Special Report: China’s leaders fret over debts lurking in shadow banking system

In March 2013, retired chemical company employee Anne Xing, her older sister and their husbands visited a China Everbright Bank branch on the outskirts of Shanghai. A private wealth manager at the bank had a special deal to offer them.

SHANGHAI/BEIJING/HONG KONG (Reuters) – In March 2013, retired chemical company employee Anne Xing, her older sister and their husbands visited a China Everbright Bank branch on the outskirts of Shanghai. A private wealth manager at the bank had a special deal to offer them.

“He said there is a high-quality product,” Xing recalls. “Only elite customers can buy it. We asked him if there was any risk. He said there was no risk.”

The two couples sank about 5 million yuan (about $762,000) into the investment product, which offered 9.5 percent annual interest over two years – substantially higher than the 3.75 percent they could earn on a fixed, two-year deposit at the same bank. Xing’s sister said she sold a property for 3 million yuan to fund her investment. The two families say they didn’t know exactly where the money was going at the time. When the contracts arrived weeks later, it turned out they had entered China’s $9.8 trillion shadow banking industry.

By December 2015, the interest payment for the second year was already well overdue and the couples were worried. “Then the sky came crashing down,” Xing said. “The money was gone, a couple of million.”

Everbright had actually sold the two couples a stake in Chang‘an Trust Coal Industry Resource Investment Fund Three – A Collective Investment Fund Plan. Their money had been lent to a coal miner that soon went bust. The Chang‘an Trust product was one of countless so-called wealth management products sold to investors to help raise money for a massive wave of lending in China that began in the aftermath of the 2008 global financial crisis.

The widely publicized default burned Anne Xing and other investors who now are suing Chang‘an. “I’ve become like the mentally ill, really,” says Xing. Amid the acrimony over the loss, Xing says, her sister divorced her husband.

Everbright did not respond to several requests from Reuters for comment. In a written response, Chang‘an said: “This case is currently being processed by the courts. Please wait for the judgment.”

Conducted outside the normal banking system, lending like this is at the heart of China’s massive shadow banking industry. For China’s rulers, the fear is that there may be more bad loans in the shadows of the financial system. The danger is that a big default or series of loan losses could cascade through the world’s second-biggest economy, leading to a sudden halt in bank lending.

Top leaders in Beijing have acknowledged that the colossal volume of complex and potentially risky lending obscured in shadow banking compounds the threat posed by the economy’s tremendous accumulation of debt since the global financial crisis. So far there have been relatively few defaults like the Chang‘an product. Some regional banks have been restructured after a spike in shadow loan failures.

Financial risk also poses a formidable challenge for the Communist Party. At a top level conference in July, party leader Xi Jinping declared that financial security was vital to national security.

Economic pain from shadow banking could also test the political climate for an authoritarian regime that justifies its one-party rule as the price the country must pay for stability and prosperity. Middle-income and high-income earners, the core of support for the Communist Party, have invested heavily in wealth management products, according to surveys of investors.

Inside and outside China, alarms are now sounding about mounting debt. Zhou Xiaochuan, the head of China’s central bank, the People’s Bank of China, has openly warned that authorities need to curb financial risks that might lead to a “Minsky Moment” – a sudden collapse of asset prices, sparked by debt or currency pressures, after a long period of growth. Zhou said corporate debt levels were relatively high and household debt was rising fast, in remarks in October on the sidelines of the Communist Party’s 19th congress in Beijing. “We should focus on preventing a dramatic adjustment,” he said.

Earlier this year, Moody’s Investors Service and Standard & Poor’s downgraded China’s sovereign rating, citing concerns over the nation’s rising debt.

Countries with close trading ties to China are monitoring efforts to restrain shadow banking and the accumulation of debt. The Reserve Bank of Australia (RBA) warned in its October Financial Stability Review that “financial stability risks in China remain high.” The RBA acknowledged that Chinese authorities were taking steps to curb risk. “But the more that leverage and risky lending grow, the more likely that China’s economic transition will include a significant disruption of some form,” the bank said.

A blizzard of regulations, high-profile arrests and official warnings over the last 18 months have sent a clear signal that authorities are attempting to reign in excesses. A veteran of the country’s financial reforms, Guo Shuqing, was appointed in February to head the China Banking Regulatory Commission. Guo almost immediately issued a flurry of directives aimed at forcing banks to improve risk management and curb the sale of complex, high-yielding wealth management products to investors.

In November, Beijing set up the Financial Stability and Development Committee, a top-level panel of regulators tasked with policing tougher rules and closing loopholes that allow risky lending. Days later, the People’s Bank of China and financial regulators jointly issued new draft rules to govern the wealth management industry.

There are signs it is working. The growth of shadow banking, particularly the sale of wealth management products, slowed over the first half of 2017, according to reports from Moody’s and Fitch Ratings.

But this too presents a political challenge: An overzealous crackdown could lead to financial and economic disruption, economists say. Shadow lending plays a major role in maintaining the 6.5 percent annual growth target that Xi Jinping has set for China’s economy. Slower growth may also expose less profitable borrowers to a higher danger of default, potentially creating the conditions for an upheaval. And smaller banks, which have benefited from the explosion of shadow banking, are resisting the new wealth management rules.

China’s banking regulator and the central bank did not respond to questions from Reuters about the risks of shadow banking.

In the case of the product sold to Xing and her relatives, the money raised through the Chang‘an Trust fund had been lent via a complicated series of transactions to Shanxi Loujun Mining, a subsidiary of coal miner Liansheng Energy. Liansheng went bust in late 2013, before the loan matured. The Liansheng failure was one of the first defaults that exposed the risks in shadow banking. It was widely covered in China’s state-controlled media.

At first, Anne Xing says, they thought they were buying an Everbright Bank product. If she had known what she was really getting, she said, “I one hundred percent would not have bought it.”

Before the 2008 financial crisis, there was very little shadow banking in China. In the aftermath of that shock, Chinese authorities launched a massive effort to stimulate the economy, mostly through a huge increase in lending. This led to a boom in property and infrastructure spending that continues today. Demand for credit increased sharply, especially from local and municipal government-owned companies.

To meet this demand, banks began selling wealth management products offering higher interest rates than normal deposits. Many investors believed these products were implicitly guaranteed by the issuer, even if it was not expressly stated in the contract. Banks also borrowed cash from other banks and companies.

For banks, these funds can then be lent to borrowers prepared to pay higher rates. But the banks want to sidestep rules designed to restrict lending to overheated sectors including property, mining and other resources. So, people in the shadow banking industry say, these loans are often disguised by directing them through a complex chain of intermediaries, including trusts, securities companies, other banks and asset managers.

To earn interest on these loans, a bank will buy a financial product from one of the intermediaries, which directs earnings back to the bank. That allows the bank to describe what is really a loan as an investment on its books. This type of lending can be more profitable because banks can set aside much less capital than they are required to hold for regular loans as a safeguard against defaults.

“WE WANT TO GROW QUICKLY”

By the end of 2015, shadow lending was growing faster than traditional bank lending, and was equivalent to 57 percent of total bank loans, according to a 2016 report from investment bank CLSA. This dramatically accelerated the speed at which overall debt expanded in China’s financial system. Moody’s said in a November report that China’s shadow banking assets grew more than 20 percent in 2016 to 64 trillion yuan ($9.8 trillion), equivalent to 86.5 percent of gross domestic product.

To fund this lending, there is intense pressure on staff selling wealth management products who earn small salaries and rely on commission for most of their income. A typical base salary would be about 5,000 yuan ($763) a month, according to an employee of a Shanghai-based trust, who spoke on condition of anonymity.

The employee said sales staff needed to sell 100 million yuan worth of these products a year, at a commission of about 0.6 percent, to meet targets. And, he said, while the marketing was slick, the quality of many of the products was poor.

At the center of shadow banking are the 12 nationally licensed joint stock banks and many of the more than 100 city commercial lenders which hold about a third of China’s commercial banking assets. From 2010, these mid-tier banks and regional lenders set about competing with the country’s so-called Big Five lenders, the state-controlled behemoths that dominate the economy. The key to the upstarts’ growth is selling wealth management products and borrowing from other banks, allowing them to create loans wrapped in financial instruments to give the appearance of investments.

In the northeastern province of Liaoning, Bank of Jinzhou Co nearly doubled its profits to 12.2 billion yuan ($1.87 billion) in the 18 months through the end of June, according to the company’s accounts. Driving this growth has been a swelling balance sheet of shadow loans, which have been growing at 30 percent annually over the last three years, according to the accounts.

In an interview in September, 2016, the bank’s vice president, Wang Jing, asked by Reuters about these loans, compared the bank’s appetite to that of a growing teenager who isn’t afraid to eat fatty meat. “We want to grow quickly,” Wang said. “Once we have a certain body mass, we’ll be able to do more things, provide better customer service, and there’ll be more opportunity to work together with the big banks.”

One of the biggest dangers is that banks must repay investors in many of the wealth management products and other creditors in three or six months. But the loans the banks make to potentially risky borrowers in real estate or mining are usually for terms of a year or more. So, lenders need to keep raising funds from new wealth management products and interbank borrowing to back their loans.

Patricia Cheng, head of China financial research at CLSA, describes how a financial crisis might unfold. In the event of major shadow banking defaults, a loss of investor confidence could mean banks find it difficult to raise funds from new wealth management products. “Then, the funding chain would collapse,” said Cheng. That in turn could lead to panic and a liquidity crunch, she added.

In the event of widespread defaults, the government would be forced to bail out investors because so many are middle and high-income earners, commentators say. Many investors also believe the banks would guarantee these products even though there may be no contractual obligation to do so. “This is a kind of untested assumption,” says Andrew Collier, managing director of Orient Capital Research and author of “Shadow Banking and the Rise of Capitalism in China.”

In the short term, though, Collier and many leading economists familiar with the Chinese banking system think Beijing has the financial tools to avoid a crash if excessive risk can be controlled in shadow lending. They argue that a grinding, protracted economic slowdown that curbs the availability of credit to the more vibrant sectors of the economy would be a more likely threat from a series of shadow banking failures.

The Reserve Bank of Australia and other observers suggest a banking crisis in China would be unlikely to lead to global contagion because the country has limited direct financial links with other countries. But global growth would suffer. China vies with the U.S. for the title of the world’s biggest trading nation.

For Anne Xing and her family, the immediate challenge is to get their money back. In May 2016, they went to Everbright’s Beijing headquarters where they met officials from the bank and Chang‘an Trust. Xing said the bank proposed lending Chang‘an the money to pay out investors. Chang‘an rejected this, she said.

In July 2016, Xing visited Chang‘an Trust’s headquarters in Xi‘an. Xing said that Chang‘an told her it was Everbright that had sought to set up the wealth management product. She said Chang‘an also told her that there was an agreement that Everbright would take responsibility for repayment of the principal and Chang‘an would handle the interest payments. Chang‘an said there was no written agreement, only an oral undertaking, Xing said.

The following month, Xing and other investors sued Chang‘an, claiming the wealth management product had not been legally created.

In May this year, they directed their frustrations at Everbright, the bank. Along with other investors they took to the street, staging a 12-day protest outside Everbright’s headquarters in Beijing.

They are still waiting for their money.

By Engen Tham, Matthew Miller and David Lague; Additional reporting by John Ruwitch in Shanghai; Editing by Peter Hirschberg

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