I am still on alert for a larger pullback in the market. The larger picture suggests the SPX will li...
China's off-the-balance-sheet bank crisis worsens
02/12/2013 11:21 pm EST
To see the crisis you have to look through the official balance sheets of China’s banks to the gray areas of China’s financial industry.
In January China’s four big state-owned banks issued a combined 380 billion yuan in loans. That was a huge increase in lending from the 163 billion yuan total in January and puts China’s banks on an unsustainable pace. China’s big four banks account for about 30% to 40% of lending in a average year so January’s activity puts China’s banks on a pace for somewhere between 11 trillion yuan and 15 trillion yuan in lending for 2013. Lending always surges in the weeks before the Lunar New Year holiday, however, as businesses stock up on cash. The People’s Bank hasn’t set a lending target yet for 2013 but it’s expected to be in the vicinity of 9 trillion yuan as the Chinese government works to--modestly--stimulate the economy.
That quota would still be a big increase from the 7.5 trillion yuan target in 2011 when the Chinese government was tightening credit to slow the economy or from the 8.3 trillion yuan banks lent in 2012.
But although this data on bank loans and bank lending is still one of the most followed indicators of government policy on economic growth and the People’s Bank intentions on expanding or contracting the money supply, it captures less and less of the Chinese market for loans. China’s Total Social Financing indicator shows bank loans hitting a record low of 52.1% of total lending in 2012. Ten years ago bank lending made up 92% of Total Social Financing. Estimates are that bank lending will drop below 50% in 2013.
It’s not that bank lending has collapsed—in fact it has been remarkably stable within the up and down channel set by government policy. Instead there’s been explosive growth in trust loans (a six-fold increase in 10-years) and in bond offerings (64%.)
What are trust loans and what’s behind their explosive growth? Trust loans are essentially off-the –balance sheet bank loans. While the interest rate that banks can pay depositors—currently 3.25%-- is set by government regulators, banks and savers can get around the restrictions by using wealth management accounts that move money collected by banks off bank balance sheets and onto the balance sheets of trust companies and securities firms. In a typical arrangement, the bank contracts with a trust or securities company to manage the money collected from investors in bank wealth management products. The trust or securities company uses the money from the bank to buy notes issued by the bank (backed by bank loans, for instance) or to buy other assets (loans from financial companies attached to local governments, for example.) The trust or securities company gets paid a fee—0.3% on average at the beginning of 2012--by the bank. Savers get a higher interest rate—4.5% to 5%--than they’d get from a regulated account at a bank. (With the government’s inflation target at 4%, the difference between regulated yields of 3.25% and wealth management yields of 4.5% could be the difference between losing ground to and keeping ahead of inflation.) Banks get to keep customers happy and to move loans off their balance sheets and onto those of trust companies and securities companies. (Bank loans sold to trusts and securities companies don’t count against a bank’s lending quota.)
As you might expect, the advantages of this system of higher rates for savers, fees for trust companies, and off-balance sheet lending for banks has led to an explosive growth in the assets at trust and securities companies. Each of the four big state-owned banks handles an average of 2 trillion a year in off-balance sheet business a year—roughly equal to the bank sector’s formal government lending quota. Efforts by government regulators to limit the percentage of assets that trusts could take from bank wealth management accounts have worked to push these off-balance sheet yuan to less-regulated securities companies. Assets under management by Chinese securities companies rose to 1.2 trillion yuan at the end of December, up from 280 billion yuan at the beginning of 2012, according to data from the Securities Association of China. About 80% to 90% of that total, according to estimates put together by Bloomberg, was tied to banks and wealth management accounts. Estimates are that up to 30 trillion of the 66 trillion yuan in credit extended to all formal borrowers in China lies outside the banking system.
There are two big dangers in this situation.
First, there’s a good chance that in reaching for 5% yields (instead of 3.25%) investors/savers have taken on more risk than they realize and that this extra unrecognized risk will rise up to bite them. The promise of the wealth management accounts to savers is strikingly like that during the mortgage-backed asset/global financial crisis: We have figured out a way, the banks, the investment trusts, and the securities companies are saying, to pay you higher yields without requiring you to take on any more risk.
Think about it: How are banks, profitable with controlled payouts of 3.25%, able to pay 5% and make the same or greater return? (Because they wouldn’t be so assiduously pursing this wealth management business is if paid less than their existing business.) A big part of the answer is that the banks are using the money they take in from wealth management accounts to make loans at 6%, 7%, and even 8% by buying bonds sold by city governments. In the first nine months of 2012, China’s Caixin magazine reports, urban bonds raised 471 billion yuan for 401 projects. That was more than the 425 billion yuan raised in all of 2011. Half of all urban bonds issued on secondary markets, Bloomberg estimates, were bought by banks with money from wealth management accounts.
These bonds are supposed to be low risk. They’re guaranteed by local governments, and the assumption, as in the U.S. mortgage market about the paper issued by Fannie Mae and Freddie Mac, is that the national government stands behind these urban bonds. (In another parallel with the global financial crisis, China’s National Association of Financial Market Institutional Investors has raised questions about the high grades given by credit rating companies to many of these bonds.) So far the failure rate on these bonds has been extremely low—near zero. But that’s likely an artifact of the very recent surge in issuance—many of these bonds haven’t been around long enough to fail. The effects of a collapse in the real estate market in many Chinese cities in 2010 and 2011, which has devastated finances for local governments and the projects they financed, hasn’t fully worked its way into the market for these bonds.
Second, it’s extremely unclear what parties are on the hook for how much if these products go bad. (Again, this reminds me of the derivative markets in the United States and Europe in the financial crisis where no one knew for sure what the net positions of the big players were in this market.)
Up until very recently the assumption and practice has been that trust companies do not let trust products default on investors. The trust company doesn’t have any legal obligation to pay investors in the case of a default but until recently a trust company would make sure that investors got repaid, even if a borrower could not pay the trust what it owed. In the competitive trust market no trust company would risk its reputation by letting investors take a hit. Consequently no one in China has ever lost money on a trust investment. Payments have been late but they’ve always been made within the contractual 6-month grace period written into a trust contract—even if the trust company had to dip into its own pockets to pay investors.
But this looks like it is changing. In January Citic Trust, China’s largest trust company by asset value, refused to guarantee payment to investors when two trusts that it sold ran into problems. Instead Citic has moved to sell the collateral put up by borrowers and has told investors that selling the assets of the borrower was the last hope that investors would get their money back. In one case, Citic has used a court order to put the land owned by property developer Shieldspear Group up for sale to recoup some of the 710 million yuan raised in 2010. In another Citic has threatened to sell the collateral of a producer of steel coatings if the company can’t bring its payments up to date.
In my opinion the move by Citic is a reaction to what that company worries is the beginning of a wave of defaults that could overwhelm the trust (and security company) sectors’ ability to make good investor losses out of the pockets of trust companies. This will open up a legal can of worms that China’s courts and financial regulators are by no means prepared to deal with. The courts will have to decide if trusts were sold with any kind of implicit guarantee. And whether trust companies can be sued in the event of a default by a borrower. How much legal responsibility flows back to the bank through affiliated trust companies and through investments that the bank sold to the trust company? (Complicating all this will be the clout of the politically connected wealthy who have bought wealth management products.)
The big question is what regulators will do with all these off-balance sheet assets? If banks were required to put them back on consolidated balance sheets, a rise in defaults could damage bank capital ratios just when China’s banks are trying to meet new international capital requirements and to make further inroads into global financial markets. Anything that required Chinese banks to buttress their capital requirements would reduce the money supply just when China was trying to increase the money supply to stimulate the economy.
On the precedent of past financial crises, and especially the Asian currency crisis of 1997, I think the odds are very low that Beijing will do anything that raises the bad loan ratio at China’s banks or that might force them to raise significant capital at this point in China’s economic recovery. In the aftermath of the Asian currency crisis Beijing’s financial regulators buried massive bad loans at China’s banks by creating new financial companies that bought the bad debt of China’s banks and took it off the banks’ balance sheets. Then through complex transactions, these new financial entities buried that bad debt.
That effort wasn’t cost free. China’s rate of GDP growth dropped from 9.3% in 1997 before the crisis hit the country’s financial system to 7.8% in 1998 to 7.6% in 1999 before rebounding to 8.4% in 2000.
This time China is starting from a weaker economic position—China’s growth rate bottomed at an annual 7.4% rate in the third quarter of 2012—in a world where developed economies are still digging out from the effects of a severe financial crisis and subsequent Great Recession. And currently China has much bigger ambitions for its banks on the global financial stage and for the global role of its currency that would be damaged by an Asian currency style crisis and any bury the bad debts fix.
I don’t see a Chinese banking crisis crashing China’s economy in 2013 anymore than it did in 1997. But it certainly wouldn’t be good for the share price of China’s bank stocks or for the important real estate and financial sectors in China’s stock markets. And even if it knocked a percentage point or two off China’s economic growth, that’s growth that the global economy sorely needs currently.
I’d watch very carefully to see how China’s banking crisis develops and how serious it might get. In doing that observing I’d pay attention to bad loan ratios at China’s banks—the official reported rate of 2% or less is clearly understated so I’d pay more attention to whether or not it starts to rise than to its absolute number. I’d pay even more attention to companies in China’s non-bank financial sector such as Citic Securities and Haitong Securities—and their related trust companies—to see how much of the problem they recognize and how they cope with it. And finally I’d look at moves by the People’s Bank to see if China’s central bank is getting nervous about bank reserve requirements. If the People’s Bank should start to raise reserve requirements even while China’s efforts to increase economic growth are still unfurling, then I think we’ve got signs that the banking crisis is bad enough to worry Beijing.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any company mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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