In China’s Shadow Banking the WMPs Are Just Beginning of Problem [ANALYSIS]

Nobuyuki Saji of Mitsubishi UFJ Financial Group Inc (ADR) (NYSE:MTU) (TYO:8306) is back from a trip to China. He notes in a new report that the latest visits to China with three particularly strong impressions: (1) the next major problem after wealth management products (WMPs) will be “asset management plans” as the shadow banking system finds new ways around the rules; (2) Chongqing is the scene of intensified competition among real estate developers; and (3) a number of companies are gaining market share on the strength of proprietary technologies. Saji says ‘shadow banking problem runs deep’ before are further details.

Also see Kyle Bass: China Could See ‘Full-Scale Recession’ Next Year

• We visited 15 banks, real estate developers, consumer market companies, and manufacturers during a five-day visit to four cities (Beijing, Chongqing, Nanjing, and Wuxi) from July 1-5. We left with three key impressions:

(1) It remains easy to obtain high-yield wealth management products (WMPs) that guarantee 25% annual interest, even after the government’s attempts to regulate the WMP sector since March. Securities companies have recently been selling such products, and are also stepping up sales of high-risk “asset management plans.”

(2) Chongqing, one of China’s Tier-1 cities in the interior, remains the scene of large-scale residential property development. Large numbers of wealthy individuals are buying multiple units costing CNY9,000/sqm. Chongqing has no limit on the number of properties that a single person can buy for cash; other major cities have a limit of two, while Beijing allows only a single purchase. It is unclear where the cash for these purchases is coming from.

(3) China is migrating to aluminum alloys from titanium alloys to manufacture the heat converter plates used in power generating equipment. A new market for such alloys is being created as a result of upgrades to domestic aluminum casting and smelting technologies. Businesses in China are starting to develop potential demand by making home-grown technologies the market standard.

Macro and financial economy

Financial economy

Agricultural Bank of China Co., Ltd.

Agricultural Bank Of China Limited (HKG:1288) (SHA:601288) (OTCMKTS:ACGBF) is one of the country’s big four state-owned banks, and one of its commercial banks, with assets of CNY13.2trn (2012). Management attributes the recent rise in the China interbank rate (SHIBOR) to (1) the prospect of a QE exit in the US, (2) the government’s attempts to curb sales of WMPs since March, and (3) a seasonal spike in demand for funds ahead of the long holiday in June. Of these, the decisive factor in driving market rates higher was the China Banking Regulatory Commission’s (CBRC) announcement on March 27 of tighter rules on WMPs. Banks must now (1) disclose more information to investors on the assets to which they are exposed, (2) identify the ultimate use of the finance provided by WMPs, (3) report earnings from WMPs in a standard way, and (4) limit the balance of non-standard assets not subject to stock exchange or CBRC regulation to 35% of overall WMP assets. The People’s Bank of China (PBoC) on the same day announced new rules on the supply of funds by commercial banks to WMP providers.

WMPs are high-yield products that have been sold to wealthy individuals via bank branches since 2004. Agricultural Bank Of China Limited (HKG:1288) (SHA:601288) (OTCMKTS:ACGBF) has sold CNY3trn of such products and currently holds a balance of CNY700-800bn. Nearly all mature within one year and 67% have maturities of three months or less. The annual yield is 4.5-4.8%, below the 6-8% that is general for the segment, because Agricultural Bank Of China invests in relatively low-risk assets. The banks that invest in high-risk assets to generate higher returns are joint-stock commercial banks (such as CMBC, China Merchants Bank Co Ltd (OTCMKTS:CIHKY) (HKG:3968) (SHA:600036), Hua Xia Bank Co., Limited (SHA:600015), Industrial Bank Co., Ltd. (SHA:601166), and Shanghai Pudong Development Bank Co. Ltd (SHA:600000)), positioned below the four megabanks. A feature of all is their close ties to a particular region.

The bulk of WMP assets are thought to be used for real estate lending, although it appears that Agricultural Bank Of China Limited (HKG:1288) (SHA:601288) (OTCMKTS:ACGBF) also lends substantially to large regional firms (sales of at least CNY300bn): specifically, steelmakers, cement producers, and manufacturers of solar panels. This shows that circuitous bank lending is being used as a way to prevent NPL rates from rising on loans to sectors with excess capacity. Agricultural Bank Of China carries CNY240bn of WMP assets on its balance sheet as well as about CNY500bn that it does not show. (It adopts the accounting standard of listing only principal-guaranteed WMP assets on the balance sheet.) Management claims it has never made a loss on its WMPs since it began selling them in 2004, although it does appear that a significant number of joint-stock banks (which differ from the wholly state-controlled Agricultural Bank Of China) have since the Lehman shock made loans to troubled firms. This could translate into losses on the balance sheet if such troubled borrowers actually fail, with the probable consequence of instability in the interbank market.

The prospect of such a scenario remains ever-present. The root causes of the Chinese government’s clampdown on WMPs in March, following the massive expansion of lending, were (1) a failure by industry to remove excess capacity, (2) greater use by banks of circuitous lending and other tactics to keep bad loans hidden, and (3) although this is only speculation, a desire by the government to be seen as imposing discipline on the banking sector, which has been criticized for helping corrupt officials to launder funds. It has been argued that rampant corruption is one reason for the growing public discontent with the current administration since last year. Real estate developers and steelmakers are not the only companies that collude with local governments. The central government wants (or at least needs to be seen as wanting) to stamp out the cycle whereby funds generated by corruption flow into WMPs and ease the cash flow of firms that would otherwise be unable to service their debts. The Agricultural Bank Of China Limited (HKG:1288) (SHA:601288) (OTCMKTS:ACGBF) anticipates even tighter government regulation of WMPs.

The Sustainable Growth Of China’s Economy

Tighter regulation is of course essential over the longer term for the sustainable growth of China’s economy, both because it will eradicate the contradictions in the financial system and because it will promote a real shake-up of industry. However, it is also a double-edged sword. It is not possible for the monetary authorities simply to curtail liquidity from its current excess levels (M2 running at double GDP); they will have to be more subtle in the way they guide monetary conditions.

One challenge for the Chinese financial markets is that WMPs are not the only problem they face. Shadow banking is a CNY20trn market, of which WMPs are a central element (CNY8trn at present), but it also includes CNY4-5trn of entrusted loans, CNY2trn of pawnbroking, and micro-credit, among many other forms. These have been joined recently by “asset management plan” products, which are selling well via security company branches. These appear to be another way of collecting funds from individuals for lending to a range of industrial sectors, although we were unable to confirm this directly during our visit. These new products look like WMPs at their launch, in the sense that they were not under the control of the CBRC and are starting to attract money from wealthy individuals. Agricultural Bank Of China regards these asset management plans as far more risky than WMPs. It has sold CNY1-2trn of asset management plans and notes that the overall balance has increased rapidly. Agricultural Bank Of China Limited (HKG:1288) (SHA:601288) (OTCMKTS:ACGBF) has not received any consumer complaints about its WMPs, but we think the new asset management plans show that China’s shadow banking is changing its form as it continues to grow. About 20% of WMPs are lent directly to corporations, but it is impossible to identify the ultimate destination of the remaining 80% because it becomes lost in the markets for securitized loans or bills. As the government clamps down on WMPs, shadow money is already finding the next way to avoid the system.

Real estate

Longfor Properties Co. Ltd. (HKG:0960)

Longfor Properties Co. Ltd. (HKG:0960) is headquartered in Beijing but also develops property in Chonqing. The Chongqing Longfor Times Paradise Walk is a 1.3mn sqm development close to the seventh stop on the subway line out of central Chongqing. The area was a residential district for government workers and ex-military personnel. Longfor acquired it and developed a 650,000sqm commercial center. The first phase (140,000sqm) consists of A and B towers: the commercial properties in Tower A opened in December 2012. It is managed by Longfor’s facility management company and houses high-end flagship stores paying CNY180-220/sqm in rent. It received applications for 700 retailers to lease the 400 stores, and occupancy is currently 90%. Tower B (already constructed) is divided evenly between retail and residential, and has been completely sold, with the retail areas purchased by casual brand retailers. The residential units are the most expensive in Chongqing, at CNY15,000-16,000/sqm. The price of housing in surrounding areas has leapt from CNY8,000/sqm to CNY12,000/sqm as a result of the development.

The retail spaces in Tower B have sold at a vast range of prices, from CNY20,000/sqm to CNY220,000/sqm, with the highest prices for ground-floor lots close to Tower A. If rented out, they would attract monthly rents of around CNY1,500 at a yield of 8.2%. Phase two will consist of 250,000sqm of office and retail space, scheduled for completion at the end of 2014. All 28 floors of office space (1,200sqm per floor) have already been sold for CNY15,000-18,000/sqm. The potential rental lease is CNY70-90 month at a yield of 5.8%. The developer has not yet set pricing or other details of the retail space in phase two.

Phase three (140,000sqm) is scheduled for completion at the end of June 2015. This is planned to be entirely retail space, half of which will likely be sold and half leased. All available lots have already been sold at CNY30,000-70,000/sqm, with the exception of the ground floor. Our impression from a site visit and management’s presentation was that office and retail property is currently selling very strongly in Chongqing. We would estimate that individuals have invested heavily in the retail portion, which offers greater returns than residential property. Longfor’s representative did report that one buyer was an individual who had purchased an entire office floor. Chongqing is the only large city in China that places no limits on real estate purchases.

Jinke Properties Group Co., Ltd.

Jinke Property Group Co Ltd (SHE:000656) is a midsize Chongqing-based developer, established in 1998, that concentrates mainly on residential projects. It has developed 60 projects and ranks 30th nationwide in sales. Total assets have increased by an annualized 44% and net assets by 62% since 2006, thanks to the rapid growth in demand for real estate in Chongqing. Property sales increased to CNY17bn in 2012 from CNY500mn in 2005. Jinke focused chiefly on top-end, low-rise family housing until 2005, rather than the condominiums in which most of the population lives. Chinese have traditionally bought single-family houses as a second home, making it the preserve of the wealthy. Jinke’s sales divided evenly between single-family houses and condos until 2010, since which condos have accounted for the majority. The change occurred because of the restrictions on real estate ownership that came into force in 2010, which depressed demand for second homes and ended the boom in such properties. Jinke therefore concentrated its resources on the condo market and broadened its geographical scope beyond Chongqing to include Beijing and Shanghai (its first move outside its home region was in 2007). As of 2012, 60% of its sales projects were in Chongqing, 20% in Beijing, and 20% in Shanghai.

Chongqing is unique among Tier-1 cities in China for having no restrictions on residential property ownership. The government’s position is that no such rules are needed because prices have risen more steadily than in Beijing, Shanghai, or other Tier-1 cities. The price of housing in Chongqing’s nine wards (the equivalent of Tokyo’s five central wards) averages CNY6,700/sqm now compared with CNY5,000/sqm three years ago, meaning consistent, sustained growth of around 10% per year. This contrasts with the volatility of other Tier-1 cities, where prices regularly fluctuate by 10% or more. Housing supply-demand has been particularly destabilized in Beijing by the government’s policy of urbanizing the population. Beijing is still home to just 1% of China’s population, compared with the 5-10% of Tokyo or New York, meaning it still has room to grow. The government’s adoption of policies to artificially increase the population living in large cities is creating greater volatility in property prices.

A more prescriptive approach to policy is also making residential prices more volatile. New rules require anybody registered outside Beijing to have paid social security premiums for at least five years before they can own a home in the city. People who are registered in Beijing are allowed to own only one property. This was intended to stabilize real estate prices and promote growth in the capital’s population, but in practice it has made prices more volatile. Chongqing is entirely unregulated: a cash buyer can purchase as many properties as he wants. Forty cities currently require a 30% cash deposit on the first property and a 60% deposit on the second, but Chongqing (along with Shanghai) is unique in operating a system of property tax: (1) 0.5% of the property price if it exceeds CNY12,500/sqm, (2) 0.5-1.2% on luxury single-family houses with more than 180sqm of floor space, and (3) 0.5-1.2% on the appraised value of condos (excluding the first 100sqm) and other residences excluding single-family homes, assessed with reference to surrounding properties in the past two years. This means Shanghai is the only city that both restricts property ownership and levies a tax—an indication of how closely the government attempts to control the
market there. Chongqing and Shanghai were the only two cities with a property tax in 2011, but speculation has risen among real estate developers and consumers that Beijing and Guangzhou will follow suit during 2013.

Management at Jinke Properties claims government attempts to regulate WMPs will have no impact on its earnings. As of 2012; development loans from banks accounted for 80% of its CNY11bn in borrowings (the remainder being working capital loans), and it has obtained no finance via WMPs. Jinke says that real estate developers that rely on funding via WMPs are small developers with only two or three projects operating on annual sales of less than CNY1bn . It claims not to know of any WMP-related collapses in Chongqing, although we note that micro-credit is an alternative way for small developers to obtain funds. Under such an arrangement, a number of small businessmen (not real estate developers) will borrow from a micro-credit company, and will use the funds to invest in a newly established joint-stock real estate development company. Such firms are unlikely to qualify for regular bank funding, since a bank will in principle not lend to a company that is not on its list of sound borrowers.

Micro-credit lenders charge average annual interest of 10-20% on loans, although some reportedly collect 30-40%. Such lenders are part of the shadow banking economy, with dozens operating in each province throughout the country. Most are
capitalized at just CNY100-300mn, and cap lending at twice their capital (according to the government). However, they are monitored by the finance bureaus of local governments rather than the central government’s CBRC, meaning that scope exists
for differences in the degree of oversight provided. Lenders cannot accept deposits and therefore rely for funding on local companies and wealthy individuals. We also heard concerns on the ground about a backdoor financing route by which banks lend money to