China’s Worrisome Economic Issues (1) – Shadow Financing

精英理财Aurora

When I say shadow financing, probably not lots of people will know what it means. But if I say Wealth Management Products (WMP), many people probably are aware of. Now let's explain each in detail.

Shadow financing stems from China’s restrictive financial system: limited inflow and outflow of foreign capital, no established bond market (only tightly controlled bank lending), coupled with suppressed unnaturally low interest rate and long term deprived domestic stock market. What come out of this are: on one side private companies are staved of credit, unable to raise money through equity or bond market; on the other side investors are dissatisfied with the investment opportunities (this is also the reason for housing bubble).Inevitably the profit seeker will find ways around, and connect unfulfilled depositors with spurned borrowers through shadow financing. The depositors are willing to loan money at a higher rate of return; the borrowers are willing to pay a higher borrowing rate in exchange for access to credit.

The results are Wealth Management Products (WMP). But what are WMPs exactly. Xiao Gang, then chairman of Bank of China, bluntly called WMPs “fundamentally a Ponzi scheme” in late 2012. WMPs often offer guaranteed return ranging from 4% to 8% and mature in less than a year. The majority of investment money goes to property developers and infrastructure projects, the rest goes to a broader array of commercial enterprises, only very little goes to stock and bonds, which all have substantial risks involved. The construction and infrastructure projects typically require decades to pay for themselves, and commercial projects take at least five years. The borrowers continuously roll out new WMPs to cover previous period loss and investors return, which indeed is nothing more than a Ponzi scheme. But if regulators were to remove the guaranteed part or impose tighter restriction, then much less investors will buy WMPs, and borrowers will face a liquidity crunch that could push many into insolvency.

Fortunately government has recognized this risk and started regulating WMPs. However, the widespread WMPs are like beasts in the forest, will be really hard for the government to rein them in. As existing flawed WMPs mature and roll into new ones, additional WMP defaults are quite likely to be flushed out in the coming years when the commercial projects and construction projects end and don’t make enough profits to cover all the WMPs, as WMPs only just started in 2009. Rating agency Fitch estimated WMPs have ballooned into 12 trillion yuan at the end of 2012. Alibaba and Baidu, both launched online wealth management services to distribute variances of WMPs. Within five hours of launch, Baidu wallet grabbed one billion yuan. Alibaba has collected 55.7 billion yuan since its launch in June till October. The huge volume of online distribution will only make government regulation even harder.