By Aditya Dhar
The average return for the S&P 500 since 1928 is a little under 10%. What if you could guarantee double that return in six months with a single investment? That’s the promise banks all across China are making to the middle class – 10, 15, 20% returns from an investment in a wealth management product (WMP). But at the heart of the rapidly expanding $4 trillion WMP industry is an off-the-books lending process that represents an existential threat to China’s financial system: shadow banking.
Capital in China is overwhelmingly state controlled, with the People’s Bank of China imposing caps on lending volumes, high reserve requirements, and penalties on lending to specific sectors. Small and Medium Enterprises (SMEs), which represented 70% of employment and 60% of China’s GDP in 2012, only receive 20% of bank loans that overwhelmingly flow to State Owned Enterprises (SOEs). Due to costly regulations, banks have begun to open up new avenues to finance regulated sectors and businesses, creating a shadow credit market. Shadow markets allow banks to overstep various regulations, including verifications of the quantity of bad loans held, oversight on credit to blacklisted entities, and reserve capital requirements. Banks extend shadow credit generally by reshuffling bad loans assets into WMPs, which are extended to investors and depositors. What makes these products shadowy is that banks do not place them on balance sheets or reserve capital to hedge against potential defaults – instead, WMPs are extended to investors via trust companies, who bundle loans into financial products that banks market and loan the money invested in the WMP to a given company. WMPs serve dual purposes for the banks: first, they reduce the capital that a bank is required to keep – if the bank has fewer loans, it needs less reserve capital; second, they obscure the liability from bad loans that banks have given out, shifting the debt burden for failed projects onto consumers. Banks marketing high returns from WMPs and state restrictions on capital have accelerated the pace of debt growth in China: private credit jumped from 90% of GDP in 1996 to 211% of GDP by the end of 2016, and annual expansion threatens to slow in order to combat the build-up of debt.
Rapid debt growth isn’t necessarily dangerous – China financed its $600 billion stimulus program after the global financial crisis via state banks extending credit to enterprises – why then, are WMPs, specifically, so dangerous? First, investors buy into WMPs on two assumptions: that the issuing bank or the government guarantees them against losing their investment; and second, that economic growth will continue unabated, propping up the underlying WMP assets. However, banks define themselves as managers of the asset rather than backers of the asset, and regularly do not give any legal certainty of a repayment in the event of a default. When one of the underlying assets of a Huaxia Bank WMP collapsed, Huaxia made no effort to repay investors because the WMP was neither explicitly nor legally backed by the bank. The second problem with WMPs is the maturity mismatch: the liability and yield for WMPs come due at different times, with the maturity of WMPs ranging from 3 to 6 months, while the maturity of the assets underlying the WMP ranging from 1 to 5 years. The result is that banks accrue liabilities faster than they accrue wealth from the WMP, which encourages banks to either rollover WMPs or repay investors when they come due, giving banks strong incentives to extend more credit in WMPs to receive income via fees. Consequently, banks have been dumping WMPs onto an unsuspecting market at expanding rates - the end of 2015 saw shadow lending growth overtake traditional lending growth, with shadow banking assets growing 20% to 86.5% of GDP between 2016 and 2017 alone, threatening China’s rising middle class with the prospect of defaults and massive household debt. Today, 169 million citizens are invested in the shadow banking market today, a rise of 66% from two years ago, magnifying the impact of risk even more.
Occasional defaults will occur, rollovers will happen – either of the stated problems would be enough to slowly add debt to the economy regardless of the success of the WMP as an instrument, but the lynchpin that guarantees defaults and rapid collapse is that the underlying assets in a WMP are effectively worthless. WMPs are low quality repackaged corporate and municipal loans, left over from attempts in 2010 and 2015 at state-run infrastructure spending sprees that resulted in a rash of incomplete local projects, and are just attempts by banks to refinance bad loans and fund low-quality projects to completion in a way that skirts regulations. Opaque and complex financial transactions between bank and trust companies, such as the investment of WMPs in so-called ‘interbank assets’ that are nothing more than camouflaged corporate credit, further obscures the composition of WMPs. There is even suspicion that WMPs are run similar to Ponzi schemes – with new money replacing older loans, rather than backing any real assets or being invested in any tangible project. In many ways, the wealth management product resembles the collateralized debt obligation (CDO) in the US system prior to the financial crisis – guaranteeing high returns, filled with subprime assets, and traded, obscured, and twisted enough to obscure risk until it was too late.
The WMP is the catalyst for a financial crisis, and the environment is ripe for one. Bank deposits have, at best, marginally increased since stimulus programs were announced, but bank lending is skyrocketing – an indication that the credit extended to businesses and industrial and property sectors is being used inefficiently and hasn’t generated a rise in actual value added in the economy. As such, 20 trillion renminbi of new credit raised nominal GDP by just 5 trillion renminbi over the 2015-2016 period. This threatens the pace of growth, threatening the confidence of investors in the assets underlying WMPs. Moreover, asset bubbles are rippling through China in the status quo, caused by significant sums of cash from the 2008-2009 and 2015 stimulus packages being trapped by capital controls in the country and dumped into various sectors, creating financial bubbles like the current property boom. These asset bubbles feature highly unsustainable markets, with prices of houses in Shanghai and Xiamen, for example, jumping 31.2% and 43.8% in 2016. Volatile prices, especially in real estate, threaten many of the underlying assets in WMPs, and will increase the rate of defaults and project collapses as the property market becomes unsustainable. Indeed, as WMPs are often dumped back into the property sector, as well as other assets, the product simply fuels a vicious cycle that is likely to end in mass WMP defaults as the underlying assets fail.
What could that financial crisis look like? First, the interconnectedness of WMPs means that a string of asset failures could occur if large WMPs that form the basis of other WMPs fail, similar to the collapse of the CDO market when, first, underlying mortgage bonds defaulted and, second, when CDOs comprising other CDOs collapsed. Second, massive WMP defaults make it likely that investors will pull money out of WMPs, effectively creating a run on the banks as investors rush to protect their earnings. Third, overexposure between banks in the form of lending and asset trading programs likely means that the collapse of certain credit lenders jeopardizes credit in the market writ large, causing liquidity to decrease as, first, big banks can no longer lend out shadow credit, and, second, banks that relied on that credit are similarly unable to extend loans. Finally, investor confidence will have dropped to the point that WMP funding will be nonexistent, banks will be unable to raise credit in the future, prolonging the likely liquidity crunch. Legitimate, low-risk projects in undervalued sectors will consequently go underfunded or unfunded, and the likelihood of credit being used responsibly and efficiently will become low.
Admittedly, there are ways to mitigate the crisis – stimulus packages, new regulations, reshuffling the bureaucracy. But these attempts will be reactive than proactive. If China wants to prevent, rather than mitigate, a possible crisis, it needs to address shadow markets, and can do so
by increasing oversight on WMPs, decreasing stringency on traditional bank lending to reduce demand for shadow credit, or simply regulating asset management and trust companies that serve as the middlemen in WMP transactions.
Double the returns, double the risk: 43 previous large credit booms have ended in sharp slowdowns or financial crisis. If China doesn’t want to be next, it needs to change now.