micro-credit companies and wealth management firms.

The essence of shadow banking can be viewed as a financial intermediary outside the traditional banking system. Therefore shadow banking may also cover non-banking credit behaviors between financial systems and the real economy, non-banking credit behaviors between banks and non-banking financial institutions, and off-balance sheet activities within the banking system itself. All represent a serious financial risk to China.

A primary risk factor showcasing China's financial vulnerability is that parties involved in shadow banking transactions all expect to be the primary benefactor in excessive credit expansion. The simple fact is many investors know little about finance and financial products. Combined with an incomplete supervision and regulatory body, investments made by impulsive local government financing vehicles and non-performing loans increase risk.

Chinese financial supervisors and institutions base financial risk on two preconditions: increasing real estate value and an appreciating Renminbi. Both of these assumptions are based on an optimistic mindset, and are full of uncertainty.

The risks hidden in China's domestic financial system will remain unseen unless housing prices drop. Regulatory authorities cite historical and current statistics claiming risk is at a manageable level, which can only be disproven with a decline in real estate value. If Western countries discontinued ongoing quantitative easing monetary policies, the RMB's international exchange rate would be adjusted accordingly. The following deprecation of the RMB would likely start a chain reaction that would burst China's real estate bubble, accelerate foreign capital outflows and cause asset prices to slide.

Also of particular note is the incorrect conclusion that domestic financial risks are at manageable levels, as published by banks and other financial institutions. If these statistics are not accurate, or even slightly inflated, domestic financial risk is even more severe than many believe.

Systematic risks for any financial system are unpredictable. Crisis only occurs when unseen risk reaches a threshold point. We must monitor the previously mentioned preconditions and be fully prepared to react to any risk that endangers our financial system.

The author is a columnist with China.org.cn. For more information please visit:

http://china.org.cn/opinion/yixianrong.htm

(This article was first published in Chinese and translated by Fan Junmei.)

Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.