Niu Dianqing stopped his motorbike at a construction site in China’s Inner Mongolia one morning last month. The front door was locked.
“They said they will pay me this month, but it seems I’m fooled again,” said Niu, who supplied nets for protecting workers from falling off bamboo scaffolding at the half- completed Purple Palace, a development including a luxury hotel and three residential buildings in the city of Ordos. “The doorman was still here last week, but now even he’s gone.”
The developer, Ordos Jin’ao Property Development Co., owes a lot more than the 10,000 yuan ($1,604) Niu is trying to collect, and it isn’t only suppliers who are out of the money. Dozens of investors nationwide have put 445 million yuan of savings into funding Purple Palace’s construction.
The two-year investment vehicles they purchased, called trusts, promised an annual interest rate of at least 10 percent and return of principal in March 2013. With at least 1,000 similar projects having ground to a halt this year in Ordos, where over-investment has resulted in a building boom gone bust, tens of thousands of investors risk default.
“The risks are significant there, and something must be done by the government to stop potential defaults of property trusts from spreading nationwide,” said Lian Ping, an economist at Shanghai-based Bank of Communications Co. “Trusts have become too large to fail.”
Trusts, targeting people with at least 1 million yuan to invest in alternatives to low-yielding bank accounts, are the fastest-growing segment of China’s nebulous world of shadow banking. They make up more than a quarter of the country’s estimated $3.35 trillion in non-bank lending, according to an Oct. 16 report by UBS AG chief China economist Tao Wang, or about 45 percent of the country’s gross domestic product.
Shadow banking worldwide is a $67 trillion industry whose size “can create systemic risks,” the Financial Stability Board said in a Nov. 18 report. The business in China, which includes banks’ off-balance-sheet vehicles such as commercial bills and entrusted loans, as well as underground lending by individuals, flourishes because more than 90 percent of the nation’s 42 million small companies can’t get bank loans.
China’s 64 trust firms, with sales offices in major cities, combine characteristics of commercial and investment banking, private equity and wealth management. They pool household savings to offer loans and invest in real estate, stocks, bonds, commodities, even bottles of sorghum liquor. No other financial firms operate across all these asset classes.
Trusts are set to overtake insurance by year-end as the nation’s second-largest financial business after banks, having expanded almost 16-fold since 2007, KPMG LLP said in a July report. Assets under management rose 47 percent in the 12 months through June, “a period during which the government supposedly clamped down on trusts,” UBS’s Wang wrote. Combined profit jumped 56 percent in the first nine months to 28.8 billion yuan after surging 88 percent in 2011, according to the China Trustee Association, a Beijing-based industry group.
Unlike other shadow-banking financing, trusts are supervised by the China Banking Regulatory Commission, which has to approve every product. The regulator last year published 36 rules and notices to curb risk, according to KPMG. It requires trust companies to honor commitments to investors or their business licenses will be revoked, forcing issuers to dig into their own pockets or issue new products to pay off old ones when borrowers can’t repay.
“China’s non-banking financial institutions are under strict regulatory supervision, rather than free of regulation as in some countries,” Central bank Governor Zhou Xiaochuan said at a press conference in Beijing last week during the Communist Party congress that chose Xi Jinping as China’s next president.
The party has pledged to promote freer movement of capital in and out of the country for investment purposes and to make the exchange rate more market-based.
Competition for trust licenses among foreign and Chinese investors has intensified as the number of permits dropped to 64 this year from more than 1,000 in 2002. Barclays Plc, Morgan Stanley and JPMorgan Chase & Co. are among global banks that have bought stakes in at least 10 Chinese trust firms.
Now, after plugging the capital shortfalls of developers amid a drop in real estate prices and a tightening of credit, trusts are facing repayment risks. As much as 15 percent of the nation’s 560 billion yuan of property-linked trusts that come due by the end of 2013 may default, according to brokerage China International Capital Corp.
“The heyday of trusts is gone, and now they’re left with quite a few land mines to navigate,” said Ivan Shi, a Shanghai- based analyst at consulting firm Z-Ben Advisors Ltd. “Surviving the peak of repayment next year is probably the biggest challenge as we know many projects are dodgy.”
Trusts need to repay investors about 250 billion yuan in principal and return on property-linked investments this year, and an estimated 310 billion yuan more will come due in 2013, according to CICC. Issuers may be forced to extend payment deadlines, sell new trusts to pay off old ones or dispose of collateralized assets, the firm said.
“Nobody knows exactly how much obligation the sector has accumulated, but we know for sure the debt must be paid one way or another,” Shi said, adding that trust firms will have to step in to honor those debts if borrowers including property developers fail to make payment.
Risks may be “artificially suppressed” by rolling over debts into new products or buyouts by stakeholders, the International Monetary Fund warned in its October Global Financial Stability Report. Such bailouts “may create a false sense of safety that induces overinvestment,” the IMF wrote, adding that some trust assets are loans extended to developers and local government investment vehicles that can’t access bank credit and may be squeezed in a liquidity crunch.
“In the event of more severe credit problems in the trust sector, some financial losses might even spill over to banks, which often act as a marketing channel for trust products,” the IMF said in its report.
One backer of Purple Palace is Chongqing-based New China Trust Co. When the firm updated investors in October, there was no mention that work had been halted or that cranes and cement structures had been abandoned for more than six months.
New China Trust didn’t respond to three calls seeking comment, and a contact number for Ordos Jin’ao couldn’t be located. An official who declined to give his name at Ordos Jinshan Property Development Group, identified in the trust prospectus as a former shareholder of the project, confirmed that construction had been halted.
Angie Tang, a Hong Kong-based spokeswoman for Barclays, said the London-based bank’s investment in New China Trust is “going very well.” A spokeswoman for JPMorgan in Beijing declined to comment on the company’s trust investments. Morgan Stanley didn’t respond to two e-mails seeking comment.
More than 35 percent of trust assets in China were funding infrastructure and real estate construction as of Sept. 30, according to China Trustee Association data. Property-linked trusts accounted for 677 billion yuan, or 11 percent of the total, a decrease of 3.3 billion yuan from a year earlier.
China’s policy makers have tried to curb the residential property market by raising down-payment and mortgage requirements and building affordable housing. The government also imposed property taxes in Shanghai and Chongqing, and placed home-purchase restrictions in about 40 cities. The result has been a 4 percent decline in home sales nationwide during the first nine months of the year and a price drop in October for new homes in 17 cities out of the 70 tracked by the government, according to the National Bureau of Statistics.
In May, repayments to a 200 million-yuan real estate trust issued by Jilin Province Trust Co. came eight days late, making it China’s first de facto trust default, China Securities Journal reported. The property developer failed to complete construction of a commercial building in Nanjing and generate enough cash flow from rentals, according to the report.
China Huarong Asset Management Co., one of four state-owned asset managers established in 1999 to take over trillions of yuan of bad loans from the largest lenders, bailed out the trust by buying the project and returning all of the money to investors, according to China Securities Journal.
Jilin Province is one of nine trusts borrowers were having difficulty repaying as of July 15, according to Benefit Wealth Co., a Chengdu-based data supplier that tracks China’s wealth- management market. The trusts had invested in natural resources, arts and properties.
Ordos, with a population of 1.9 million and rich in coal, natural gas and cashmere, is dotted with unfinished real estate projects as the drop in home prices and a collapse of private lending squeezed buyers and developers.
Work at almost two-thirds of the city’s 2,000 construction sites has been halted, while at least 300,000 migrant workers who came to build the city may have left over the past year, according to contractor Zhu Yadong. Zhu said his company was owed 20 million yuan in labor and material costs after laying the foundation for Ordos’s “World Trade Center,” where construction also stopped this year.
“The more we build, the more money we lose,” Zhu said as he watched two workers loading piles of rusty steel pipes onto a truck so they could be resold to reduce his losses. “This place was built on a bubble and needs a long time to get back on its feet. There are just too many properties and too few buyers.”
A few blocks from the Purple Palace, another developer’s plan to build a complex including two luxury hotels, a shopping center and office buildings funded by 1.1 billion yuan of trust investments also was put on hold.
The trusts, promising a 10 percent annual interest rate and set to mature starting in July, according to a prospectus, haven’t generated much income, said Lu Yixuan, the project’s only remaining saleswoman. The developer stopped selling residential homes in the complex this year, Lu said, sitting in a dim showroom.
Trusts have gone through the ups and downs of six periods of industry overhaul since the 1979 establishment of China International Trust & Investment Co. by the late Vice President Rong Yiren. Their functions have evolved from central and local governments’ borrowing arms to loan issuers and asset managers.
The 1998 collapse of Guangdong International Trust & Investment Corp., which borrowed domestically and overseas on behalf of southern China’s Guangdong province, was the most notorious. It left creditors including Germany’s Dresdner Bank AG and Chicago-based Bank One Corp., which later merged with JPMorgan, with $3 billion of unpaid bonds. The bankruptcy marked the first time Chinese authorities didn’t bail out a state-owned borrower. Only 50 of more than 240 trusts survived.
Trusts took off again in 2010 as they helped banks move loans off their balance sheets and circumvent lending quotas amid monetary tightening. Developers had to rely on trust loans for working capital even as borrowing costs including interest and fees amounted to about 15 percent this year and almost 20 percent last year, according to Benefit Wealth. That compared with the benchmark one-year lending rate of 6 percent.
When some loan requests were rejected by big banks because of repayment risks, they made their way to trust companies that offered financing at a higher cost, according to Zhou Hongliang, general manager of Agricultural Bank of China Ltd.’s private- banking unit, which competes with trust firms to manage assets for people with at least $1 million to invest.
China ranked third globally with 1.4 million millionaire households in 2011, following the U.S. and Japan, an increase of 16 percent from a year earlier, according to Boston Consulting Group. The world’s second-largest economy is set to dominate Asia’s wealth market, which Swiss bank Julius Baer Group Ltd. estimates may double by 2015 as the number of high-net-worth individuals increases to at least 2.8 million.
Trust buyers are mostly small-business owners and senior corporate managers, with half of them controlling at least 10 million yuan of assets, according to a 2012 survey conducted by a unit of Ping An Insurance (Group) Co. (2318), China’s second-biggest insurer. Almost 77 percent of trust investors bought real estate-linked products, while 75 percent said they achieved annual returns of more than 9 percent, the survey found.
“The popularity of trusts is a reflection of the growing high-net-worth-individual market and demand for diversified financial services, especially with the help of implicit guarantees on repayment,” Z-Ben’s Shi said. “But that has turned into a double-edged sword. What made the trusts prosper in the past few years is now threatening to bring them down.”
Ke Kasheng, who until October oversaw trusts at the banking regulator, said in August that while some products face repayment risks the possibility of widespread defaults is limited. The amount of multi-investor real estate trust products that need to be repaid is 71 billion yuan this year and 184.2 billion yuan in 2013, he said.
The regulator in May required the four biggest state-owned asset managers to seek approvals before buying distressed real estate trusts and asked issuers to have a bailout plan six months before maturity if they foresee any risk of default. Firms were told earlier to impose higher weightings on property and other risky assets when calculating net capital, inspect compliance and risks of loans to property developers and stop offering them loans for working capital or land purchases.
Not all trust issuers heeded the call. Shanghai AJ Trust & Investment Co. in September raised 300 million yuan for a trust to invest in a residential project in a province including the city of Wenzhou, promising a minimum annual return of 11 percent for the three-year investment. Individual investors needed at least 3 million yuan.
The proceeds will help Zhejiang Kunlun Properties pay off its land purchase so the developer can start building. The annual return on investment can go as high as 17.4 percent if the selling price of the apartments reaches 12,100 yuan per square meter, according to the marketing document.
Home prices in Wenzhou dropped 16 percent in September from a year earlier, the seventh consecutive monthly decline, according to the statistics bureau.
Mao Zhen, a Shanghai-based sales manager of AJ Trust, said he spent hours on the phone fielding questions from potential clients suspicious of a return that’s almost four times the benchmark one-year deposit rate.
“I can’t stress enough that the return is guaranteed, though you won’t see that on the contract,” Mao said. “We did our homework and made careful selections on projects. Even in the worst-case scenario, investors will get what they were promised with money from the company’s own pocket. We will do everything to protect our business license.”
At least a quarter of trust buyers took such guarantees seriously and didn’t prepare for any losses, according to Ping An’s survey.
Prospects for the business remain unclear. Trusts weren’t mentioned in the 12th five-year plan China’s top regulators drafted for the financial industry in September. The plan detailed development guidelines through 2015 for banks, brokerages, mutual funds, futures firms, insurers and fledgling informal lenders such as loan guarantors and pawn shops.
“This speaks loudly of regulators’ concern about the unruly expansion of trusts and their sustainability,” said Fan Jie, a Chengdu-based analyst at Benefit Wealth. “The uniqueness and competitive edge of trusts as an all-inclusive asset manager will be undermined going forward as every other type of financial firm is encouraged to sharpen such skills.”
The China Securities Regulatory Commission in September allowed mutual funds to manage money from designated investors with at least 1 million yuan for investment in both listed and unlisted securities and debts, putting them in head-to-head competition with trust firms.
At the Purple Palace in Ordos, Niu sees little chance of getting his money back.
“I came here every four to five days just to check whether there’s anything magically going on,” Niu said. “But did you see anybody around here? No buyers, no nothing. If anybody wants to get money back, they can finish this building in their dreams first.”
--Luo Jun and Bonnie Cao, with assistance from Alfred Cang in Shanghai. Editors: Sheridan Prasso, Robert Friedman
To contact the editor responsible for this story: Chitra Somayaji at firstname.lastname@example.org