What You Need To Know About China's Fragile $2.2 Trillion Shadow Banking System

It is clear that the Chinese economy is slowing, and some think the risks of a hard landing are rising substantially.

If economic growth in China continues to slow, rising and sudden defaults on loans made in the country's shadow banking system could threaten to bring down China's traditional banking sector and throw the world's third-largest economy in jeopardy, according to Bank of America Merrill Lynch China Strategist David Cui.

The hodgepodge web of non-banks that comprise the shadow nexus in China includes pawn shops, underground banks, various wealth management products, trust companies, and guarantors – many of which don't take deposits to insure against risky lending activities and operate completely beyond the eye of regulators and authorities.

What follows are highlights from Cui's comprehensive report examining China's shadow banking system.

Why the shadow banking system in China is so important

The sheer size of the system is overwhelming. At an estimated 14.5 trillion renminbi ($2.2 trillion) according to BofA, the amount of loans made by shadow banking entities amount to 25 percent of all the loans made in China by the traditional, regulated banking sector.

The system is also highly leveraged. Shadow lenders make most of their money by borrowing from regular banks at low interest rates and lending out at higher interest rates to riskier borrowers. No deposits at these institutions means they are highly vulnerable to loans gone bad, especially given the types of less-than-creditworthy clients who borrow from shadow banks.

wenzhou

www.flickr.com

Wenzhou
Cui walks through the shadow banking system in China and takes a look at the institutions that comprise it and the unique risks posed by the activities of each.

Shadow banking entity #1: The investment trust industry

Investment trusts are basically companies that manage other people's money by lending it out to finance various business projects or property loans on the one side and, on the other, guaranteeing a certain percentage return to the investors.

The investment trust industry in China has seen stunning growth recently. In 2007, the industry managed 1 trillion renminbi; in 2011, that number was up all the way to 4.8 trillion renminbi, a nearly 5x increase in under five years.

Cui says his team at BofA has "noticed early signs of stress in the system, e.g. at least three property trust products had failed to meet their repayment schedule and had to be bailed out." Furthermore, he estimates that leverage in the investment trust entities "remains high, often reaching 10-15x."

Not only is the trust industry highly leveraged, but also highly concentrated. Of the 62 Chinese investment trusts, 10 of them account for half of all assets under management industry-wide, and 20 account for 72 percent.

The huge issue in Cui's mind is the total lack of transparency in the investment trust industry. Only 2 of those 62 companies are required to disclose any sort of investment returns. This leads to investment "pooling," wherein a trust will take an investor's money and invest it in multiple projects at the same time.

The problem is that the investment trusts don't really have to disclose any sort of detail on the investments in the pool, either. And Cui says that "some local experts think the share of pooled products in total trust assets may surge from 5% in 2011 to 30-40% by the end of 2012."

Bottom line: If property prices and other investments turn sour and highly-leveraged, highly-concentrated investment trusts have guaranteed a certain level of returns to investors, they will have to be bailed out or they will face collapse.

Shadow banking entity #2: Pawn shops

There are over 4,000 pawn shops spread across China. They will probably provide the earliest warning signal that the system is melting down, according to Cui.

Pawn shops will show up on the radar first because of the nature of their lending business: most borrowers seek loans from pawn shops for extremely short periods of time, and for the typical borrower, it only takes one to three days to secure a loan.

Hong Kong pawn shop China

flickr / paularps
So, with the pawn shops, it's all about short-term lending. And, being pawn shops, they accept all sorts of collateral against these short-term loans – everything from cars and jewelry to financial securities like stocks and bonds, and property.

Bottom line: The property is a big issue, because if volatility in China's property market continues and property prices take a further tumble from here, thousands of pawn shops will be left holding the bag on defaulted loans backed by collateral heavily discounted in value.

Cui warns in his report that we know how this sort of situation could play out because we already saw the exact same thing happen last summer. He writes, "for example, seven pawn shops in Wenzhou reported big losses in July 2011 because they couldn't liquidate their collateral fast enough while their carrying costs were high."

Shadow banking entity #3: Guarantors

China has guarantors of over 19,000 different businesses. They provide guarantees on loans to risky borrowers, making it more palatable for traditional banks to lend to those who are less creditworthy than the average client.

The upshot here is that guaranteeing loans to risky borrowers isn't that great of a business to begin with since a guarantor makes probably half the rate on a given loan that a pawn shop does, for example.

Given that, guarantors are turning to illegal practices in order to boost their returns. Cui surmises that "the biggest risk in the industry is guarantors are acting more like a lender rather than focusing on their core guarantee business."



BofA Merrill Lynch

What do the guarantors do to make money instead? They literally take a portion of the loan they are guaranteeing from the borrower they are guaranteeing and lend that money back into the shadow banking system to other underground borrowers. The net effect, of course, is amplified leverage within the shadow nexus.

And that is how the loan guarantee business in China really gets wild – instead of providing guarantees on clients' loans, guarantors themselves are taking the loan money they are guaranteeing and lending it out to even riskier borrowers.

Bottom line: When those new shadow loans blow up (potentially due to any of the four triggers mentioned at the beginning of this article), it is the clients – who are supposed to be guaranteed by the guarantors in the first place – that end up footing the bill.

And the big worry is that this has already begun. Two guarantors, for example – Huading and Chuangfu – have already run into trouble. Cui writes that "many of their clients have been sued by their banks for loan repayments although the borrowers claim that their guarantors have been using the fund," and that "some of these borrowers are now seeking help from the municipal government of Beijing...to negotiation for a loan extension with the banks."

Shadow banking entity #4: Underground banks

Cui calls underground banks "arguably the most unstable shadow banking sector". And the commodities business is currently a major player in this area.

Letters of credit – trade finance agreements in which a bank pays the seller of a commodity and then goes and collects payment from the buyer of the commodity – are booming, and they are off-balance sheet vehicles, meaning they don't factor into the traditional banking sector's balance sheet leverage ratios and regulations regarding loan quotas.


Cui points out that many of the companies that are shut out of the official loan market are resorting to securing letters of credit from banks using copper and other commodities as collateral.

And metals traders are getting in on the game, too. A trader will borrow to buy copper or steel via a bank who issues a letter of credit to the seller on behalf of the trader. The trader can then take his new metal stock and pledge that as collateral for a normal bank loan, which he can then take and make money by lending the funds back into the shadow banking market at a higher interest rate.

When it comes time to for the trader to cover the letter of credit several months later, he recalls the loan from whoever he lent it to and pays back the bank.

Bottom line: Cui says these practices in the steel market are potentially explosive because "local warehouses, unlike those four or five well regulated in bonded areas, often provide multiple bills of lading to traders so they can obtain loans from different banks using the same steel inventory."

In other words, there's a lot of hidden leverage all over the place that is very difficult to quantify.

Shadow banking entity #5: Wealth management products

Wealth management products set up by traditional banks have some characteristics that are similar to trust companies that cause concern, and there are rumblings that a lot of the industry could be operating one big Ponzi scheme.

Indeed, the biggest problem with wealth management products in China is that by and large, no one has any idea what they are investing in or what kind of returns they generate.

Here's an idea of how much we know about what a typical wealth management product – specifically, one of China Merchants Bank's "most popular 7-day WMP products," according to Cui – is invested in:

Asset allocation disclosure by one typical WMP, China shadow banking



In other words, not much. Cui writes, "So in theory, the bank can invest up to 70% of the fund in areas we have zero information on."

When Cui looked into all 59,082 of the wealth management products that have been issued in China since 2004, he found that less than half have even disclosed what return the investments have generated in the past few years.

Bottom line: Pooling is a big concern. Cui says banks will "issue multiple WMPs with various durations, pool the funds together, and invest in various areas with different durations jointly and pay out 'expected' returns from the pool."

Cui continues: "According to some industry insiders, some banks have been using new WMP proceeds to cover losses from previous products in the pool – in our view, this is not fundamentally different from a Ponzi scheme. However, the music may stop at a certain point if/when WMP asset size stops expanding."

The underlying problem facing all the institutions that make up China's colossal shadow banking system is a slowdown in growth.

In fact, just last week we wrote about four major triggers that could bring down China's shadow banks, all of which stem from continued economic weakness, just like the one China is currently experiencing. The four triggers are 1) (Illegal) Ponzi schemes falling apart; 2) a wave of defaults in highly-leveraged loans within the shadow banking system; 3) more turbulence in the Chinese property market; and 4) shrinking corporate sector earnings.

Given the shadow banking system's enormous size, importance to the real economy in terms of the credit it provides, and the numerous feedback loops back into the traditional banking sector, China could face major issues if it starts to look like no one is able to pay anyone else back.