Author Archives: Andrew Collier

China’s Shadow Banking Tug-of-War

1/17/14 China’s shadow banking tug of war | East Asia Forum

Sara Hsu, State University of New York, and Andrew Collier, Orient Capital Research

The party is over for Chinese banks, who have for the last few years enjoyed record profits. Since the end of 2008, the Chinese leadership’s desperate bid to keep the wheels of growth turning has let a flood of credit into the banking system and led to an unprecedented US$6.2 trillion of bank loans to state-owned companies and local governments.

 Many of these loans bypassed the banks’ books entirely, going through the so-called ‘shadow banking’ market made up of everything from giant financial trusts to mum and dad mini-banks. After a while, even the state banks joined the game. While the regulators turned a blind eye, the four state banks and the smaller city banks took customer deposits, wrapped them into neat little financial tools called ‘wealth management products’, and sold them on to eager buyers. These included wealthy people chasing yield, real estate developers signing property deals, and even importers short of ready credit.

This explosion into new markets was a change for the state banks. Up until 2010 they had ‘toed the line’, making loans to safe borrowers such as state firms, and following strict rules on interest rates. But a tug of war was going on in the upper levels between more conservative elements such as the People’s Bank of China (PBOC), which was worried about risky loans, and the more aggressive politicians in the State Council, who feared an economic slowdown. In the end — at least until recently — the spenders won out.

Although regulators banned products that allowed banks to move loans off balance sheets, the desire for greater yield on the part of banks and their customers eventually prevailed. Real estate developers previously rejected by banks suddenly discovered they could obtain loans from trusts or, even more riskily, from what the banks like to call ‘entrusted loans’ handed down from one lender to another.

As a result, bank profits boomed. Return on equity (profits based on the equity the banks hold) climbed from less than 5 per cent in 2004 to 21 per cent in the first quarter of 2013.

While the banks have done well, so too have many customers. Interest on typical three-month wealth management products stayed in line with the deposit rate until the fall of 2010. But as credit rose, and the banking system devised ever more complicated wealth management products, the three-month rate soared above deposit rates.

But in June, even the more aggressive camp got nervous and there was quiet talk about a crackdown on the shadow banking market. That rattled the nerves of the banks and suddenly the interbank lending rate known as the shibor tripled to 13.44 per cent. The PBOC, which traditionally hasn’t paid much attention to the interbank market, refrained from immediately jumping in with fresh cash — and the markets panicked. Suddenly it looked like the policy allowing banks to ‘chase yield’ was quickly reverting to ‘toeing the line’.

The banks are now at a crossroads. A crackdown on shadow banking means tightening credit and a slower economy. But beyond this ‘stimulus or no stimulus’ debate, the de facto liberalisation of interest rates has created an uncomfortable atmosphere of competition in the banking system. State banks accustomed to a cosy relationship with depositors and borrowers are now competing with local city banks.

Meanwhile, new rules that would allow local governments to issue municipal bonds will likely cause city governments to withdraw support from the local banks. Why pay the bank a fee for a loan when the city can go to the markets directly? And the fact that Beijing is experimenting with a private-placement bond program for small and medium companies is another sign of progress for the capital markets — to the exclusion of the banks.

Scrambling for deposits, stuck with growing non-performing loans from their aggressive expansion, and declining support from their government backers, the smaller banks are going to be forced to consolidate. This will create cross-provincial relationships new to China’s historically regional banking system. Other changes are likely as banks respond to the unintended consequences of the free credit era. One thing is clear: the days of easy money are over.

Sara Hsu is Assistant Professor of Economics at the State University of New York.
Andrew Collier is the Managing Director of Orient Capital Research and was previously the President of Bank of China International.

Where Beijing Can’t Shed Light – Wall Street Journal Opinion

Wall Street Journal

June 11, 2011

The liabilities of China’s shadow banking system are unknown and uncontrolled

By ANDREW COLLIER

In October, I sat down in Nanjing with a senior banker for one of China’s “Big Four” state banks. I asked him about the new regulations just put in place by Beijing to restrain the growth in lending. “There are ways around these rules,” he said.

Despite a consistent crackdown on bank lending by senior officials in Beijing, it’s not clear that local governments are listening. A two-week tour this month through Fuzhou, Shanghai, Beijing and Chengdu highlights the extent to which local banks and governments are devising new and clever ways to supply money to capital-starved businesses without going through official channels. These new sources of capital raise doubts about Beijing’s control over the financial system, as well as its ability to reduce inflation and forestall a crash in the property market.

One property developer in Fujian Province explained his method for raising capital. To build a nearly 2 billion yuan ($308 million) building, he has raised 1 billion yuan through presales of apartments, but is still short about 800 million yuan to complete construction. Banks won’t lend to this sector owing to recent Beijing efforts to cool the property market. Instead, the developer is looking for an innovative source of capital: pledges of future personal mortgage loans as collateral, a collateral that doesn’t yet exist. Although this type of financing is unusual and the details aren’t completely clear, the developer requires future residential buyers to purchase their mortgages through the bank that provides the developer a loan.

Banks in several provinces have found another way to circumvent the rules. Two years ago, the banks started packaging project loans, often for new property developments, and selling them to wealthy investors as investment trusts. Despite high interest rates of 12% to 20%, there was demand among the borrowers due to a shortage of capital. However, the China Banking Regulatory Authority (CBRC) got wind of this tactic, and banned it last year. To get around this, the local bank branches have begun to arrange “meetings” between their corporate borrowers and their high net worth clients, where the lenders put together the same loan packages. The bank provides “implicit” support for the loan but it never shows up on the books.

A truck distributor on China’s coast described another tactic. The distributor’s contracts contain a clause that requires the distributor’s supplier of trucks to “help” the distributor unload unsold trucks. Rarely invoked in good times, this is a form of lending guarantee that could come back to haunt the supplier in bad times.

The local governments themselves are getting creative, too. Since they officially can’t issue bonds, they have created “platform” companies as investment vehicles, often using land as capital. But the central authorities, through the People’s Bank of China and the CBRC, have put a stop to the growth of these trusts. So the local governments are turning to non-bank sources of capital that can’t be traced by the regulators—usually state-owned firms.

“The local government can’t inject [funds] into the platforms, but they can sell state-owned shares or inject SOE [state-owned enterprises] capital,” according to the assistant general manager at a branch of a state bank. The regulators can control lending to the corporations, but there’s not much they can do once the corporates have the money.

All of these, and plenty of other tactics taken together, add up to a financial system that in some respects is running out of control. The more liabilities build up out of sight of regulators, the more serious the risk that a financial crisis could catch authorities by surprise. It’s not a question of the competence of the authorities. Both the PBOC and CBRC are doing their best to manage the situation, and appear to have a pretty good idea of the contours of all this off-balance-sheet lending. But precise data are in short supply, a fact that would stymie even the best regulators.

This problem is twofold: It is very difficult to capture information about non-bank sources of lending, which comprise everything from corporate balance sheets to unrecognized promises for future profits. Second, the bank regulators control only the banks, but not the whole economy. They are in a tug of war both with China’s planning board—the National Development and Reform Commission—and local governments, all of whom have a vested interest in spending as much money as possible.

Arguably, this shadow banking system has a positive side. It is teaching wealthy Chinese how to evaluate the costs and benefits of recycling their savings into profitable projects, instead of leaving them in low-yielding bank deposits that could be funneled into useless investments. One of my former interns said her father, a metals trader in Shanghai, constantly receives investment proposals for private projects and probably has a good sense of what is a good and bad investment.

But the downside is more frightening. There is a rampant growth of credit, uncontrolled or even incalculable by the country’s top leadership. This means the financial system is

generating liabilities that could easily turn sour and, come some kind of crisis, prove difficult to clean up. Does this remind anyone of America’s subprime crisis?

Mr. Collier is an independent China analyst and the former president of the Bank of China International’s U.S. office.

A truck distributor on China’s coast described another tactic. The distributor’s contracts contain a clause that requires the distributor’s supplier of trucks to “help” the distributor unload unsold trucks. Rarely invoked in good times, this is a form of lending guarantee that could come back to haunt the supplier in bad times.

The local governments themselves are getting creative, too. Since they officially can’t issue bonds, they have created “platform” companies as investment vehicles, often using land as capital. But the central authorities, through the People’s Bank of China and the CBRC, have put a stop to the growth of these trusts. So the local governments are turning to non-bank sources of capital that can’t be traced by the regulators—usually state-owned firms.

“The local government can’t inject [funds] into the platforms, but they can sell state-owned shares or inject SOE [state-owned enterprises] capital,” according to the assistant general manager at a branch of a state bank. The regulators can control lending to the corporations, but there’s not much they can do once the corporates have the money.

All of these, and plenty of other tactics taken together, add up to a financial system that in some respects is running out of control. The more liabilities build up out of sight of regulators, the more serious the risk that a financial crisis could catch authorities by surprise. It’s not a question of the competence of the authorities. Both the PBOC and CBRC are doing their best to manage the situation, and appear to have a pretty good idea of the contours of all this off-balance-sheet lending. But precise data are in short supply, a fact that would stymie even the best regulators.

This problem is twofold: It is very difficult to capture information about non-bank sources of lending, which comprise everything from corporate balance sheets to unrecognized promises for future profits. Second, the bank regulators control only the banks, but not the whole economy. They are in a tug of war both with China’s planning board—the National Development and Reform Commission—and local governments, all of whom have a vested interest in spending as much money as possible.

Arguably, this shadow banking system has a positive side. It is teaching wealthy Chinese how to evaluate the costs and benefits of recycling their savings into profitable projects, instead of leaving them in low-yielding bank deposits that could be funneled into useless investments. One of my former interns said her father, a metals trader in Shanghai, constantly receives investment proposals for private projects and probably has a good sense of what is a good and bad investment.

But the downside is more frightening. There is a rampant growth of credit, uncontrolled or even incalculable by the country’s top leadership. This means the financial system is

generating liabilities that could easily turn sour and, come some kind of crisis, prove difficult to clean up. Does this remind anyone of America’s subprime crisis?

Mr. Collier is an independent China analyst and the former president of the Bank of China International’s U.S. office.