"China's shadow banking system," the name alone sounds mysterious and uncertain. In recent weeks, this complex system of wealth management and trust products has struck fear into investors, due to apprehension about a potential default. As we follow the ongoing developments in shadow banking, we ourselves are concerned. However, over the long-term we are optimistic for China's plans to further liberalize interest rates and promote financial disintermediation.
During our trip to Asia last fall, we met with the major players within the Chinese banking system, including those with expert understanding of how the banks' off-balance-sheet products work, the magnitude of the market, and the fallout that changes to industry dynamics could have on the larger financial system. Our discussions confirmed the complexity of this financial system. There are varied estimates on size and potential impact, but there’s general agreement that the system has grown rapidly. J.P. Morgan estimates that the shadow banking system doubled in size between 2010 and 2012, equivalent to nearly 70% of GDP, and that it may have grown an additional 30% in 2013.
The shadow banking system broadly refers to an estimated $7.5T* in credit intermediation outside the regular banking system. This Chinese shadow banking system's products differ from those offered by banks in the United States and United Kingdom in that many of the products are directly controlled by the banks and are merely an alternative means to extend credit to their other customers. Few are market traded and the counterparties are non-financial corporate borrowers and investors, as well as retail investors. Trust loans at an estimated $1.5T* represents a non-bank extension of credit (that is, off the banks' balance sheets) in the Chinese shadow banking system and have received increased attention over the past couple years given their outsized growth and increased reports of defaults.
In response to customer demands for higher yields, $1.5T of trust products have been created. The banks have benefited significantly as these products allow them to extend credit outside of the banking system, and thus above the government's stated targets for credit growth. The largest borrowers of the loans underpinning the trusts are local governments, property developers, and corporations looking to fund long-term investments.
The loans in the trusts typically have terms from 18 to 36 months and yields in the 9% to 13% range. Despite these high yields, Chinese investors largely perceive these trusts to be "risk-free" given their implied backing from the banks and government. This system works as long as investors are willing to reinvest every 18 to 36 months or new investors come into the market.
China's government is committed to slowing credit growth and allowing markets to price credit risk through the removal of implied bank and government guarantees. However, the government also clearly recognizes that these longer-term objectives must be balanced with more immediate concerns—including the potential that defaults could spiral out of control and lead to a liquidity crisis and a seizing up of the financial system. This would not be unlike what happened when U.S. banks stepped away from the auction-rate preferred market, leaving investors with illiquid securities. This was the first indication that the financial system was starting to seize up.
Shadow banking is a by-product of innovation within a heavily regulated, traditional banking system that is struggling to satisfy the country's credit and liquidity demands, while providing attractive real interest rates to households and business depositors. The healthy direction for the shadow-banking system would be to improve transparency, appropriately price risks and increase monitoring and control of the market, in parallel to the interest-rate liberalization of the banking system. Unwinding this without fueling systemic risk will be complex because credit is not being priced accurately and nonperforming loans are shuffled around the financial system.
While we have seen more than 50 trust defaults over the past few years, they have been relatively small and easily contained. However, the most recent threat of default was a different matter, given its size ($500M) and initial indications from the Chinese Central Bank that it would not support this product in default. Global markets participants feared that if Chinese investors began to view these trust products as entailed high risk, this changed perception could spiral quickly, causing China's trust and wealth management industries to seize up, with ensuing fallout that could roil the global financial system to the extreme. However, after Asian markets closed on Monday, an unknown "investor" stepped in to purchase the defaulted trust from its current holders. It is widely hypothesized that the unnamed investor is connected in some way to the central bank.
Emerging markets have received a reprieve and a systemic risk has been temporarily taken off the table. Still, this should serve as a wake-up call for those investors who are focusing on the returns in emerging markets without giving equal—or greater—consideration to the risks. We have always been diligent in our monitoring of events and potential consequences within the Chinese banking system, and this certainly won't change.
China is clearly in a period of transition. The government wants the market to set prices and allocate capital, which would help prevent excess leverage in unproductive products. What is important to us as investors is how China navigates this transition. It is our hope that the government sends the right signals, while not disrupting the flow of liquidity within its financial system. The unknown investor that came to the rescue illustrates how the government is trying to balance their nearer-term and longer-term priorities, in this case—communicating the risks of these products without allowing a default to happen.
We expect we will discuss Chinese trusts again this year, as other high-profile trust products will likely default. But, we also expect that our team will be identifying companies positioned to benefit from the longer-term financial disintermediation trends. While we remain underweight to Chinese banks, we are finding new opportunities within the private banking system as e-commerce companies begin offering online banking services and the brokerage and insurance industries benefit from the opening of the world's second largest economy.