This week’s required reading, for anyone interested in the Chinese economy, is an article published by Caixinabout the surge in off-balance sheet “private wealth management” funds being raised and invested by Chinese banks. The article is an important complement to the Bloomberg article I highlighted last week, on local government bond issuance, because it explains, at least in part, who is financing all these risky investments.
According to Caixin, Chinese banks — limited in their ability to lend by China’s efforts to rein in inflation — have introduced a dizzying array of “private wealth management” (PWM) products aimed at higher-income investors.
About 9,000 types of wealth management products were available to Chinese investors during the first half of 2011, double the number offered in 2010. Capital turnover for these products topped 8 trillion yuan between January and June.
The products vary in design, but generally offer a much higher return than regular deposits — upwards of 10%, compared to the regulated deposit rate of 3%, which is below the current rate of consumer inflation. The question, though, is whether the sponsoring banks can really find enough high-quality investments to deliver the promised returns. Critics fear that the money is being channeled into infrastructure and real estate projects that may turn out to be losers. For instance:
CCB’s clients include the Yunnan Highway Development Investment Co., a provincial government-affiliated platform for financing road projects, that borrowed billions of yuan. The bank provided loans by selling some 4 billion yuan worth of wealth management financial products to its clients. The platform was close to default early this year.
Why are Chinese banks suddenly so active in selling these products? One possibility is that they are simply an end-run around high reserve requirements. Instead of struggling to gather deposits (at less and less attractive interest rates) and then setting aside 21.5% as cash reserves before lending the rest out, banks can promise high interest rates and channel the whole amount directly into lending, collecting a fee instead of a spread.
The other possibility is that PWM funds provide a way for banks to shift growing lending risks onto customers. Rather than underwriting loans, they’re playing matchmaker. In some cases, critics fear, banks may have a conflict of interest, and may actually be shifting not just risk but known losses onto naive investors. For instance, if bank helps a local government sell bonds in order to repay its troubled bank debt, it can offload its problem debts onto its clients.
Alternatively, critics worry that some products, which offer a guarantee fixed rate of return, may leave banks on the hook for serious losses if the funds don’t perform as advertised. If that’s true, banks may be accumulating more and more loss exposure from funding projects that isn’t showing up on their balance sheets.
The most alarming part of the story, however, is how banks have been rolling over and pooling short-term, high-return funds in a way that makes it very difficult to trace how, exactly, investors are being paid off.
The rolling nature of the investment money can be seen clearly by comparing the wealth product “flow” and “outstanding” values.
At the end of the first quarter, CBRC said, the total value of all outstanding wealth management products – all yet-to-mature products at any one time – was 1.9 trillion yuan. That’s equivalent to about 2 per cent of total commercial bank assets in China.
But the flow – total capital turnover during a given period – was 8.25 trillion yuan during the first six months of the year, up from 7.05 trillion yuan for all of 2010, according to the firm Benefit Wealth.
The danger, of course, is that banks are successfully paying investors high returns not from the real returns being generated by the money invested, but from money coming in from new investors — the very definition of a Ponzi scheme (Charles Ponzi promised investors a 50% return in 90 days, but had no practical way of investing the money at all. When the first 90 days were up, he paid the initial investors back — plus their 50% interest — with new money he raised in the meantime. When people saw the first investors getting rich, they piled into the fund, making it possible to continue the trick, for as long as the blind enthusiasm lasted).
Whether or not this is actually happening is obscured by the practice of pooling multiple funds into one pot:
A source at a joint-stock bank said capital from a bank’s short-term wealth management product goes into a capital pool. The pool’s size is maintained by continuously rolling through new products. And an ever-increasing share is steered into high-yield, risky assets, the source said.
A China Banking Regulatory Commission (CBRC) official said this “capital pool method is not consistent” with the regulator’s basic “principles” of separate and transparent accounting for wealth management plans.
If there are losses taking place, nobody will necessarily know for quite a while — until fundraising slows, and there’s not enough money in the pot, causing the whole thing to come crashing down.
In the best case scenario, the shift to PWM funding may simply be a backdoor way of deregulating interest rates to reflect real risk and returns in China’s domestic capital markets. There’s nothing wrong with risk, per se. The problem is when investors ignore or misunderstand risk, looking only at high returns. That is particularly true when investors are led to assume that someone else — the bank, the government, etc. — bears the real risk, and will cover any losses that may occur. That opens the door to reckless behaviour and unexpected collapse.