The Shadow Banking System in Emerging Markets

Shadow banking. These two words have come to encompass everything that was wrong about the 2008-2009 financial crisis. Shadow banking was first used by Paul McCulley of PIMCO in 2007 to describe the giant "soup" of non-depository institutions but later popularized by supremely bearish economists such as Nouriel Roubini in 2008 (then among a small list of contrarian opionists) to include all forms of financial institutions like hedge funds, insurance companies, and investment banks. But this term is not just confined to the West.

The superficial forms may be different but the underlying structures and intent - off balance sheet money creation - remain just as potent in a broad swathe of regions ranging from Latin America to the Middle East, Far East, South Asia, and Eastern Europe (including the CIS countries).

Most economists ignore these capital flows b/c it is hard to capture systematic data on such a diverse group but their influence is equally hard to dismiss - surging inflation, and frenzied speculation on (insert favored asset class of the month - real estate and stocks remain favorites but other speculative targets include precious metals, art, jewelry, and even wine). Sources include remittances from foreign workers and family, off the book transfers to SOEs (state owned enterprises), grey market additions or subtractions on trade letters of credit, unofficial lending systems like "hawala" prevalent in many Muslim communities, and even funds from organized crime syndicates.

I would argue that in some cases (depending on the country's level of official financial innovation), these flow of funds can surpass the volume of funds issued by the central bank and can add huge pressure. While the individual actors in the system may be small their collective impact is overwhelming. Certain regions receive their funding sources from a small but dominant group. For example, Latin America tends to receive a huge number of remittances, so much so that in countries like Mexico, remittances are the number 1 or 2 (depending on whose counting and what political agenda they may have) source of GDP growth. In other states with Communist backgrounds (the CIS, China, Vietnam), off balance sheet transfers to SOEs are prevalent.

An additional note about China. Due to its enormous size, China has a proportionate impact on global levels of supply and demand, and - despite protestations of party officials - inflows and outflows of money. For years, the fixed (now tightly managed band) exchange rate contributed to all sorts of games played by exporters and importers on letters of credit, the trade documents that serve to lubricate wholesale trade. Parties to a transaction would routinely mark up or down their costs at the behest of their partners (usually for tax reasons) but also to import additional funds beyond the official limits. China also has its SOE legacy. It is hard to imagine now, but China used to be a Maoist state in every sense of the word. Money losing ventures in (sometimes) obscure parts of the country would produce goods for the sake of producing goods. These operations have more or less ceased to exist but their "losses" remain on the country's financial balance sheets (no one is really talking at Beijing much about this problem - did you really expect transparency from an authoritarian state?). But by some independent accounts, the scale of losses on these operations rivals the deflationary collapse in 1980s Japanese real estate.

Halwa, or the unofficial Muslim money transfer network, deserves special mention. The system incorporates scores - if not hundreds - of semi-independent brokers interwoven in a complicated network of trust. Deals are sometimes made on nothing more than handshake and accounts kept in paper ledgers. On this framework alone, funds can be sent from the rudest mountain village to the shiny cosmopolitan cities of Europe and North America. The system was developed in an effort to frustrate medieval tax authorities but was also molded in the cauldrons of internecine conflicts (called "brush wars" by Western analysts) when funds needed to be quickly sent and official lines of communication had broken down.

Organized crime has a special place in the role of money creation and transfer. It is prevalent in every society but really flourishes in regions where the rule of law is weak or more sinisterly, incorporated, into elements of the government. Profits from illegal activities such as the narcotics trade, piracy, human smuggling, prostitution, arms trafficking, counterfeiting, and credit card fraud (to name but a few sources of revenue) contribute unofficial amounts to GDP growth. The funds are sent through multiple channels - some of it is laundered to foreign operations and some of it is spent at home. The ruthless intelligences directing these funds make organized crime figures some of the shrewdest and most efficient capitalists of all. In their own ways, crime lords provide a source of jobs and growth to regions unmatched by official government stimulus efforts.

The sum effect of all this additional money sloshing around the globe is the same as that created by official government sources. The effects are currently inflationary, buoyed in large part by the interplay between central bankers - the doves of the West and the hawks of, well, everywhere else. But the pendulum can easily swing the other way - prolonged periods of economic malaise can send foreign workers packing back home and a key source of remittances would dry up. The same applies to cases of trade finance where importers and exporters depend on certain assumptions underlying their relationship - cheap, unofficial subsidies and exchange rates to artificially boost buying power. Even successful law enforcement efforts to clean up crime can have a short term deflationary effect on local economies.

The Bottom Line: The Shadow Banking system operates all over the world and should not just be applied to cases of large sophisticated fund managers. The collective force of many small actors can be enough to rival or even surpass official authorities. The global sloshing of funds is currently tilted firmly towards the inflationary camp but may swing the other way due to macro-economic developments in the West.