China Relies on ‘Shadow Banks’ for Economic Growth. That’s Not a Recipe for Stability. | Big Think

For many years, financial markets have been regulated in terms of the amount of interest that can be charged on loans and the types of securities that can be offered by different entities. Whether loans have collateral or not, all of those things are heavily regulated in China. This has led to what's called a shadow banking system, where there are billions and billions of dollars being lent out through non-bank institutions to make business possible where the supply of regulated credit is insufficient.

China wants to regularize this shadow banking industry. It wants to bring it into the formal sector, but to do that, they're going to have to slowly start to liberalize these other regulations that have been constraining that sector. This could be quite a disruptive process because every time they liberalize one of the asset classes—a certain type of loan or security—all of the returns on that asset class will change, and there will be shifts in where credit is available in the market.

This is part of their overall economic reform plan. It's part of what they're seeking to do to open up their capital markets further, to make their currency a convertible currency that can be used freely in international markets and move across its borders freely. But it's going to take time, and it will have disruptions along the way.