China's shadow banking system, a key alternative funding source for companies with relatively weak credit profiles, will likely continue to shrink as even the nonbank lenders get cautious amid economic weakness and ongoing trade tensions between Beijing and Washington, analysts say.

Disruptions triggered by the novel coronavirus have raised the risk of default, especially by weaker companies, and the government has only slightly loosened its grip on shadow banks as they are still seen as a source of financial risk that could have a systemic impact.

In May, core shadow banking assets, which include outstanding entrusted loans, trust loans and undiscounted bankers' acceptances, totaled 22.17 trillion yuan, down 6.7% from a year earlier, according to data from the People's Bank of China. May's year-over-year contraction rate, however, was the slowest since September 2018, when core shadow banking assets shrank 6.3% from a year earlier.

"The still relatively slow improvement in shadow banking activity indicates that credit is not moving fast enough to [small and medium-sized enterprises] and the real economy," Rory Green, China economist at TS Lombard, told S&P Global Market Intelligence.

As China posted the biggest economic contraction on record in the first quarter, the shadow banking system has become a lifeline to cash-strapped businesses that do not qualify for direct bank loans. However, Beijing has so far unwound very few measures that were put in place in 2017 and 2018 to contain the financial risk of the once fast-growing nonbank lenders, especially following high-profile defaults of trust companies such as Anxin Trust Co. Ltd.

Shrinking trusts

Among the core shadow banking activities, trust loans have been declining more quickly since the beginning of 2020, while entrusted loans and undiscounted bankers' acceptances have contracted more slowly in recent months.

In May, trust loans declined 6.1% to 7.4 trillion yuan from a year earlier, the biggest drop since the 7.5% year-over-year fall in May 2019. Meanwhile, entrusted loans shrank 5.8% in May from a year earlier, the lowest since July 2018, and undiscounted bankers' acceptances dropped 10.2%, the least since January 2019.

"The shadow banking sector has a substantial portion of real estate and [local government financing vehicle] financing, there are stricter macro level financing policy restrictions on both these sectors. The trust sector has more explicit caps on real estate financing," said Harry Hu, an analyst at S&P Global Ratings.

The China Banking and Insurance Regulatory Commission had told some trust companies to stop financing property developers that did not have all necessary licenses or met requirements on shareholders and capital, Caixin reported in July 2019. Leading trust companies, such as China Everbright Trust, canceled trust products that planned to raise funds for property investments, the report said.

Green said the need for local government financing vehicles to tap into shadow banking sources was reduced due to large local government bond quotas and issuance over April and May.

China's premier, Li Keqiang, said in May that local governments plan to issue bonds totaling 3.75 trillion yuan in 2020, of which the central government will aim to subscribe to 600 billion yuan. The target amount is 1.6 trillion yuan more than in 2019, he said. The funds will be used to finance projects for infrastructure, new-generation telecommunications, 5G networks, electric cars and battery-charging stations for them.

"I expect the trend to continue until the fourth quarter of 2020 when local government bond quotas are exhausted and firms will need to increasingly turn to trust financing," Green said.

Limited easing

Beijing has modestly loosened its grip on shadow banking activities, on which the real estate sector and local government financing vehicles that in turn fund local infrastructure projects had relied heavily. Major easing measures include postponing the execution of more stringent rules on asset management by one year to 2021.

In response to the liquidity stress for small and private businesses, the government has also cut banks' reserve requirement ratios since the start of 2018, urged them to increase lending to small businesses at lower interest rates, and introduced a loan prime rate mechanism last year to reduce funding costs.

Although bank lending has increased and funding costs have fallen in recent months, many lenders are still reluctant to heed the government's call to fund small and private businesses more aggressively.

"The funding cost cuts and the passing on of lower rates to the real economy is largely carried out by the banking sector. Associated initiatives such as [medium-term lending facility] rates and [required reserve ratio] cuts are most applicable to banks," said Hu from S&P Global Ratings. "I believe this trend will continue."

For the first five months of 2020, outstanding domestic bank loans rose 13.2% from the same period in 2019, according to the central bank.

"Forced lending to less-creditworthy borrowers will inevitably cause a spike in nonperforming loans one to two years ahead," Green added.

As of July 6, US$1 was equivalent to 7.02 Chinese yuan.