A commuter’s shadow is cast on the ground at the HSBC Holdings Plc headquarters in the central district of Hong Kong, China. (Photographer: Brent Lewin/Bloomberg)

China’s $15 Trillion Shadow Bank Edifice Shows More Cracks

(Bloomberg) -- Strains are spreading in China’s $15 trillion shadow banking industry as investors pull back from the debt-like savings products that helped drive leverage to dangerous levels.

Most affected are some $3.8 trillion of so-called trust products, until now the fastest-growing shadow banking segment and a popular way for debt-ridden property developers and local governments to raise funds from millions of ordinary Chinese. In recent weeks, at least two of the products have been forced to delay payments as the market started to freeze up, making it harder to refinance maturing issues with new ones.

"On the one hand you have cash-strapped borrowers scrambling for refinancing; on the other you have cash-rich investors not knowing where to put their money for fear of getting burned,” said James Yang, a sales manager at Shanghai Xiangyi Asset Management Co.

China has doubled down on steps to cut leverage in the financial system after President Xi Jinping consolidated power at a key party congress last year. Authorities have issued a flurry of regulations in recent weeks to curb shadow banking, adding to about 30 new rules published since March when the government stepped up its deleveraging drive.

After the recent crackdown, financial institutions no longer want to act as intermediaries between borrowers and investors, said Yang, adding that it’s his worst start to the year for new business since he started marketing the products four years ago.

A late-December ruling from the China Banking Regulatory Commission has discouraged banks from referring their clients to invest in trust products. That so-called channel business accounted for about 66 percent of total trust assets, UBS Group AG’s chief China economist Wang Tao wrote in a note issued on Wednesday.

Payment Delays

The tensions bubbled to the surface last week. Zhongrong International Trust Co. delayed more than 900 million yuan ($141 million) of payments on two trust products which were issued to fund a local borrower in southwest China, people familiar with the matter said at the time. Zhongjiang Trust also delayed payment, according to local media.

Both were repaid days later, according to a statement and media report. But such delays are also undermining the confidence of depositors who may finally be getting the message that the government won’t always step in. That so-called implicit guarantee has allowed less creditworthy borrowers to raise money, underpinning an array of shadow banking products.

"The old ways of fulfilling implicit guarantees on asset management products are dead," said Lu Zhengwei, Shanghai-based chief economist at Industrial Bank.

One of the most far reaching changes announced last year was a plan to align yields with the risks and returns of the underlying products, instead of offering guarantees. China wants to phase in the change by the middle of next year.

The impact is most obvious in the trust market, where only 229 new products have been issued so far this year, down from 666 in the same period of 2017, according to industry data provider Use Trust. That’s the slowest start to a year since 2011, raising the prospect that more borrowers might struggle with timely payments should issuance stay depressed.

Because of their poor credit profiles, the companies and local government entities that use the trust market to raise funds have little chance of getting bank loans or other types of financing, especially when lenders are restricting credit due to the deleveraging campaign.

Defaults Predicted

China Merchants Bank Co. analyst Li Liuyang said he expects to see one or two high-profile defaults this year that will bring home that the implicit guarantee on shadow banking products is gone.

To be sure, until now, defaults have been rare in the trust industry, with issuers usually finding a way to repay depositors through new issuance or other means. Defaults on wealth management products -- which tend to invest their proceeds in the bond or money markets -- have been even more unusual.

Though market volatility is likely to increase as shadow bank financing dries up, Chinese authorities will step in if necessary, for example with injections of liquidity by the central bank to smooth market operations, according to Wang at UBS.

In the past, products sold by securities firms partly plugged the gap left by crackdowns on trust products. But now the government appears determined to curb financial risk and regulators across the banking, insurance and securities industries are coordinating their approach.

Read more: an explainer on China’s crackdown on financial risk

"We’ve seen all kinds of clampdowns in the past, but it always ended with a more covert funding channel emerging," said Yang at Shanghai Xiangyi Asset. “This time it’s different."

©2018 Bloomberg L.P.

With assistance from Jun Luo, Helen Sun, Ling Zeng, Heng Xie

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