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America’s Latest Export: The Shadow Banking System

June 25, 2012 by SMB Matters Blog Leave a comment

The Unknown Risks of China’s Trusts, published by Also Sprach Analyst

: China Insurance Building (中国保险大厦), Shanghai (Photo credit: thewamphyri)

Over the past many months, we have been talking (on and off) about the growing size and risks of the shadow banking in China. The market started to become aware of the risks of the unknown shadow banking system last year when some companies’ bosses started running away from the creditors, particularly in Wenzhou. While the focus has been shifted away from all these underground lending, the problem is not going away.

The so-called “trust” in China is yet another component in the Chinese shadow banking system. The size of the trust industry in terms of assets has reached RMB5 trillion and counting. In the past few years, one of the major sources of funding for trusts has been banks’ depositors. These trusts products offered higher returns than bank deposits (e.g. 10%), thus they appeared to be very attractive, especially when bank deposits have been hugely negative in real term thanks to high inflation, making these trust products a popular destination for bank depositors who want better returns than bank deposits (this has allegedly been one of the causes of the deposit flights, but we would leave the problem for now). Trust companies then take the money raised from banks and invest in stuff that they think can offer high return. The problem is where to invest to generate high return. In a certain sense, this is not very far off from securitisation.

As many real estate companies last year were pushed into desperate situations when the government tightened monetary and credit policy, the real estate industry turned out to be a popular destination for trust companies’ investment as demand for funding from real estate companies meant that these companies were willing to accept high costs of funding. According to this report, real estate accounts for 14.83% of total trust industry’s investment. Both equity and debt investments are common. Of course, these investments can only be fine as long as the real estate market is growing with prices and sales going up, which is not happening.

Moneyweek (via Sina) has a story on one of the major trust companies: China Credit Trust, a trust company with some RMB200 billion of assets. Earlier, this trust company has already been questioned on the investments in real estate sector. As early as 2010, this trust company has invested in a real estate company which ended up being unable to repay the debt. But the real estate market is not the only source of risks for trusts, of course. As in other trust companies, banks helped to distribute the products, thus depositors would invest in the trust products. In the case of this particular trust product by China Credit Trust, it took money from banks’ depositors with interest rates at 9.5-11%. ICBC is the custodian bank.

One of the products raised a total of roughly RMB3 billion, and the money raised is then invested in the equity capital of an energy company in Shanxi, which is a family business. The investment will reach maturity on 31 Jan 2014. However, despite the fact that this was an energy company which produces coal, it turns out that the company was then involved in shadow banking lending itself. In this case, they appeared to have become a loan shark themselves. But they are themselves deeply indebted, and perhaps they have borrowed quite a lot of money from the shadow banking channel as well. Thus in last year, creditors came to demand repayment. Now the bosses of the companies are said to be “under control” by the police, while the debt outstanding amount to RMB5 billion. The company in question might well be insolvent. In any case, this investment is gone.

For those depositors who have bought into this sort of products, the risks are obvious. As the economy slows, the probability that those money cannot be repaid would increase, not to mention that investors in these products have no idea if the one who got funding from their investments are of good credit, or whether these companies are performing fraudulent practices, etc. As far as we understand, banks do not offer guarantee to depositors for these products (although those who bought into these schemes seem to have been led to believe that there is guarantee), thus it will be interesting to see what will happen if more and more problems emerge from the trust sector of the shadow banking system.

And importantly, banks themselves are partnering with trusts to provide lending to companies without being reported in their books as lending. Few months ago the 21st Century Business Herald reported that banks have been using the partnership with trust companies to provide lending to companies. On banks’ books, as a result, they are not described as loans, but probably as equity interest in trusts. As a result of such trickery, these loans are not subject to the same regulation and scrutiny as other loans. The report put the size of such scheme at RMB100 billion, and that’s the figure for the year of 2012 till March.

With the slowing economy being worse than most have expected, and given how China banks decide who to lend to, it should come as no surprise that quite a portion of the outstanding debts through this channel will go bad, while the equity investments through this channel will be wiped off. The size of the industry in terms of assets is roughly at 10% of China’s annual GDP in 2011. Incidentally, the size of subprime mortgage market was estimated at US$1.3 trillion on March 2007, which is, incidentally, more or less at 10% of US annual GDP in 2006. That is not to say that this is subprime for China. Rather, the point is that even though “10% of GDP” does not look large, that could present significant systemic risks thanks to the interconnectedness within the financial system that we may not fully understand yet. So beware of a potential ticking time bomb here that may or may not explode.

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