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China haunted by ghost inventory, shadow banks

** FILE ** In this April 10, 2008 file photo, a bank clerk counts Chinese currency notes in Shenyang, in northeast China's Liaoning province. China promised Wednesday, Feb. 18, 2009 to keep its exchange rate stable and said it will use part of its $1.95 trillion in foreign reserves to boost imports and consumer spending to combat the global financial crisis. (AP Photo/File) ** CHINA OUT ** AP

(MoneyWatch) As China's economy slows, the country is also dealing with another impediment to growth -- investors and lenders that obtain loans through the country's unofficial banking system are getting scammed.

This "shadow banking" system in China involves state-sanctioned financial institutions, along with individuals, that loan out or manage money. Shadow banking is prevalent in China because more than 90 percent of the nation's 42 million small businesses are unable to get bank loans, while such investments offer returns at least several times higher than deposits, according to Bloomberg.

According to the People's Bank of China, what it calls the "social financing" system accounted for at least $1.18 trillion in loans last year, or about four times the amount seen in 2002. But some experts say the market for such loans could be even larger, with the French bank Societe Generale pegging it at $2.4 trillion, or about one-third of China's official loan market.

Even China's own data say its economy is troubledChina's economy continues to slowChina warns of persistent economic problemsChina won't commit to eurozone aid

As Minxin Pei, a professor of government at Claremont McKenna College, recently explained:

Typically, the shadow banking system pushes something called "wealth management products," which are short-term financial products yielding a much higher rate than bank deposits for investors. To evade regulatory oversight, these products do not appear on a bank's balance sheet. According to Charlene Chu, a highly respected banking analyst for Fitch ratings, China had about $1.6 trillion in wealth management products, about 11.5 percent of the total bank deposits, at the end of June this year.

Many of those "wealth management products" were investments in China's real estate bubble. The collapse of that bubble has meant that money has vanished, destroying huge amounts of personal wealth. Chinese private-loan borrowers filed more than 600,000 lawsuits valued at $17 billion last year, a 38 percent increase over 2010. In the first six months of 2012, the number of suits rose 25 percent, according to People's Court, a newspaper run by China's Supreme Court.

It isn't only individuals who have been scammed. Several banks trying to seize stocks of steel used as collateral for defaulted loans are finding that the steel never existed. Chinese authorities are investigating a number of cases in which steel documented in transaction receipts turned out not to be real, belonged to another company or had been pledged as collateral to multiple lenders.

Meanwhile, steel prices are slumping because of China's faltering economy, making it hard for companies to keep up with payments on the $400 billion of debt they racked up during years of double-digit growth, Reuters reports.

Such ghost inventories are exacerbating the wider ailments of the Chinese steel industry. The business is now swamped with over 200 million metric tons of excess production capacity created during last decade's development boom.

One Shanghai trader told the wire service, "What we have seen so far is just the tip of the iceberg. The situation will get worse as poor demand, slumping prices and tight credit from banks create a domino effect on the industry."

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