Chinese debt concerns are complicated by two structural issues – the rise in borrowing by local governments and the increase in the role of the shadow banking system.
Both sectors are testament to Chinese entrepreneurial spirit, but also point to deep problems in China’s financial system.
Local But National…
Outside of security matters or foreign affairs, China’s provinces, regions and centrally controlled municipalities enjoy a degree of autonomy. After the global financial crisis in 2007/ 2008, the aggressive stimulus measures to boost economic activity required the central government to relax controls on local government spending programs.
But by law, China’s local governments are not allowed to borrow, requiring creative solutions with the tacit approval of Beijing. Local governments created LGFV (Local Government Financing Vehicles), also known as UDICs (Urban Development And Investment Companies). These special purpose arm’s length vehicles, which are separate from but owned or controlled by the local government, can borrow.
The LGFV generally borrows funds predominantly from banks (as much as 80% or more), with the remainder raised by issuing bonds or other equity like instruments to insurance companies, institutional investors and individuals. In recent times with pressure on banks to curtail loans, LGFV has borrowed from the shadow banking system.
There are several issues around local government borrowings.
With over 10,000 LGFVs in China, the exact level of borrowings remains in dispute despite increasingly scrutiny.
There is concern about the quality of the underlying projects financed, which are sometimes expensive politically motivated trophy projects.
Many of the LGFVs do not have sufficient cash flow to service debt, being reliant on land sales and high property prices to meet debt obligations. The LGFVs also have significant mismatches between short term borrowings and long term investments being financed. With cash flow insufficient, many LGFVs now use new borrowings to repay maturing debt.
Probably something more than 50% of LGFVs have unsustainable debt levels and face the risk of insolvency.
Local governments also may not have the financial capacity to guarantee the solvency of their LGFVs. According to the World Bank, China’s local governments have responsibility for 80% of total spending but only receive about 40% of tax revenue.
With few assets other than land, reliance on land sales and development taxes as a large portion of revenue also restricts their financial flexibility especially if the real estate prices fall.
The pathology of China’s local government financial problems is recognisable. The combination of excessive borrowing, capital misallocation and debt servicing based on increasing property prices is familiar.
Eager for growth and increased revenue, local governments increase borrowings to create ever larger development projects resulting in a rapid increase in supply on new properties and land inventory held by the LGFVs. Land and property sales slow and prices come under pressure constraining the ability to monetize the assets to meet debt obligations.
Lender concern reduces credit availability and interest costs further straining cash flows. The LGFV have insufficient finance to continue, resulting in slower completion or leave incomplete projects. Contingent liabilities are not honoured. Ultimately, the LGFV and its local government must be bailed out or face insolvency.
There are political complications. Local government debt financed investments helped maintain China’s growth after the onset of GFC. This was crucial in assisting the Central government to save face and maintain social stability. Deep seated links, systems of patronage and factional competition within the Chinese Communist Party (“CCP”) make it difficult for Beijing to take drastic steps to abruptly reverse policy.
An ancient Chinese proverb – shan gāo, huángdì yuǎn- states “The mountains are high and the emperor is far away”. The saying implies that Beijing’s control over its regions is historically weak, with local autonomy and little loyalty, meaning that central authorities have limited influence over local affairs.
Shadow banking, a term used by US investment manager PIMCO’s Paul McCulley in 2007, refers to a diverse set of institutions and structures used to perform banking functions outside regulated depository institutions. In recent years, China has evolved its own substantial shadow banking system, which has several layers.
There is the informal sector which encompasses direct lending between individuals and underground lending, often by illegal loan sharks (referred to as curbside capitalists and back-alley bankers) that provide high interest loans to small businesses.
The larger sector consists of a range on non-banking institutions, which are subject to various degrees of regulatory oversight. It involves direct loans of surplus funds by companies to other borrowers or trade credit (often for extended terms). It involves non-bank financial institutions such as finance companies, leasing companies or financial guarantors. There are also more than 3,000 private equity funds, funded in part by foreign investors. In personal finance, it encompasses micro-credit providers, consumer credit institutions and pawn shops. The largest portion of the non-banking institution sector is trust companies and wealth management products (“WMPs”).
There are also capital markets allowing insurance companies and institutional investors to purchase debt and equity securities.
The growth is driven by the structure and regulation of China’s financial system.
The credit markets are dominated by the four major. State controlled banks (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China) that focus on lending to State Owned Enterprises (“SOEs”), firms associated with the government and officially sanctioned projects. Other businesses have more limited access to bank credit. The shadow banking sector fills this market gap.
Government regulation of deposit interest rates has also facilitated the growth of the shadow banking systems. For much of recent history, bank deposit rates have been below inflation rates. Negative returns and the loss of purchasing power have led savers to seek higher available rates in the shadow banking systems.
In recent years, the central government has sought to rein in runaway credit expansion, by reducing loan quotas, limiting lending to specific sectors such as local government, property and restricting riskier transactions. This has perversely encouraged growth of the shadow banking sector.
Trust companies are the most important component of the Chinese shadow banking sector. They finance riskier borrowers and transactions that banks cannot undertake due to regulations.
Trust assets are estimated at more than US$1.8 trillion (20% of GDP). While only a small part of total credit in China, trust assets have been growing at an annual rate of over 50% in recent years and constitute 10-20% of new TSF.
Trust companies raise money from investors which are then invested in loans or securities. Investors are usually high net worth individuals or corporations that can meet required minimum wealth standards (several million Renminbi (“RMB”) in assets) and the minimum investment size (typically RMB 1 million (about US$160,000)).
The major attraction for investors is the high returns; around 9-12% per annum compared to bank deposits rates in low single digits. After adjusting for the trust company’s fee of 1-2% of loan value, the ultimate borrower must pay around 10-15% per annum for the funds, well above the 7-8% charged by banks.
The funds primarily finance local government infrastructure projects (via LGFVs), real estate and industrial and commercial enterprises. Following the central bank’s decision to restrict banks financing of local governments and property projects, trust companies have become major providers of finance to these sectors.
The high interest rates mean that the borrowers are riskier. Problems with assets supporting Trust loans are well documented, most notably the “Purple Palace,” a half built and abandoned luxury development in Ordos.
WMPs are higher yielding deposit or investment products, with a variety of seductive monikers – Easy Heaven Investments, Quick Profits and Treasure Beautiful Gold Credit. WMP assets are estimated around the small level as Trust assets and are also growing rapidly.
WMPs are sold through banks or securities brokers to a broader investor base than Trust Company investments. The minimum investment is RMB 50,000 (around US$8,000). Investments are typically short, around 6 months. WMPS offer investors a return of around 2% above bank deposits. WMPs can be sold with or without a guarantee of the payment of interest or principal from the sponsor.
WMPs invest in a variety of assets, ranging from low risk inter-bank loans, deposits and discounted bills to higher risk trust loans, corporate securities and securitised debt.
A central feature of China’s shadow banking sector is its relationship with its regulated counterpart. Banks may arrange and act as an agent in a loan from one non-financial company to another (known as entrusted loans). Banks can sell assets to trust companies or create WMPs to channel client funds to them. Banks use undiscounted bankers acceptances to transfer assets to the shadow banking sector, against a partial or full payment guarantee from the issuer. Corporate bonds may be bought by Trusts, which are then repackaged into WMP products for bank depositors.
China’s shadow banking system exemplifies a popular Chinese saying -shang you zhengce, xia you duice-meaning “policies come from above; countermeasures from below”.
The Chinese shadow banking system poses increasing risk.
While the exact size is disputed, the Chinese shadow banking system is large, estimated at around 70-100% of GDP (US$6-9 trillion) and growing rapidly.
With Chinese banks’ share of new lending having fallen to around 50%, from 90% a decade ago, the economy has become increasingly reliant on shadow banks as an important source of finance,, especially true for local governments, property companies and small and medium-sized enterprises (“SMEs”).
While the majority of Wealth Management Products (“WMPs”) are invested in interbank deposits, money markets and bond markets, the credit quality of many borrowers from shadow banks is uneven. Collateral securing loan is variable. A high proportion of trust loans and some WMP investments are secured by real estate. This exposes investors to losses if property values fall sharply. The Golden Elephant No 38 WMP, which offered investors 7.2% per annum, was found to be secured by a deserted housing estate in a rice field in Jiangxi province.
Increasingly other forms of riskier collateral, such as industrial machinery and commodities, have become more common. In a few more extreme cases, the collateral has been more exotic (tea, spirits, graveyards etc.).In some cases, lenders seeking to foreclose loans have discovered that the underlying collateral has been pledged more than once or does not actually exist.
The products entail significant asset-liability mismatches, with short dated investor funds being used to finance long term assets, which are sometimes non-income producing e.g. undeveloped land. The constant repayment or refinance requirement exposes the vehicles and the financial system to the risk of a liquidity crisis. For example, in 2014, around US$660 billion of trust products alone mature.
The trust companies and financial guarantors frequently lack adequate capital. Trust companies have average leverage of over 20 times, which is high given the nature of the investments.
Many products do not detail the exact use of investor funds. The documentation is vague. Due diligence by the sponsor or investment managers, enforceability of security interests and investor rights are unclear. As the system operates with only limited regulations, controls and oversight are weak.
Inter-connections between the shadow banking system and the traditional banking system create additional risk and moral hazards.
Banks frequently use the shadow banking to shift loan assets off their balance sheets and “window dress” financial statements for regulators and investors. Banks also use Trust Companies and WMPs to arrange high interest loans to companies, such as property developers, that they are unable to lend to due to risk of regulatory reasons.
Banks work closely with Trust Companies and Security Brokers to create investment products for depositors seeking higher returns, effectively acting as a conduit between savers and borrowers. Bank issuance of WMPs has increased by around 25/ 30 times, from around US$ 100 billion US$2.5 to US$3 trillion. Banks increasingly rely on these products to maintain market share and earnings, via fees and commissions received from distributing shadow banking products.
The linkages can be complex. Banks sell acceptance bills or risky loans to a trust which is then repackaged as a WMP to be sold to bank clients. There are transactions between different shadow banking entities. A financial guarantee can be used by a firm or individual to borrow from a bank with the proceeds invested in a trust or WMP. Banks, trusts and WMPS sometimes pool deposits as well as assets or securities from different schemes. New products are created to raise funds to meet repayments of maturing products.
In principle, the risk of these structures and investment rest with the investors. WMPs state that returns are expected rather than guaranteed or promised returns. WMP investors are typically required to confirm that they will bear the financial shortfall if assets funded by the pool default. In part, these provisions are included to ensure that WMP sponsors are able to keep the liabilities raised from investors and the assets purchased off balance sheet. But the ultimate responsibility for defaults is more complicated.
Investors in trusts may believe that they are protected from loss because the trust companies risk losing their operating license if their products suffer losses. In recent years, trust companies have sometimes concealed losses by using their own capital, arranging for state owned entities to take over impaired loans or using proceeds from new trusts to repay maturing investments.
Investors may also assume that banks will guarantee repayment and returns on shadow banking investment. This impression is reinforced by the transfer of bank assets to trust companies and WMPs and the distribution of shadow bank products by banks.
These problems are compounded by the lack of sophistication of some buyers and wilful ignorance of others. Banks also bear reputational risk.
Regulators would be concerned about systemic risks.
Failure of a riskier trust or WMP may lead to inability to issue fresh products or withdrawal of funds, requiring sponsoring banks to support these vehicles as happened in 2007/2008 in developed markets. The resulting losses and cash outflows could trigger wider problems within the financial system, which would affect solvent businesses and growth.
Policy makers would also be concerned about customer anger. In recent years, there have been a number of scandals where investors who had invested in products believing that they were guaranteed by the selling banks laid siege to the sponsoring bank. The high political risk may result in governments forcing banks to support the structures to avoid any threat to social stability.
Putting Worms Back In Cans…
In recent years, policy makers have taken steps to slow the rapid growth in debt and the expansion of the shadow banking system.
Policy makers have used quantitative measures to reduce credit creation, increasing reserve requirements to reduce bank lending. Qualitative measures, primarily loan quotes and specific restrictions on certain types of loans, have been used to control borrowing growth.
In early 2014, the Central Government announced plans for measures designed to rein in shadow banks. Banks are to be subject to more rigorous enforcement of existing rules and bans on moving certain loans and assets off-balance sheet. Banks would be required to set up separately capitalized and provisioned units for wealth management businesses. Co-operation between banks and trust companies or security brokers would be restricted.
Trust companies would be prohibited from pooling deposits from more than one product or investing in non-tradable assets. Private equity firms would not be allowed to lend to clients.
The Central Government also announced plans for three to five new private banks to increase the capacity of the banking system, outside the dominant state-owned lenders.
In mid-2013 and again in early 2014, authorities also intervened in money markets, draining liquidity and increasing interest rates to restrict excessive credit growth and to improve bank risk management practices. The actions resulted in a sharp rise in interest rates (in June 2013 they reached more than 13%) and increased volatility. They also revealed weaknesses in the structure of the financial system, particularly the instability of the shadow banking system.
The large Chinese state banks control the major proportion of customer deposits. Other banks tend to have smaller deposit bases. They are more reliant on wholesale funding, particularly from the interbank market. Liquidity in the interbank market depends on the larger banks who are net lenders in this segment and WMPs which invest in money market instruments, many of which are sponsored by smaller banks.
Reduced liquidity and higher rates can quickly set off a chain reaction. Tighter conditions in the interbank market place pressure on smaller banks. It also triggers redemption of WMPs which further reduces availability of funding in the interbank markets, setting off a cycle of increasing rates. Unlike large banks, smaller banks hold lower amounts of government bonds limiting their ability to raise funds using the securities as collateral in repos. Smaller banks may be forced into distressed selling of illiquid assets, causing prices to fall.
The deteriorating financial position of smaller banks would force up their cost of borrowing. Some banks can lose access to funding, due to concerns about their solvency.
The actions of authorities can affect solvent and viable businesses in an undesirable way. In June 2013, the interest rate for AAA rated corporate bonds rose rapidly by 2.00% per annum. Like the experience of money markets in developed countries during 2007/ 2008, scarcity of funds, payment issues combined with payment or solvency issues in small banks or the shadow banking system can quickly trigger broader economic problems
Despite the increasing urgency of intervention, the actions have had limited success in slowing in the growth of borrowings.
A central problem is the reliance on debt funded economic growth and the need to expand credit to maintain high levels of economic activity. In addition, the increase in the size and complexity of the shadow banking sector reflects structural problems. The need is for major and widely based economic, financial and structural reform, which is politically unpalatable.
As a consequence, attempts to slow credit growth, regulate the shadow banks and reduce speculation are inconclusive. After both episodes of intervention by the central banks, authorities stepped in and supplied significant amounts of liquidity to alleviate concerns about a slowdown in growth and financial problems.
Responding to the regulations covering shadow banking in January 2014, Anne Stevenson-Yang at J-Capital wrote: “The hilarious new Document 107 on shadow banking betrays how toothless the government is in the face of the mounting debt, because the only solution presented is more debt.”
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money