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Shadow banking not so dark [Commentary]

The World Economic Forum in Davos, Switzerland gave us an excellent window into the concerns that world leaders have about the global economy — particularly China's shadow banking system. But while the concerns may be legitimate, the expressed fear — that China will implode from the weight of the system's problems — appears overblown.

Although ominous sounding, shadow banking exists in every country. In fact, the more thriving and capitalist a country's economy, the more thriving its shadow banking system typically is.

What exactly is it? It is the totality of financial entities that don't fall under direct bank regulation. So, for example, if you have ever held a money market mutual fund or used a mortgage broker, you have been a participant in the U.S. shadow banking system. Not necessarily frightening, is it?

Concern about China's shadow banking system is nothing new. The creation of an efficient financial industry there has been a difficult challenge at least since China embarked upon its unavoidably winding and bumpy capitalist road. It should not be surprising that China's shadow banking system, like the economy itself, will have its growing pains. Furthermore, in China, with rule of law still evolving, the road is bumpier still. Thus, quite uncharacteristically for me, I actually agree with the Davos intelligentsia up to this point.

However, my agreement does not extend to their conclusion, that the shadow banking system will destroy China, first taking down Asia with it and then the rest of the world. Even after making full allowance for probable hyperbole at such a media event as the World Economic Forum, I think the Davos grandees went too far. The worst of the possible outcomes can be ameliorated with simple openness and transparency, and I think the Chinese know this.

Market practitioners know that opacity and evasiveness about an economic problem make it far worse. That's a big no-no. Without open resources, the market has no chance to evaluate and discount the problem and therefore must assume the worst.

Concern about China's shadow banking system has some parallel with concerns about another topic discussed in Davos: Bitcoin. Bitcoin is a digital private market currency. It is not backed by the good faith and credit of the U.S. Treasury or of any other treasury. It is backed only by the trust that the market accords it.

Like concerns about China's shadow banking system, concerns about Bitcoin's business model are not new. Credit cards are also private market currencies. They are accepted for purchase because buying and selling parties trust their efficacy. The eventual success or failure of Bitcoin depends on whether enough parties will similarly trust it as a medium of exchange. In Davos, U.S. Treasury Secretary Jack Lew was notably skeptical of this. And Bitcoin has had its troubles: A major Bitcoin exchange in Tokyo was offline Tuesday, having closed off transactions, according to a statement, to "protect the site and [its] users" amid rumors of theft. Allegations of money laundering have also damaged Bitcoin's reputation, though many still stand by the new currency.

It's like that for China's shadow banking system too. Its success or failure also substantially depends on whether the market trusts it. There are other factors as well, but without the trust of the market, all of those other factors could not sustain it. Consider a run on a bank. If I distrusted a bank, I would withdraw my money immediately. If everyone else did similarly, a bank run would result even if the distrust was unfounded.

China needs to earn trust that, to judge from this year's World Economic Forum, is missing now. The first step would be a simple, transparent admission of the troubling situation. Sweeping problems under the rug accomplishes nothing. Hoping that overall economic growth accelerates to such extent as to trivialize the problem also accomplishes nothing. Less than 20 years ago, some other countries right in China's backyard experienced very great pain from trying that. China must surely have been watching.

Chinese President Xi Jinping knows that his economic legacy will be very significantly determined by his handling of this particular problem. He seems a practical man and surely must know what any doctor would advise, that a clear and frank admission of an illness is a necessary first step to curing it. However politically painful it may be for President Xi to make such admission, the benefits are too great for him not to, which is why I doubt that the worst fears expressed in Davos will manifest.

Michael Justin Lee is a lecturer in the University of Maryland's Department of Finance and Center for East Asian Studies, the author of McGraw-Hill's "The Chinese Way to Wealth and Prosperity" and chief snark at http://www.CapitalistSnark.com. His email is leem@umd.edu.

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Copyright © 2014, The Baltimore Sun
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