Real estate investments are at the core of many wealth management products, which have been identified as a source of systemic risk to the financial sector in China. Stefanie Eschenbacher looks at the shadow banking sector and the reforms the government is taking.
Its ghost cities have come back to haunt China. Eerie and lonely, entire cities sprawling the length and breadth of China and Inner Mongolia have been abandoned.
In a Wonderland theme park near Beijing, supposedly the largest in Asia, local farmers started to grow crops between the ruins after construction stopped a decade and a half ago.
Its decaying Cinderella Castle was a magnet for photographers with a fascination for derelict buildings, even featuring in National Geographic magazine, until it was bulldozed down earlier this year.
The New South China Mall in Dongguan, the world’s largest by leasable space, on its website promises to become a “miracle of commercial history”. Seven years after it opened, lifts are covered in dusty sheets and shops remain empty.
Then Xianrong Yi, an economist at the Chinese Academy of Social Sciences, a government think-tank in Beijing, threw a headline-grabbing number into the property discussion.
Electricity meter readings, Yi says, suggest that there are at least 64.5 million apartments and houses without occupants in urban China.
“If this outsized property bubble does not burst, it will hurt residents’ well-being, and also affect national financial security and co-ordinated national economic development,” Yi writes in the People’s Daily.
The article was published only in the overseas edition of the official Communist Party newspaper, but even government entities have publicly voiced concerns. In a paper, Evaluating conditions in major Chinese housing markets, the National Bureau of Economic Research concludes that “housing markets look very risky”. Other experts have compiled alarming data, too.
Jinsong Du, a property analyst at Credit Suisse, studied 287 Chinese cities and found population outflows in 190 of them, despite urbanisation.
“We believe that over the next few years at least, many lower-tier cities’ housing oversupply, in general, will only worsen,” Du writes in a research note, China Property Sector.
Not only those who financed these projects are being haunted but also those who bought the debt, repackaged as wealth management products.
Ivan Shi, a senior associate at Z-Ben Advisers, a Shanghai-based consultancy, says infrastructure and real estate projects are attracting a lot of investment from the shadow banking sector.
With a widespread belief that infrastructure projects will work out and troubled financial institutions will be propped up by the government, money has come easily.
“There is a lack of information about the assets held in the shadow banking sector, especially among regular loans that were given to local governments for infrastructure investments,” Shi says. “It is difficult to assess the quality of these assets.”
According to statistics from Trustee Association China, 26.8% of trust assets under management is invested in infrastructure, 9% in real estate, 10% in financial institutions and the rest in other enterprises.
“Infrastructure is the fastest growing shadow banking sector,” Shi adds.
International regulators have become increasingly concerned with the growth of shadow banking sector around the world, not only in China.
In November last year, the Financial Stability Board issued an influential, if controversial, assessment, Consultative documents on strengthening oversight and regulation of shadow banking. In it, the organisation puts the size of the shadow banking sector globally at $67 trillion at the end of 2011, or 111% of GDP.
China accounts for an estimated $400 billion, or 1%, of the global shadow banking sector. This would equal the size of Australia’s shadow banking sector and would be less than half of that in Hong Kong.
This figure, however, has been repeatedly challenged.
Nicholas Borst, a research associate and China programme manager at the Peterson Institute for International Economics, says the macro-mapping approach adopted is inadequate in measuring the true size of shadow banking in China.
Borst implies that the regulator neglected Chinese fund flow data because it is released with a long lag time and not well aggregated.
Instead, he says, it is likely that the research is relying entirely on financial sector balance sheet data and using the category labelled “non-bank financial institutions” as a proxy for shadow banking activity.
These non-bank financial institutions, however, are a minor part of the system.
Disputing the figure of $400 billion, Borst says the total is in fact around $2.5 trillion. Borst says not only is the estimate “false”, the low number “may be used as a justification of inaction”.
JP Morgan Chase Bank in Hong Kong also casts doubts over these figures. In an economic research note, Shadow banking in China, Haibin Zhu, Grace Ng and Lu Jiang put the size of the sector at 18.3 trillion renminbi ($3 trillion), or 46% of GDP, or 19% of bank assets.
Although the size of shadow banking in China is still small, relative to the size of its economy and its banking system, they warn that the rapid growth is “worthy of attention”.
The most likely causes of systemic risk are trust funds and wealth management products, they say, estimating the total size of these two markets to be about 14.6 trillion renminbi, or 28% of GDP, or 11% of bank assets.
“The two markets grew separately initially, but in recent years have interacted with each other as some trust companies have used wealth management products as a funding source,” they write.
“It is not clear how much overlap there is between the two markets, but from the usage perspective, 36% of wealth management products are used as credit-related, which is likely to be project-related investment and could be connected to trust loans.”
It is unclear how efficient lenders are in risk management, but they say at least in wealth management products, “there are legitimate reasons for raising concerns”.
Citic Trust, the biggest trust company in China, had a 13 billion renminbi product default; Anxin Trust, a small-tier trust company, had a 215 million renminbi product default in March; Zhongrong Trust, one of the biggest trust companies, had a 385 million renminbi product default in December last year.
Despite a handful of widely publicised cases, default is rare.
“It is more of a risk on the issuer side than on the investor side, because of the implicit guarantee trust companies provide” Shi says. “But if many products default at the same time, the issuers might not be able to absorb those losses.”
John Greenwood, the chief economist at asset manager Invesco, says although there are some parallels, it is unlikely that China has a subprime mortgage sector like the US had before the global financial crisis.
Still, he says it “is clearly risky” and possible that the real estate market or other underlying investments collapse, resulting in a surge of defaults.
Shadow banks also tend to have lower liquidity buffers and may not receive support from the central bank in a crisis.
The wealth management product sector has boomed in recent years, mainly because returns on bank deposits were little more than a compensation for inflation.
“One year ago, when inflation was much higher than interest rates, deposits were unattractive to investors,” Greenwood says. “Banks developed a range of products to meet the demands of investors and, instead of putting them on balance sheets, they put them in trust loans.”
Those investments were off-balance sheet for banks. Money poured into real estate or other projects, which Greenwood says were supposed to generate a high return.
Up-to-date data is not always available, but Greenwood says normal lending loans growth stood at 16% in April. Other types of products, plus financial institutions, grew at a rate of 33.5%. He says the answer is to deregulate deposit rates.
The Chinese regulators appear to grow concerned about the rapid expansion of the wealth management sector.
In March, the China Banking Regulatory Commission released a document, entitled Notification on issues regarding regulating commercial banks’ investment operations for the wealth management business.
The law limits the participation of banks in the shadow banking sector to finance their activities.
In recent months, the regulator has announced a couple of changes, including that it will liberalise interest rates and build a deposit insurance. Shi says this “is only the start for the government to effectively contain the expansion of the shadow banking sector”.
And in July, the central bank ended restriction on lending rates. Those previously had a floor of 70% of the benchmark rate. Other than those for residential mortgages, banks are free to set their lending rates.
“Cosmetic changes,” says Joe Zhang, a former vice chairman of UBS in China turned shadow banker, of the policy amendment.
Zhang says it would be more important to liberalise deposit rates, which are set at 2%. “This policy is ill advised and poorly designed,” he says. “As a result, the bottom of the pyramid is unfairly punished.”
Lending rates used to be set at around 6%, but Chinese inflation was also at around 6%. This artificially stimulates borrowing.
Shadow banking is only loosely defined. Apart from wealth management and trust bank activity, informal lending also falls into the shadow banking sector.
“Credit is never enough,” Zhang says. “Who gets the credit? Government entities, large and well-connected entities or those brave enough to bribe.”
Zhang, who is the chairman of The Slow Bull Capital, a financial advisory firm, says ordinary Chinese pay as much as 25% for credit.
“No matter how hard they work, they can never compete with the large players and get credit for 6% interest,” he says.
Zhang published Inside China’s Shadow Banking: The Next Subprime Crisis?, a memoir of his time as chairman at microfinance company Wansui Micro Credit in Guangzhou but also a desperate call for financial reform in China.
Zhang resigned from UBS in 2011 to develop microfinance programmes and help the small-scale entrepreneurs that had been turned away from banks.
Initially, he says, it was a business decision to tap into a huge, unserviced market.
“The criticism of the shadow banking sector is unfair,” Zhang says, adding that the sector also serves those that have been turned away by formal banks.
Although acknowledging some of the problems with wealth management products, he highlights that “defaults have been at no cost to the taxpayer”.
Zhang says investors should not worry about how wealth management products are used, just like they should not worry about how banks use their deposits. “Do we need
to know how our money is being used by banks? No. Why should we care? Just because they are Chinese?”
He also points to the Lehman minibond crisis in Hong Kong, among other mis-selling scandals. “[Wealth management products] are deposits in disguise, only that they pay higher rates,” he says. “Some of these finance stupid real estate projects, that is true, but normal bank deposits are no different.”
JP Morgan Chase’s Zhu, Ng and Jiang say the average rate of return is only about 100 basis points above that of bank deposits.
Zhang says the government should liberalise interest rates because bank deposit rates “are so low that even terrible projects look good”. Most wealth management products offer guaranteed returns to their investors, even if the underlying investment defaults.
But the experts at JP Morgan Chase note that wealth management products are increasingly not guaranteed, meaning that investors bear losses. They warn that when investors bear the losses, banks and trust companies may lose their incentive to monitor credit quality of the underlying projects.
“Right now, regulators are issuing a number of restrictions to minimise the short-term risk, but in the long term, they are building a much better framework for credit expansion to take place more in the standard banking system instead of the shadow banking system,” Shi says.
“In five years, banks will be able to trade deposits and loans in the interbank market, which is regulated.”
Banks face a lot of restrictions so they lend to the shadow banking sector to issue more loans and grow their asset base.
“We definitely see that businesses will still have very much of an incentive to compete in the shadow banking business because they want to compete with each other,” Shi says. “Now even brokerage and mutual fund companies are joining.”
The shadow banking sector, Shi adds, cannot be abolished. “The entire system is so flexible, there are always ways to participate.”
When Funds Global Asia went to press, the Financial Stability Board had not released its latest policy recommendations for the shadow banking sector due in September. The China Banking Regulatory Commission did not respond to requests for an interview.
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