Trust Me

I mentioned in a recent blog post that a reporter had called me up to ask “what I thought about a Hong Kong-listed baby formula producer that was loading up on loans and relending the money to non-ferrous metals, tungsten, and highway companies.”  That reporter — I can now disclose — was Shai Oster from Bloomberg, who published an article on this story on Friday which is important reading for anyone who wants to understand the rapidly evolving risks to China’s financial stability.

The story, in a nutshell:  Hong Kong-listed Ausnutria Dairy Corp. (HK:1717), based in Changsha, is China’s 13th largest producer of baby formula, using quality-ensured milk imported from Australia.  In April, it invested RMB 200 million (US$31 million) — roughly two years’ worth of profits – in Yunnan International Trust Co., which used the money to buy four loans from China Merchants Bank:  two loans to Hunan Nonferrous Metals (HK:2626), which mines and refines zinc, lead, tungsten, and antimony, and one each to Chenzhou Diamond Tungsten Products Co. and Hunan Bismuth Industry Co.  After fees, Ausnutria hopes to earn at least RMB 11 million ($1.7 million) in interest on the loans, and says that it already earned RMB 10 million on loans to a Hunan highway company it bought in a similar transaction with Hunan Trust and Investment Co.

But the returns are not guaranteed, and neither Ausnutria nor the trust hold any collateral on the loans.  This worries a growing number of observers, who fear that many Chinese companies like Ausnutria may be taking bigger risks that they realize in search of higher yields.  But the alternative — seeing their ordinary bank deposits eaten away at regulated rates that are at least 3% less than inflation — is pushing more and more companies into the arms of trusts promising far more attractive rates of return (on essentially the same assets).

The result has been an explosion in trusts and similar investment vehicles (see my previous post on this subject).   As Shai notes, non-bank lending has grown from just 4% of loans in China in 2002, to an estimated 55% this year — which means that the supply of credit in China is more than double the official reported figures.  This is actually the second ”trust boom” that China has seen in recent years.  The first one came to an ugly end in the late 1990s, when numerous trusts imploded, including the Guangdong International Trust and Investment Co. (GITIC) which defaulted on $200 million in bonds, many of them held by foreign investors — the largest bankruptcy China has seen to date.  The current one, which really only gathered steam at the beginning of this year, is being driven by the pressure to find ways around tighter bank lending controls in an economy that has become dependent on cheap and unlimited credit to drive investment-led growth:

“If you limit what banks can do, there’s still demand for loans,” said Zhang Liwen, president of Suzhou Trust, sitting in an office on the second floor of a cement-and-glass building on a leafy street in Suzhou, 50 miles west of Shanghai. “The market still needs capital.”

As Shai points out, almost half the money managed by Chinese trusts is invested in infrastructure and real estate projects, and trust loans to real estate developers has catapulted 150% from RMB 235 billion in March 2010 to RMB 605 billion today.

The big concern the chain-reaction that could unfold if those developers run out of ready financing and go bust:

There are signs the real estate market is already cooling . . . Hungry for cash, some developers are borrowing at 12 percent to 25 percent . . . “Medium-sized property developers appear to have borrowed heavily for short-term and bridge loans,” said Il Houng Lee, the IMF’s senior representative in China. “Property developers’ strains could hit trusts.”

Any sign of weakness in China’s real estate market could have a chilling effect on trusts and their investors, said Jason Bedford, a manager at KPMG LLP in Beijing.  “Imagine that you have a real estate product and suddenly the real estate markets start to plummet,” Bedford said. “What was a liquid product suddenly becomes very illiquid as investors pull out and can’t be replaced.”

“It will cause a significant amount of wealth destruction,” [Michael Werner at Sanford C. Bernstein & Co. in Hong Kong] said. “The party goes on until someone turns on the lights and you can’t roll over these assets. There will be wealth destruction. The question is how much.”

I particularly noticed Jason Bedford’s comments, because in my past interactions with him here in Beijing, I always found him relatively confident concerning the financial condition of both the banks and the trusts, compared to chronic skeptics like myself.

In my initial conversation with Shai, I noted the parallels between what’s happening right now in China and the role that trusts played in triggering the “Panic of 1907″ on Wall Street, and forwarded an article on the latter subject by former Fed economists Ellis Tallman and Jon Moen.  I was very gratified to see that he reached out and contacted one of the authors for comment.  In their article, the authors conclude that in 1907:

Unequal regulation among financial organizations, the authors find, led to a concentration of riskier assets in less regulated intermediaries, primarily trusts.  Trusts’ riskier asset portfolios made them the focal point from which the crisis spread to other segments of the financial market.

If you have any serious interest in the topic, I highly recommend you read the whole article, which you can find online here, and decide for yourself if “this time is different,” or whether we really have seen this movie before and know how it ends.

In all of the recent articles I’ve seen on China’s credit climate, it’s always the little things that speak volumes.  The one that caught my eye in Shai’s article was this (my own bold italics added):

There is no sense of panic at the headquarters of Noah Holdings Ltd. (NOAH) in the Pudong section of Shanghai, where customers sip coffee and browse glossy brochures while sitting on leather and chrome sofas . . . It offers wealth-management products including those issued by trusts to clients who the company says invested an average of $1.3 million last year. On Noah’s website is a quotation from Chairman and CEO Wang Jingbo: “The world revolves around money, and it makes its own rules.”

This post originally appeared at An American Perspective From China and is reproduced with permission.