Text message solicitations began arriving on the mobile phones of many of China’s wealthy last month, promising access to lucrative wealth management products which offer higher returns than government saving schemes.
One text message read: “China Merchants Bank will issue a high interest financing product starting from June 28th to 30th. The product shall mature in 90 days with an interest rate of 5.5 percent, please call us for further details.
A day later came another message from the same bank which read “Interest rates of yesterday’s product has been hiked to 6 percent, limited access to the product, first come first serve basis”.
Interestingly these messages are not coming from any ‘fly by night’ operators or NBFC’s but some of the leading Chinese banks. They are injecting liquidity to the banks to finance a relatively new and highly profitable sideline business: lending outside the scrutiny of bank regulators, defined in financial parlance as the off-balance-sheet loan, as this financial arrangement does not find a place in the books of the bank and outside the scope of regulatory authorities. The complex way they go about making off- the –balance- sheet loans is at the heart of China’s $ 6 trillion shadow banking industry, which the government is now trying to tame. Efforts to rein in the dodgy lending practices put stock markets worldwide in a tizzy in late June.
The risky shadow
Economists and regulators in China are worried that legitimate banks are using sparsely regulated wealth management products to repackage old loans and prop up risky companies that might not otherwise be able to borrow money. Analysts warn this off-the-balance sheet loans which is helping to fuel the rapid growth of credit in a weakening economy, could lead to a series of bank failures, a situation which may is bound to happen, as the system of shadow banking is unregulated and a quick and easy source of profit to banks in China.
Manufacturing activities in China has gone down considerably and its exports have declined, economists opine that the country with the largest population and workforce is in the midst of a “middle income trap”. International Finance Magazine had carried out a story on the manufacturing industry’s crisis in China and its middle income trap.
Dong Tao, an economist at Credit Suisse says “This is the biggest uncertainty I’ve seen in my 18 years following the China market,” in a veiled reference to shadow banking. “You don’t know how banks are deploying capital, and the credit risks associated with the arrangement of the capital. “
Strategy behind the lengthening shadow
What banks are resorting to are pressing the customers to shift money from the regulated part of their operations, the savings deposits to the largely unregulated part consisting of high yielding wealth management products that circumnavigate government interest rate controls and can be used to finance high interest loans to desperate consumers. This unregulated financial arrangement has sent the political fraternity in China into a tizzy about a possible credit risk, to overcome the crisis the country’s central bank tightened credit in the interbank market, where banks typically go to borrow money from other banks. The investments in these unregulated wealth management securities pay an annual interest rate of 6 percent which is far above the savings deposit rates set by the regulators which stand at 3.3 percent, consumers withdraw money from their regular savings account and put it into a wealth management product that promises a much higher rate. Though the products have high popularity, their disclosures are often poor, though banks guarantee the principal amount, the contracts for wealth management products are vague and carry an element of risk. The money collect from depositors is invested in Real Estate due to the boom in property development and soaring housing prices. Since these loans are made off the balance sheet, all the parties would stand to benefit immensely. China’s shadow banking activity was valued at $ 6 trillion, twice the level in 2010, and equivalent to 69 percent of the nation’s GDP as per JPMorgan Chase.
The term “shadow banking” was first used by an economist Paul McCulley in 2007, he described the lending process as a large segment of financial intermediation, routed outside the balance sheets of regulated commercial banks and other depository institutions.