Wealth Products Threaten China Banks on Ponzi-Scheme Risk

Wealth Products Threaten China Banks on Ponzi-Scheme Risk

Zhang Defa hurried into an Industrial & Commercial Bank of China Ltd. branch in Shanghai on a sizzling July afternoon breathlessly looking for the manager.

The day before, Zhang had received a text message saying the bank was selling a 37-day wealth-management product with a 5 percent expected annualized return, principal guaranteed. He was too late. The offer, requiring a minimum of 500,000 yuan ($81,000), had sold out in less than three hours. Zhang would have netted 2,534 yuan in just five weeks. “This is crazy, but where else can I put my money without losing sleep these days?” said Zhang, 61, a retired engineer who has been moving cash out of his savings accounts into such investments for more than a year. “The return is fairly decent, and more importantly, I know my money is safe at a government-owned bank. Even if the bank runs out of the money, the government won’t.”

China’s credit crunch in June spurred hundreds of millions of households and companies to divert a record share of their savings into wealth-management products, known as WMPs. The amount of such investments surged eightfold from 2009 to 8.2 trillion yuan as of the end of March, according to government data. That’s almost the size of the Australian economy. Fitch Ratings put the amount even higher in May, at 13 trillion yuan.

The flows are fueled in part by government efforts to curb property speculation and bolster the stock market, which has lost almost 40 percent of its value since 2010. Though offered by banks, WMPs are considered part of China’s shadow-banking system, estimated by JPMorgan Chase & Co. at $6 trillion, or 69 percent of gross domestic product.

Higher Rates

WMPs look like time deposits to investors, except that about 70 percent of them don’t have their principal guaranteed by banks. About half invest in low-risk deposits, bonds and money markets. The rest venture into riskier areas including stocks, derivatives and loans to local governments and property developers, according the China Banking Regulatory Commission, which requires banks to register all WMPs they sell.

The investments are popular because they provide rates of return higher than savings deposits, which are set at 3 percent annually, below this year’s government targeted inflation rate of 3.5 percent.

As investors pile in, financial firms need more inflows of cash to pay off maturing products, resulting in mounting risks that prompted China Securities Regulatory Commission Chairman Xiao Gang to call them a “Ponzi scheme” even before the latest record purchases. Issuance of new products and borrowing from the interbank market are among the most common ways banks pay out maturing WMPs, according to Fitch.

‘Huge Size’

“The WMP market has inflated to a huge size,” said Wilson Li, a Shenzhen-based analyst at Guotai Junan Securities Co. “Should they go bust, Chinese banks have their reputation on the line, and they face the risk of compensating investors because of pressure from the general public.”

A record 1,137 WMPs were sold by about 70 banks in the two weeks ended June 28, an increase of almost 50 percent from the first two weeks of the month, according to Benefit Wealth, a Chengdu, China-based consulting firm that tracks the data back to 2007. It didn’t provide the amount invested.

Products linked to yuan-denominated bonds and money-market investments were offered at an average yield of 5.11 percent in the final week of June, the highest in at least a year and up 0.96 percentage point from May.

While sales of WMPs surged in June, China’s aggregate financing, which includes bank loans, entrusted loans and bankers’ acceptance bills, fell to 1.04 trillion yuan last month from 1.19 trillion yuan in May.

‘Fresh Money’

“In an environment where liquidity is tight, banks will find it more and more difficult to attract fresh money to keep the game going,” said May Yan, a bank analyst at Barclays Plc in Hong Kong. “Until investors are hit by a real default, they won’t understand what they are really buying into.”

Chinese banks, almost all state-controlled, have relied on such products to beef up their deposit base and finance long-term loans, some of which are held off their balance sheets and repackaged into assets to be sold to investors. Banks time the distribution and maturity date for the last days of the month so that the money can be returned to a saver’s deposit account and await purchase of new wealth-management products on the first day of the following month. That allows it to be considered a deposit on the bank’s balance sheet at month-end.

Risk Perceptions

The banking regulator said in January that lenders and wealth-management investors have inconsistent perceptions of risk. While banks say the products’ returns are volatile and should reflect market realities, most customers regard them as de facto deposits and expect to “make yields irrespective of drought and flood,” the regulator said.

The central bank on June 20 allowed the worst cash crunch in at least a decade and warned lenders to avoid raising short-term money to finance long-term loans as part of efforts to crack down on issuance of the products.

While the two-week surge in borrowing costs was designed to reduce risky positions, the initial impact was to drive investors out of a plunging stock market and further into the shadow-banking system as lenders offered higher yields to attract savers’ money to ease their own liquidity shortage.

“To some extent, this is fundamentally a Ponzi scheme,” Xiao, the CSRC head who is formerly chairman of Bank of China Ltd. (3988), wrote in a commentary in October. “Under certain conditions, the music must stop when investors lose confidence and reduce their buying or withdraw from WMPs. The rollover of a large share of WMPs weighs heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back.”

Heated Competition

Industrial & Commercial Bank of China, the Beijing-based lender known as ICBC, planned to raise a record 200 billion yuan by selling principal-guaranteed wealth products between the end of June and early July as competition for deposits intensified, the 21st Century Business Herald reported July 6.

At Bank of China, investors with at least 100,000 yuan could receive an annual return of 5.4 percent on a 35-day product sold from June 27 to July 1, according to the Beijing-based bank’s website.

Unlike investors in trusts, buyers of wealth-management products are mostly bank savers who are less savvy about investments and can’t afford to incur large losses. An investor with as little as 50,000 yuan can buy WMPs that have maturities ranging from a few days to as long as a year. For trusts, investors need at least 20 times more cash and an investment horizon exceeding a year.

Property Restrictions

China’s home-purchase restrictions over the past two years have led families to invest in WMPs and trusts, according to Standard Chartered Plc. Real estate’s share of total household assets declined to 62 percent in 2012 from 65 percent in 2009, Dorris Chen and David Yin, Hong Kong-based analysts, wrote in a July 4 note.

While China’s cash crunch eased in early July, investors’ appetite for wealth-management products intensified.

A 1 billion-yuan, 32-day product issued by Shenzhen-based China Merchants Bank Co. sold out in less than 20 minutes when the sale started online at 8 p.m. on July 4. The investment, put into the less-risky money market, offered an annualized return of 5.6 percent, according to a prospectus.

Asset Pools

More than half of off-balance-sheet wealth-management products are linked to asset pools rather than specific investments, making it impossible to know the real returns, according to China’s central bank. The maturity mismatch, poor transparency and lack of clarity about bank responsibility add to the risks, it said in May.

“Banks have a long history of taking deposits, and everybody thinks it’s risk-free to put money there,” Shang Fulin, chairman of the CBRC, said on June 29. “The wealth-management products are actually a type of investment products. It is different from deposits, and investors must shoulder some risks. The question is did banks clearly tell them of that?”

Some banks display a sentence about the risks on a screen at the entrance to their branches. Still, investors have sought and received compensation for losses in the past.

Dozens of investors in another type of investment product sold through a former employee of Beijing-based Huaxia Bank Co. protested in December after losing money when the issuer, a private-equity firm, defaulted.

Full Repayment

It was the first default of such a product, and investors said they believed Huaxia was the distributor and affiliated with the issuer. The principal was repaid in full after regulators stepped in and a guarantee firm bought the assets.

Bank of Communications Co. also is compensating investors for a wealth-management product whose value dropped 20 percent in two years, the Economic Observer reported on July 5.

Spokesmen for Shanghai-based Bank of Communications, Bank of China and ICBC declined to comment or didn’t respond to questions about their wealth-management products.

In May, among 2,255 maturing wealth products that disclosed performance, only four failed to deliver the highest expected yield, according to Benefit Wealth. All were linked to the performance of gold and foreign currencies.

“The big question is not only how do banks meet their ever-growing obligations, but also how to make hundreds of millions of investors realize that these are not real deposits,” said Ye Linfeng, an analyst at Benefit Wealth. “Such false perception is devastating to banks, which essentially assume far more responsibility and liability than they should have and can possibly cope with.”

Capping Investment

The CBRC told banks in March to cap investments of clients’ money in “non-standard” credit assets, those less liquid and not publicly traded, at the lower of 35 percent of all funds raised from the sales of wealth-management products, or 4 percent of total assets. Banks also were required to stop pooling assets and to isolate the risks of such investments from their own operations.

Because the 30 percent of products that are principal-guaranteed are on banks’ balance sheets, they are subject to provision charges and capital-weighting, meaning that the impact on banks’ earnings should be minimal if these products default, according to Barclays.

For products that aren’t principal-guaranteed and held off balance sheets, every 1 percent increase in the default rate will reduce Chinese banks’ earnings by 1.5 percent. The potential liability would be larger in the event of failure of other agents’ products that banks help distribute, such as trusts, Barclays estimated in a note in May.

Past Bailouts

The Chinese government, which hasn’t established explicit deposit insurance to provide a safety net to savers, has bailed out the banking industry twice. In late 1990s, it injected 270 billion yuan of capital into the four largest lenders, which were 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.

The moves helped the lenders lower the bad-loan ratio to less than 5 percent from more than 20 percent and sell shares to the public. The banks are now among the largest in the world by market value.

Premier Li Keqiang’s government, which set a 7.5 percent goal for China’s annual expansion in March, is cracking down on shadow-banking and deposit-collection activities that have undermined attempts to cool property prices and local-government borrowings. Economic growth in China has held below 8 percent for the past five quarters, the first time that has happened in at least 20 years. The economy grew 7.5 percent in the second quarter from a year earlier.

‘Bad Boy’

Shadow lending supplies a line of credit to small businesses that can’t otherwise get bank loans. An estimated 97 percent of the nation’s 42 million small companies aren’t eligible for credit from state lenders, according to Citic Securities Co.

Total credit outside the official banking market may double to 46 trillion yuan by the end of 2017 from an estimated 23 trillion yuan as of March 31, according to Standard Chartered.

“Shadow banking is a bad boy that has done some good deeds,” said Lu Zhengwei, a Shanghai-based economist at Industrial Bank Co. “We should try to turn him into a good boy rather than have him disappear.”

About 30 percent of the proceeds from wealth-management products aren’t invested to help the economy, according to CBRC’s Shang. Still, investors like Zhang, the retired engineer, say they aren’t bothered.

“These things are not for me to worry about, Zhang said. “The bank must know better. All I care is that I put my money here, so this is where I am going to collect it back, not one cent less.”

To contact Bloomberg News staff for this story: Jun Luo in Shanghai at jluo6@bloomberg.net

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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