The good and bad of Chinese shadow banking
While the term “shadow banking” in English is very much a pejorative, its Chinese language equivalent 影子银行 (yingzi yinghang) sounds far less negative to the wide range of Chinese savers and corporations that participate in it. Whatever its name in any language, it has become one of the top concerns for investors.
We spend time monitoring the subject, both on a macro and policy level, as well as when we meet with existing or prospective portfolio companies. At the same time, we also need to consider benefits of shadow banking for the Chinese economy and financial markets and realise that it is part of the financial system’s deregulation roadmap.
While much talked about recently, shadow banking in China is not a new phenomenon and actually represents a small percentage of bank assets compared to other countries. Moreover, in China this system is also simpler, without multiple levels of securitisation and is partially regulated.
Chinese banks are strongly controlled and regulated by the government, and are generally reluctant to take too many risks. This means that banks mainly lend to state-owned enterprises and avoid lending to SMEs and the private sector in general. Many of the companies we invest in are free of bank debt because they have had to grow and develop this way. Companies and entrepreneurs without access to bank channels find other ways to finance themselves, including taking peer-to-peer loans or trust financing. Chinese investors, meanwhile, invest money in wealth management products (WMP) in search of higher returns than the low state determined deposit interest rates. WMPs are managed by trust companies that are usually controlled by state firms themselves. Since trusts manage assets that often show higher risk level, it enables them to pay higher rates on WMPs.
The first concern with trusts and WMPs is that, although they are sold via regular banking channels, they are definitely not safe. As far as I could see and hear when visiting so-called investment banking arms of Chinese banks, valuation of the assets used as underlying collaterals is not always done with appropriate risk management procedures. Also, companies using trusts as a source of financing might be seen as more risky since they would otherwise have accessed bank loans. Secondly, according to the China Trust Association, most of the trust financing has been made in industrial, infrastructure or real estate projects that by nature are of a longer term than the maturity of products sold for 1, 2 or 3 years. That, therefore, raises the question of what happens when trust products mature if underlying assets or investors’ confidence deteriorate. Thirdly, their exponential growth is also a concern. When I moved to China in 2010, trust assets were at 3 trillion RMB, they have now reached 10-15 trillion RMB. How big will this become if the government does not rein it in and what effect will it have on Chinese economic growth if it does?
At a time when we hear about potential defaults of trusts, the difficult task for the authorities is to protect investors, but also prevent the rise of overall systemic risks while not increasing the risk of moral hazard driven by implicit guarantees. Going forward, we believe that the government will not crack down on shadow banking, but instead regulate it by improving risk control, penalties, and information disclosure. This will be positive for the Chinese economy and financial systems, as well as for investors. It might also bring back some appetite for the domestic stock market when local Chinese investors understand that WMPs will not always be a safe high-yielding alternative.
