What Ponzi scheme? The risks of China's shadow banking system are manageable.

• Author: Lo, Chi

China's shadow banking system (or underground finance) has been a key funding source for the debt-ridden local government sector in recent years. This has the potential to set off a systemic problem because the official banking sector has a large exposure to shadow banking activity. Due to these concerns and the fact that China's total credit has approached 200 percent of GDR Fitch Ratings downgraded China's long-term local currency debt rating by one notch to A-plus (from AA-minus) in April 2013. Shortly after the downgrade, a top Chinese auditor (Zhang Ke of ShineWing Certified Public Accountants) joined the chorus in warning about a potential debt crisis in China.

Rapid debt build-up and shadow banks are indeed potential problems. However, some of the pessimistic arguments are misplaced, and evidence shows that the scale is not yet alarming in China. Most analysts focus on the total size of China's shadow banking system. They assume that all the underlying assets are equally high risk and conclude that China has an impending financial crisis. This is an exaggeration. A clarification is needed.

COMPARING APPLES TO ORANGES

It is important to note that the widely cited estimation of China's 200 percent credit-to-GDP ratio (and hence the argument that this would lead to financial implosion soon) is not comparing apples to apples. This is credit-to-GDP that the market is talking about, even in Fitch's own language, not debt-to-GDR This 200 percent credit-to-GDP ratio of China's includes everything from bank credit, capital market activity (that is, bond issuance), and shadow banking activities.

When broken down, China's public debt (including local governments) is about 60 percent of GDP, and China has very little household debt (personal loans, including mortgage debt, account for less than 20 percent of total banking assets in the Chinese system). By contrast, U.S. public debt is 107 percent of GDP; its household debt is 85 percent of GDP. Famously, Japan's public debt is 245 percent of GDP, and household debt 65 percent of GDE The point is that lumping China's credit altogether into 200 percent of GDP and comparing it to the debt-to-GDP ratios of other economies is comparing apples to oranges.

Further, the claim that "China's credit is now twice as large as its GDP" misses the point. China has an underdeveloped capital market. Its corporate bond market is still non-existent; its equity market is not a mature funding channel. At this...