The problem with China's Wealth Management Products, or WMPs, is not new: we have covered this pillar of China's shadow banking system on various occasions over the past three years, usually just before and after the time of the latest spectacular WMP fund blow up, which promptly becomes headline news and then fades again until the next such collapse.
"Wealth management products in China have come under the spotlight after a series of missed payments raised concerns over the shadow banking sector that often directs credit to firms shut out from bank lending or capital markets," Reuters said last February, after reporting that China's top brokerage, CITIC, was looking at ways to repay investors after the issuer of one of the wealth management products the broker sold missed a $1.12 million payment to investors.
Although wealth management products are often described as "murky" and "opaque", the basic concept is fairly simple. WMPs are marketed to return-greedy investors (which in China is pretty much everyone these days) as a way to get more bang for their buck (er, yuan) than they would with bank deposits. Funds from these investors are then invested at a higher rate. If the assets investors' money is used to fund run into trouble, that's not good news for WMP investors. Simple.
One such prominent WMP blow up took place last August when Hebei Financing Investment Guarantee, the largest loan guarantee company in the northern province of Hebei, wholly owned by the provincial regulator of state-owned assets, went apparently broke, which was bad news as it guaranteed CNY50 billion in loans made by dozens of trusts who in turn issued wealth management products to investors.
As we explained last summer, the core reason why the underling assets of WMP were going bad, fast, is because investor money was funneled into real estate development and other parts of the economy which generated high levered returns but are now struggling mightily as a result of the commodity collapse; in fact most WMPs can no longer generate nearly enough returns to satisfy investors; this means that absent finding new ways to generate historical returns, there is a latent threat of terminal withdrawals which in turn could topple the entire industry.
Even more important than the surge in bad assets was the sheer size of the WMP/shadow banking market: back in 2010, as regulators tried to rein in the explosion in bank credit resulting from the country’s 4 trillion yuan economic stimulus plan, banks turned to trusts to help them comply with lending controls. Since then WMPs have grown at an exponential pace and currently amount to about 24 trillion yuan, the equivalent of $3.6, or over a third of China's GDP. Essentially trusts helped banks offload credit risk at the behest of the PBoC. Here’s the process whereby banks use trusts to get balance sheet relief:
And since WMP issuers are perpetually borrowing short to lend long with ever more leverage to provide the required return, it meant that WMP managers had to find greater and greater fools to provide these underlying financial products with funds just so they could repay existing investors.
In other words, a classic Ponzi scheme, which however had the added benefit that it was "too big to fail" - so many Chinese investors had parked cash with WMPs, the government was facing a revolt if it were to allow mass defaults within the shadow banking sector. Which is also why the abovementioned Hebei was ultimately bailed out.
But while through the government's actions - call it the "Beijing Put" - any risk of investing in WMPs was gone and any investments in WMPs are now seen as having implicit backing by banks, as well as the local and state government, there was one major loose end: none of the traditional assets generated the types of returns WMPs had come to expect in recent years. There was another problem - potential WMP investors no longer rushed to their nearest, friendly neighborhood shadow financing Ponzi outlet, as they had found other more creative ways to lose money, whether investing in the stock market bubble, the bond market bubble, or, most recently, the steel and rebar bubble (if there is one thing China has at any given moment, it is bubbles).
Which brings us to the current state of the WMP market in China. As Bloomberg writes, "the risk of a default chain reaction is looming over the $3.6 trillion market for wealth management products in China."
What Bloomberg means is that in its infinite financial engineering ingenuity, China has found a way to push beyond the conventional "Minsky Moment" envelope. Recall that according to Minsky, the third and final stage before a financial regime hits its terminal collapse moment, is the so-called "Ponzi finance" stage, a regime in which borrowers have insufficient cash flows to pay either principal or interest and therefore must either borrow or sell assets to make interest payments.
China passed that stage over a year ago. Instead, where China finds itself now is in that nebulous void between Ponzi Finance and Minsky Moment, where unable to find traditional investors, Chinese Ponzis are now investing in other Chinese Ponzis (and vice versa) just to kick the can longer for a few more months, weeks or days.
As Bloomberg writes, WMPs, which traditionally funneled money from Chinese individuals into assets from corporate bonds to stocks and derivatives, are now increasingly investing in each other. Such holdings may have swelled to as much as 2.6 trillion yuan ($396 billion) last year, based on estimates from Autonomous Research this month.
As noted above, the main reason for this infernal loop is the lack of high yielding returns, something that has been a stable of the Chinese shadow banking system, where tens of trillions in Yuan slosh around every single day: "There’s abundant liquidity in the financial system, but a scarcity of high-yielding assets to invest in," said Harrison Hu, the chief Greater China economist at Royal Bank of Scotland Plc in Singapore. "All the risks are accumulating in an overcrowded financial system."
WMPs found a stop-gap solution: use all the excess funds from one Ponzi to bootstrap the returns of another Ponzi, in hopes the other Ponzi can generate a high enough return to attarct new investment at which point it can return the favor, and so on in a move that even America's corrupt, incompetent regulators would find simply too much for popular consumption.
But not in China, where circular Ponzi investing is now all the rage.
As a result, the trend has China watchers very worried. For starters, it means that bad investments by one WMP could infect others, causing a loss of confidence in products that play an important role in bank funding. It also suggests WMPs are struggling to find enough good assets to meet their return targets. In the event of widespread losses, cross-ownership will create more uncertainty over who’s vulnerable - a key source of panic in 2008 when soured U.S. mortgage securities triggered a global financial crisis.
Those concerns have become more pressing this year after at least 10 Chinese companies defaulted on onshore bonds, the Shanghai Composite Index sank 20 percent and China’s economy showed few signs of recovery from the weakest expansion in a quarter century.
Meanwhile, the growth in WMPs has been nothing short of exponential: from just over 4.5 trillion 5 years ago, the total outstanding value of WMP assets is now CNY24 trillion, or almost $4 trillion, and account for 35% of China's GDP!
According to Bloomberg, an average 3,500 WMPs were issued every week last year, with some mid-tier banks, such as China Merchants Bank Co. and China Everbright Bank Co., especially dependent on the products for funding.
But the scariest finding is the following: Interbank holdings of WMPs swelled to 3 trillion yuan as of December from 496 billion yuan just one year earlier, according to figures released by the clearing agency last month. As much as 85% of those products may have been bought by other WMPs, according to Autonomous Research, which based its estimate on lenders’ public disclosures and data on interbank transactions. The firm speculates that in some cases the products are being “churned” to generate fees for banks.
In short, what is happening China now is a carbon copy of the financial innovation that brought down the US financial system in 2005-2006.
"We’re starting to see layers of liabilities built upon the same underlying assets, much like we did with subprime asset-backed securities, collateralized debt obligations, and CDOs-squared in the U.S.," Charlene Chu, a partner at Autonomous who rose to prominence in her former role at Fitch Ratings by warning of the risks of bad debt in China, said in an interview on May 17.
What is perhaps even scarier about China's WMP products is the far greater asset-liability mismatch: most WMPs have a duration of less than six months and some can be as short as one month. A search of 1,300 products listed on the website of government-run Chinawealth.com.cn showed the highest annual yield on offer was 8 percent, compared with a one-year deposit rate of 1.5 percent. Typical yields range from 3 to 5 percent.
Not only is this not sustainable, but it means that once the selling avalanche begins, it will make the Lehman failure seems like a walk in the park.
Another question is what are these WMPs invested in? According to Bloomberg, while individual products don’t disclose their underlying assets, bonds represent the largest exposure for WMPs as a whole.
WMPs have become such big players that they are now the biggest investors in Chinese corporate debt, according to China International Capital Corp. And, as we reported late last year and in early 2016, China's bond market market suffered its biggest losses in 16 months in April after a wave of defaults at state-owned enterprises spooked investors.
It is only going to get worse unless Beijing bails out absolutely everyone.
"My concern is that bond defaults might trigger some losses that will lead to WMP impairments or WMP investors being unwilling or unable to roll over the funding, which then leads the bank to take some of these assets back onto the balance sheet,” said Matthew Phan, credit analyst at CreditSights in Singapore. "If this happens in a large scale, it could cause some issues, given the mismatch between the duration of the WMPs and the bonds."
Not if... when.
When will China's finally move on to its Minsky moment? One possible answer is that once all possible profits from WMPs are exhausted. For now, many of these ponzi schemes are still profitable. As Bloomberg calculates, a majority of WMPs have been profitable for both investors and the institutions who manage them. Chinese lenders earned 117 billion yuan from the products last year, according to the nation’s clearing agency. Demand for WMPs has remained buoyant after this year’s stock market crash and a wave of failures at peer-to-peer lenders made the products look safer by comparison, according to Shujin Chen, a banking analyst at DBS Vickers Hong Kong Ltd.
Which, of course, is ludicrous as by definition, a Ponzi scheme can only survive as long as it has at least one additional dollar in distributable capital, and at least one greater fool. In China both are rapidly shrinking.
As Bloomberg concludes, the industry’s ability to meet its return targets thus far may overstate its stability. The most common source of funds for repayment of WMPs is the issuance of new WMPs, Fitch analysts Jack Yuan and Grace Wu wrote in March. That leaves the products vulnerable to any sudden drop in demand, a risk alluded to in 2012 by Xiao Gang, then chairman of Bank of China Ltd., when he warned of “Ponzi scheme” dangers for the industry.
"The worst scenario will be if investors stop rolling over,” said Wu, who works for Fitch in Hong Kong. That “could cause a liquidity crunch for banks," she said.
The good news for Chinese investors is that they have been thoroughly and extensively warned that the biggest source of return for investors is nothing but a Ponzi scheme. Whether or not anyone listens before the inevitable crash sweeps away trillions in "assets", that is a different story entirely. The good news is that as long as central banks make conventional, stable investments such as government treasury bonds increasingly more repressed, there will remain demand for even the most sordid of Ponzi product.
As such, when the final bubble bursts look no further than to your friendly, local central bank to find the culprit who made this period of monetary insanity possible.
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