Du Ronghai received an urgent phone call from his private banker at Industrial & Commercial Bank of China Ltd. about an investment opportunity promising a 10 percent annual return. Only for the privileged few, he was told.
Du, who owns an apparel manufacturer in southern China, said he hopped on a plane the next morning for a four-hour flight from his home city of Harbin. That afternoon, at an ICBC office in Guangzhou, he looked at the sales contract he was required to read in person and invested 3 million yuan ($488,000), his first foray into the high-yield world of shadow banking. The employee kept telling him the product, called a trust, was so good that bank staff were pooling money to buy it, he said.
“I knew nothing about it, but the return was very, very tantalizing, and the way they presented it was like if I don’t buy it now, someone else will grab it in seconds,” said Du, who at the time, about two years ago, had almost 30 million yuan parked at Beijing-based ICBC in deposits earning less than 3 percent annual interest. “I was thinking, if I can’t trust ICBC, who else can I trust?”
More than 700 ICBC clients including Du invested 3 billion yuan in what was known as Credit Equals Gold No. 1. The product was issued by China Credit Trust Co., one of 67 companies with license to act as intermediaries between banks and borrowers in providing shadow financing. In January, it almost became the nation’s biggest trust default in at least a decade, jolting global markets until an 11th-hour bailout.
The drama highlighted the risks of shadow banking, which over the past three years has evolved from underground lending among individuals and small companies into a complex and interconnected web, estimated by JPMorgan Chase & Co. to be valued at $7.7 trillion, involving the nation’s biggest banks, state-owned firms, local governments and millions of households.
The mixing of funds makes it more difficult for the government to rein in the nation’s credit supply and to shield its state-controlled banks from rising defaults as the economy cools. Banks had an estimated 6.6 trillion yuan of off-balance-sheet loans channeled mostly through trusts to risky corporate and local-government borrowers, according to Mike Werner, a Hong Kong-based analyst at Sanford C. Bernstein & Co.
That figure is equal to more than 80 percent of banks’ shareholder capital and has increased 65 percent annually for the past three years, Werner wrote in a Jan. 22 note.
As China’s top legislators start their annual meeting in Beijing tomorrow to set economic targets, efforts by policy makers to crack down on unregulated lending threaten to undermine financial stability.
“The failure of one product could lead to defaults of many others in a chain reaction,” said Christine Kuo, a Hong Kong-based analyst at Moody’s Investors Service. “The fall of shadow banking, starting with trusts, will spill over to the whole financial system, trapping banks and other stakeholders. That’s why the government is extremely cautious for fear that any misstep may trigger a systemic crisis.”
At stake is what the China Trustee Association, an industry trade group, estimates are $1.8 trillion of products developed by trust companies. Lenders also created $1.6 trillion of high-yield wealth-management investments, up 40 percent in the nine months through Sept. 30, according to JPMorgan.
Banks have more than their reputations on the line. They have channeled their own capital as well as clients’ money through trusts to risky borrowers they’re normally prohibited from lending to, such as coal mines and property developers, according to the Trustee Association.
About 5.3 trillion yuan of trust products will come due this year, up from 3.5 trillion yuan in 2013, Haitong Securities Co. estimated in January, warning that the trust industry can no longer shoulder risks tied to offering implicit guarantees, as companies lack sufficient capital to bail out investors.
At least 20 trust products have run into difficulty making payments since 2012, according to Beijing-based China Securities Co. All have avoided default as issuers or third parties such as state-owned bad-loan managers and guarantee firms eventually repaid investors in full.
“The government is faced with a dilemma,” Moody’s Kuo said. “It knows that the implicit guarantee cannot last forever, but at the same time it is very worried about triggering a systemic crisis.”
China’s trusts are unique in that they can invest across all asset classes from loans and real estate to bonds and commodities, under China Banking Regulatory Commission supervision. Cooperating with trusts helped banks get around regulatory restrictions to expand lending and offer new products to yield-hungry investors. It also helped the trust industry take off after six periods of ups and downs since its inception in 1979.
Before 2010, lenders used trusts to offer off-balance-sheet loans directly to property developers and local-government financing vehicles. At the end of 2010, more than half of China’s 3 trillion yuan in trust assets originated from banks, mostly funded by wealth-management products sold to banks’ clients, Trustee Association data show.
Regulators intervened in January 2011 by requiring banks to reduce such tie-ups and bring business with trusts onto their balance sheets. Trust firms were told to hold capital against certain loans. As a result, the official level of cooperation between banks and trusts fell to 20 percent of the total 10.9 trillion yuan in trust assets at the end of last year, Trustee Association data showed.
The decline masked the extent of banks’ exposure to trusts as lenders responded by creating new, more-intricate structures that allow them to invest clients’ funds as well as their own capital in high-yielding trusts that divert money to riskier corporate and local-government borrowers, according to Stephen Green, Standard Chartered Plc’s Hong Kong-based head of China research, and Bernstein’s Werner.
The practice often involves so-called trust-beneficiary rights, which are the legal rights to trust products. Typically, another company will be brought in to buy the trust product and then sell the rights to the bank, enabling it to book the loan as a financial asset held under a repurchase agreement.
Such assets require a capital charge of 25 percent compared with 100 percent for booking a loan, Green wrote in a November note. Sometimes another bank will be brought in as an intermediary to create an interbank exposure that allows for lower risk-weightings and credit costs than a standard loan.
Credit-underwriting criteria for such loans, with most going to industries such as mining, property development and local-government borrowing arms, are often more lax than those applied by banks or debt capital markets, making them vulnerable in an economic slowdown, according a November report by McKinsey & Co. and China Ping An Trust Co. Trusts are arguably the second-most risky financing channel for companies, after underground financing, Zhang Zhiwei, an economist for Nomura International Hong Kong Ltd., wrote in a Jan. 28 note.
Fewer than 10 percent of trust firms are formed by the private sector, with the rest owned by large state-owned enterprises, financial conglomerates and local governments, the McKinsey and Ping An Trust report said. The state-owned companies often own each other’s shares, and the government is involved in appointing the heads of these firms.
The top three shareholders of Beijing-based China Credit Trust are state-owned enterprises, including People’s Insurance Company (Group) of China Ltd., which owns a 33 percent stake and is the trust’s biggest investor.
Credit Equals Gold, the trust product Du bought, was structured to allow ICBC to offer an off-balance-sheet loan to Shanxi Zhenfu Energy Group, according to brokerage China Securities. Buyers staged protests at an ICBC branch in Shanghai in January, demanding the lender repay investors the principal and full amount of interest owed after the coal miner went bankrupt in 2012.
ICBC’s Beijing-based press officer declined to comment about the matter. China Credit Trust’s board secretary didn’t answer several phone calls.
Du said he tried to collect his money soon after learning of the possible default. He failed, discovering that his account manager had left ICBC for another bank, he said.
“As a conduit for banks, trusts won customers who believe banks will be held responsible if anything happens to their investments, and behind banks is the Chinese government,” said Liu Jun, a Wuhan-based analyst at Changjiang Securities Co. “That’s how perception of the implicit guarantee was formed and later reinforced with repeated bailouts.”
Since trusts gained popularity in 2010, the CBRC, which also supervises banks and companies that dispose of bad loans, has required trusts to ensure repayment to investors and prevent the chaos that led to several rounds of government-led restructuring and consolidation of the industry. That forced trusts, eager to retain their licenses, to dig into their own pockets or issue new products to pay off old ones. The regulator recently issued a notice making trust companies and some employees liable for life for products created under their watch even after they leave the companies, two people familiar with the matter said on Feb. 28.
The CBRC, created in 2003, also has the power to decide on top executives of eight financial institutions, including China Credit Trust and the nation’s four bad-loan disposal companies, according to two people with knowledge of the matter. The leaders of the five state-controlled banks, including ICBC, are appointed by the ruling Communist Party’s personnel department.
The regulator named Deng Hongguo, who was in charge of three policy lenders including China Development Bank Corp. at the time, as China Credit Trust’s chairman in 2010. The previous year, the CBRC appointed Lai Xiaomin, its equivalent of chief of staff, as president of China Huarong Asset Management Co., the nation’s biggest bad-debt manager.
During the bailout discussions on Credit Equals Gold, Huarong was approached to take part in the rescue, according to a person with knowledge of the matter who asked not to be identified because the information is private. Huarong rejected the idea, partly because involvement might derail a planned initial public offering, the person said.
Chinese authorities are seeking to rein in shadow financing by tightening liquidity and to reduce leverage in the economy after the credit-to-gross-domestic-product ratio rose 42 percentage points from the beginning of 2009 through September to 163 percent, according Nomura. The nation’s borrowing spree since 2008 has evoked comparisons to debt surges that tipped Asian nations into crisis in the late 1990s and preceded Japan’s lost decades.
Financial-sector regulation and liberalization may be among areas discussed at the National People’s Congress, Barclays Plc Hong Kong-based economist Chang Jian wrote in a note to clients yesterday. Policy shifts that could incur greater financial risks and require policy coordination such as shadow banking and local government debt are lagging, she wrote.
Wu Xiaoling, a former deputy governor of the central bank, said on Feb. 10 that China’s financial risks are accumulating and the government should allow investments such as trusts and wealth-management products to fail under the precondition that the banking system remains stable.
“China needs a default, but not now,” said Xu Gao, Beijing-based chief economist at Everbright Securities Co. “A default would lead to an exodus of capital from similar financial assets, followed by a bank run, as liquidity is quickly drained in the financial system. Nobody will be willing to lend to each other -- just like what happened when Lehman went bankrupt. This is simply unaffordable to the government which has repeatedly vowed to avoid systemic risks.”
China has a record of bailing out banks in distress. In the late 1990s, it injected 270 billion yuan of capital into the four largest lenders, which were then on the brink of bankruptcy, and carved out 1.4 trillion yuan of nonperforming loans from their books. Since 2003, the government has spent $79 billion recapitalizing the firms and wiped away another 1.4 trillion yuan of bad loans.
A bailout might not be as easy this time around. China’s nebulous world of shadow banking, which includes trusts and wealth-management products, as well as guarantor and underground financing, accounted for 84 percent of GDP in September 2013, rising from 70 percent at the beginning of that year, according to JPMorgan.
The world’s second-largest economy grew 7.7 percent in 2013, the same rate as in 2012. Expansion is forecast to be 7.5 percent this year, the weakest pace since 1990, based on the median estimate in a Bloomberg News survey.
The biggest crisis in China’s trust industry was the 1998 collapse of Guangdong International Trust & Investment Corp., which borrowed domestically and overseas on behalf of Guangdong province. 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 trust companies survived.
Since then investors have been shielded from default risks as trust companies provided an implicit guarantee, especially when retail customers are involved, for fear of social instability and reputational damage. As a result, Chinese have pumped more money into risky assets with the belief that they will be rescued, creating a so-called moral hazard.
In the event of default, investors tend to go to the distributor, usually a bank, for repayment. When Credit Equals Gold ran into difficulty, ICBC, as distributor and custodian, was actively engaged in discussions even as it publicly rejected calls to bail out investors. Among options discussed by ICBC, China Credit and the Shanxi provincial government was a plan for ICBC to lend billions of yuan to the trust company to enable repayment, according to a person briefed on the discussions. The sides disagreed on the size of the loan and interest rate.
Buyers of Credit Equals Gold eventually had their principal repaid in full before the Jan. 31 due date. Despite taking a cut on the last interest payment, investors have had an average annual return since 2011 of about 7 percent, more than double the benchmark one-year rate on deposits.
Still, about 20 investors from Shanghai, Zhejiang, Beijing and Guangdong provinces gathered at ICBC’s Shanghai branch again last month to demand unpaid interest plus compensation for the cost of transportation and hotels. Disgruntled investors yelled at ICBC’s local officials, asking for an immediate solution and threatening to escalate their case to Beijing by having the Chinese Communist Party’s Central Commission for Discipline Inspection investigate whether any corruption was involved in the product’s design and distribution.
For Du, the roller coaster of Credit Equals Gold didn’t stop him from putting more of his savings into trusts. He said he has recently bought similar products from other banks, including China Minsheng Banking Corp. and Shanghai Pudong Development Bank Co., and will continue to invest.
“The risk is not with trusts, it’s about which bank you plan to partner with,” said Du. “I’m totally done with ICBC and now going with the smaller ones because they are more willing to honor what they said.”
— With assistance by Jun Luo, and Dingmin Zhang