Financial Times: China’s shadow finance time-bomb could trigger crisis

By | June 27, 2017
Rising middle class would face harsh lesson if WMPs market collapses

In the past decade, shadow banking has taught China great lessons about capitalism. That is, except for the most important one: failure.

Since the 2007 financial crisis, China has poured more than $600bn into the economy to avoid getting caught in the downturn. Alongside the formal bank loans have been a flood of money from the informal or “shadow” economy. These loans have been funnelled through a variety of financial institutions, including government-owned trusts, investment banks, Mom and Pop shops and even the state banks. Shadow finance amounts to approximately 80 per cent of China’s GDP, up from less than 10 per cent a decade ago.

One corner of this shadow market has been an important teacher of capitalism to the ordinary consumer: wealth management products (WMPs). These financial instruments have ballooned into a $4tn market and include everything from investments in commercial property to a small business or a corporate bond.

With the growth of WMPs, Chinese citizens have been able to avoid the casino-like stock market, and the paltry returns from savings deposits in the banks, and put their money into new projects.

Like touts at a carnival, the banks selling them have promised outsized returns — 10, 12, 15 and even 20 per cent, for all sorts of investments. WMPs have caught the imagination of a rising middle class and wealthy elites hungry to benefit from their newfound wealth.

But this wild west of investments has come with a starry-eyed optimism about China’s economic growth. No project is deemed worthless.

I met one saleswoman for an investment bank who kept asking me what kind of investment return I wanted. I repeatedly asked, what is the project? Her response? “I think it’s a bridge in Nanjing.”

In fact, there is widespread suspicion even among Chinese that many of these loans are Ponzi schemes, under which new money simply replaces an earlier loan.

The enthusiasm for WMPs is based on two axioms. First, China’s economic growth will go on forever; and second, the Chinese government is behind all these investments. Neither may be true. In case of a downturn, who is backing these orphan investments?

At root, capitalism is about the efficient allocation of capital towards profitable ends. And with that comes success and failure. China’s booming economy and reluctance by the banks to allow a default has prevented consumers from experiencing losses. That could change.

Technically, the banks are not responsible for these products. Most of them are “off-balance sheet”, so banks do not have to account for them as part of their loan book. Once the contract has been signed, they have been paid their sales commission and the buyer is out the door, the banks wash their hands of these loans.

While the People’s Bank of China, the central bank, has made halfhearted attempts to slow the deluge of WMPs, the leadership approves of this growing pile of personal debt. “The household is under-leveraged,” a senior regulator in Beijing told us recently. Beijing is happy to shift debt from the state and corporates to the household because it views this as removing a problem from the official economy.

However, this game is going to become increasingly difficult if there is an event, such as a big fall in property values, that triggers a crisis in confidence in China’s WMP market. If buyers flee, what will China’s central bank do if $4tn in loans suddenly vanish? Is it able or willing to fill bank coffers with new money? And what would China’s connected ambitious middle class do if their wealth vanished overnight? What would widespread default mean for faith in the Chinese leadership?

Any problems would rifle through China’s economy like dry timber in a forest fire. Corporations, banks, even local governments could face financial ruin if this huge pile of credit is withdrawn. Many local governments rely on household financing through WMPs for pet projects that have helped to bolster the property market and drive up land sales, a key source of revenue for them. And some of the smaller regional banks have started to use WMPs to increase their asset base.

A collapse of the WMP market could jolt China into a financial crisis.

Already, the warning bells are ringing. In May, China’s Foresea Insurance warned of “mass defaults and social unrest” if Beijing forced the market to cancel issuance of WMPs.

China needs to reduce its reliance on easy credit, increasingly placed on the backs of households, and allocate whatever capital is available to more productive uses. This would require a more efficient banking system and less credit to state companies.

Shadow lending has taught consumers an important lesson about investing in a capitalist world. Let’s hope that Beijing has enough sense to teach the harsher lesson about capitalist failure without causing a financial crisis.

Andrew Collier is managing director of Orient Capital Research and author of a new book, “Shadow Banking and the Rise of Capitalism in China”.