Last month, we took a detailed look at what we said could be a multi-trillion yuan black swan.
In short, one of China’s many spinning plates is the country’s vast shadow banking complex which allowed local governments to skirt borrowing restrictions leading directly to the accumulation of debt that totals some 35% of GDP and which has channeled trillions into speculative investments via the proliferation of maturity mismatched wealth management products.
One of the problems with the system is that it allows Chinese banks to obscure credit risk.
As Fitch noted earlier this year, some 40% of credit exposure is effectively carried off balance sheet in China’s banking sector, making it virtually impossible to assess the extent to which banks are exposed. When considered in combination with the unofficial policy whereby the PBoC forces lenders to roll bad debt thus artificially suppressing NPLs, a picture emerges of a system that’s decidedly opaque. Here’s what we said back in May:
The percentage of loans which are not yet classified as non-performing but which are nonetheless doubtful is much higher than the headline NPL figure and in fact, [Fitch] seems to suggest that some Chinese banks (notably the largest lenders) may be under-reporting their special mention loans. But ultimately it’s irrelevant because between bad assets that are ultimately transferred to AMCs, loans that are channeled through non-bank financial institutions and carried as “investments classified as receivables”, and off-balance sheet financing, nearly 40% of credit risk is carried outside of traditional loans, rendering official NPL data essentially meaningless in terms of assessing the severity of the problem.
Well don’t look now, but according to Moody’s, the practice of obscuring credit risk using one or more of the methods delineated above and outlined in these pages on any number of occasions looks to be getting worse. Here’s Bloomberg:
China’s riskier banks are investing more customer funds in financing that is kept off their loan books, making it harder for rating companies to gauge their asset quality.
There has been a surge in a balance-sheet item known as receivables, which often includes shadow funding such as trusts and wealth products, said Moody’s Investors Service. Fitch Ratings said it is hard to analyze this escalation in activity. Listed banks excluding the Big Four saw short-term investments and other assets -- which include receivables -- jump 25 percent in the first half, compared with total asset growth of 12 percent, data compiled by Bloomberg show.
Slower growth in the world’s second-largest economy coupled with "still significant" credit expansion prompted Standard & Poor’s to cut its view of the banking industry’s economic risk to negative from stable this week. Shadow-finance assets, estimated at 41 trillion yuan ($6.4 trillion) by Moody’s at the end of 2014, have become more attractive as five interest-rate cuts by the central bank since November curbed profits from lending.
"Our concern with some of these investment positions is banks are using them as a way to bypass lending restrictions," said Grace Wu, a senior director at Fitch in Hong Kong. "Unlike bank loans, they don’t get reported into loan provisions, so it’s more difficult for us to ascertain the asset quality."
The nation’s shadow-banking industry emerged as a way for creditors to circumvent lending restrictions and for savers to attain yields higher than the legally capped deposit rate. It includes trusts, asset-management plans and wealth-management products, which package loans into products for buyers.
Shanghai Pudong Development Bank Co.’s receivables made up about a quarter of assets as of June 30, according to its semi-annual financial statement. Out of 1.1 trillion yuan of receivables, 82 percent were trusts and asset-management plans that purchase trust loans, while 11 percent were other lenders’ wealth management products.
The receivables climbed in the first half because the bank invested more in other lenders’ guaranteed WMPs as well as in asset-management products derived from bills issued by large banks, Shanghai Pudong said in an e-mail. It added that its credit and liquidity risks are both manageable.
Make no mistake, assessing the risk posed by China's shadow banking system is famously difficult and has confounded more than a few analysts and commentators, but the simple, one-line takeaway here is that NPLs at Chinese banks are likely to be orders of magnitude greater than the headline figures and indeed, we suggested as much more than two years ago:
China is preparing to admit that the level of problem Local Government Financing Vehicle debt is double what was first reported just two years ago, something many suspected but few dared to voice in the open. But not only that: since the likely level of Non-Performing Loans (i.e., bad debt) within the LGFV universe has long been suspected to be in 30% range, a doubling of the official figure will also mean a doubling of the bad debt notional up to a stunning and nosebleeding-inducing $1 trillion, or roughly 15% of China's goal-seeked GDP! We wish the local banks the best of luck as they scramble to find the hundreds of billions in capital to fill what is about to emerge as the biggest non-Lehman solvency hole in financial history (without the benefit of a Federal Reserve bailout that is).
And while the consequences of a banking sector implosion are hard to assess, the fallout from social upheaval is even more indeterminate. We bring that up because as we saw last month with Shan Jiuliang head of Fanya Metals Exchange, when WMP investors suspect they may have been misled about the safety of their investment, things can go south rather quickly and what the above suggests is that far from scaling back their use of shadow conduits, at least some mid-tier banks are dramatically increasing their exposure.
For those interested, we've included our full review of Chinese WMPs below.
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"Wealth management products in China have come under the spotlight after a series of missed payments raised concerns over the shadow banking sector that often directs credit to firms shut out from bank lending or capital markets," Reuters said in February, after reporting that CITIC (China's top brokerage), was looking at ways to repay investors after the issuer of one of the wealth management products the broker sold missed a $1.12 million payment to investors.
That news came a little over a year after the now infamous "Credit Equals Gold #1 Collective Trust Product" incident and a subsequent default scare on a similar product backed by loans to a struggling coal company.
Although wealth management products and CTPs (which differ from WMPs) are often described as "murky" and "opaque", the basic concept is fairly simple. WMPs are marketed to investors as a way to get more bang for their buck (er.. yuan) than they would with bank deposits. Funds from these investors are then invested at a higher rate. If the assets investors' money is used to fund run into trouble, that's not good news for WMP investors. Simple.
The main issue here is the sheer size of the market. As FT notes, "in 2010, as regulators tried to rein in the explosion in bank credit resulting from the country’s Rmb4tn economic stimulus plan, banks turned to trusts to help them comply with lending controls." So essentially, trusts helped banks offload credit risk at the behest of the PBoC. Here’s the process whereby banks use trusts to get balance sheet relief:
The amount of trust loans outstanding in China has ballooned to nearly CNY7 trillion (total trust assets under management is something like CNY14 trillion) and now, Hebei Financing Investment Guarantee Group - which, as Caixan notes, is "the largest loan guarantee company in the northern province of Hebei [and] is wholly owned by the provincial regulator of state-owned assets" - is apparently broke, and that’s bad news because it guaranteed some CNY50 billion in loans made by dozens of trusts who in turn issued wealth management products to investors.
In short, if Hebei can’t guarantee the loans, WMP investors could be forced to take a loss and as anyone who follows developments in China’s financial markets knows, Beijing is not particularly keen on permitting SOEs to collapse - especially if there’s a risk of rattling retail investors’ fragile psyche. Here’s FT with the story:
Eleven shadow banks have written an open letter to the top Communist party official in northern China’s Hebei province asking for a bailout that would enable the bankrupt credit guarantee company to continue to backstop loans to borrowers. If the guarantor cannot pay, it could spark defaults on at least 24 high-yielding wealth management products (WMPs).
Hebei Financing Investment Guarantee Group has guaranteed Rmb50bn ($7.8bn) in loans from nearly 50 financial institutions, according to Caixin, a respected financial magazine. More than half of this total is from non-bank lenders, mainly trust companies, who lent to property developers and factories in overcapacity industries
The letter appeals directly to the government’s concern about social stability and the fear of retail investors protesting the loss of “blood and sweat money”. The 11 companies sold 24 separate WMPs worth Rmb5.5bn.
“The domino effect from the successive and intersecting defaults of these trust products involves a multitude of financial institutions, an immense amount of money, and wide-ranging public interests,” 10 trust companies and a fund manager wrote to Zhao Kezhi, Hebei party secretary.
“In order to prevent this incident from inciting panic among common people and creating an unnecessary social influence, we represent more than a thousand investors, more than a thousand families, in asking for a resolution.”
Hebei Financing stopped paying out on all loan guarantees in January, when its chairman was replaced and another state-owned group was appointed as custodian.
Though Hebei Financing guaranteed loans underlying WMPs, the products themselves did not guarantee investors against losses. Caixin reported that several trust companies, fearing reputational damage, have used their own capital to repay investors.
The 11 groups behind the recent letter have taken a different approach, pressuring the government for a rescue.
There a few things to note here. First, the reason the underling assets are going bad is because WMP investors' money was funneled into real estate development and all manner of other parts of the economy which are now struggling mightily. Second, the idea that China should allow for defaults on trust products is nothing new. In fact, we've been saying just that for at least a year. Finally, and perhaps most importantly, the banks' playing of the social instability card underscores an argument we made when China's equity market was in the midst of its harrowing plunge last month. In "Why China's Stock Collapse Could Lead To Revolution" we warned that "it is only a matter of time before all the 'nouveau riche' farmers and grandparents see all their paper profits wiped out and hopefully go silently into that good night without starting mass riots or a revolution."
Yes, "hopefully", but maybe not because as is becoming increasingly clear by the day, simultaneously micro managing the stock market, the FX market, the command economy, the media, and just about every other corner of society is becoming a task too tall even for the Politburo and sooner or later, something is going to break and shatter the "everything is under control" narrative.
Whether or not the catalyst for widespread social upheaval will be a catastrophic chain reaction in the shadow banking system we can't say for sure, but as FT reminds us, technical defaults on trust products have in the past been met with "public protests by angry investors at bank branches."
Here's a snapshot of WMP issuance (note the durations as it gives you an idea of what kind volume we're talking about on maturing products):
As you might have noticed from the above, it appears that maturity mismatch could be a real problem here. Here's what the RBA had to say about this in a bulletin dated June of this year:
A key risk of unguaranteed bank WMPs is the maturity mismatch between most WMPs sold to investors and the assets they ultimately fund. Many WMPs are, at least partly, invested in illiquid assets with maturities in excess of one year, while the products themselves tend to have much shorter maturities; around 60 per cent of WMPs issued have a maturity of less than three months (Graph 5). A maturity mismatch between longer-term assets and shorter-term liabilities is typical for banks’ balance sheets, and they are accustomed to managing this. However, in the case of WMPs, the maturity mismatch exists for each individual and legally separate product, as the entire funding source for a particular WMP matures in one day. This results in considerable rollover risk.
In other words, the WMP issuers are perpetually borrowing short to lend long. The degree to which this is the case apparently varies depending what type of WMP (or trust product) one is looking at, and we will mercifully spare you the breakdown of the market by type (other than to include the pie chart shown below), but the important thing to note here is that it seems highly likely that at least CNY8 trillion in WMPs are exposed to the "considerable rollover risk" mentioned above.
Allow us to explain how this could end. If China allows a state-run guarantor like Hebei Financing Investment Guarantee Group (the subject of the FT article cited above) to go broke and that in turn triggers losses for investors in WMP products, demand for those WMPs will dry up - and right quick. If that happens, WMPs will stop rolling, freezing the market and triggering a cascade of forced liquidations of the underlying (likely illiquid) assets.
It's either that, or China bails everyone out. As the RBA concludes, "a key issue is whether the presumption of implicit guarantees is upheld or the authorities allow failing WMPs to default and investors to experience losses arising from these products."
And while that is certainly a key issue, the key issue is what those investors will do next.