The explosive growth of wealth management products in China is sounding alarms for observers who see a parallel between the opaque investments and the subprime mortgages that sunk the U.S. economy.
The products consist of packages of high-risk business loans that are sliced into pieces small enough to appeal to average consumers. They are sold through banks and carry attractive rates of interest – although poor disclosure means that most buyers have little idea what assets underpin their investment.
The fear is that a slowdown in the Chinese economy could lead to widespread defaults in these products, which would hurt the country’s savers and ripple through the wider economy.
Some China-watchers see a striking resemblance between these risky syndicated loans and the mortgage-backed securities that caused the U.S. financial crisis. Collateralized debt obligations (CDOs) bundled together mortgages and other debts, then sliced them into tiered levels of debt to appeal to different buyers, many of whom had little idea of what they were purchasing.
“Like in the United States, these [wealth management] products ultimately maximize lending to the property market,” writes Andy Xie, an independent economist formerly with Morgan Stanley. “The [packaging] techniques are really marketing ploys to suck in financial investors with [the appearance of] low risk. I’m afraid something bad will happen in this market soon.”
Wealth management products appeal to the average Chinese saver because the country’s government has kept interest rates artificially low to spur the nation’s economy. Bank deposits typically pay 3 per cent interest, far below the 6 per cent rate of inflation. In contrast, wealth management products pay 6 to 8 per cent a year.
To increase returns on savings, consumers have turned to the products en masse, shovelling ¥12-trillion ($1.94-trillion U.S.) so far in 2012 into the largely unregulated area.
Introduced as an investment vehicle only five years ago, wealth management products now account for ¥10.4-trillion ($1.6-trillion) or 11.5 per cent of total Chinese bank deposits according to a study by Fitch Ratings.
At the centre of China’s wealth management industry are trust companies that raise funds for small- and medium-sized businesses (SMEs). Without land or other assets to use as collateral, these firms previously had difficulty getting approval for bank loans.
The trust companies initially specialized in securing bank loans for SMEs by agreeing to repay the borrowed funds in the event the company defaulted. Eventually, the trust companies began pooling these loans into bond-like structures similar to U.S.-style CDOs and selling them to bank customers with the promise of high-yield payments.
The danger arises from the quality of the assets underlying many of the vehicles, which is hidden from investors by poor disclosure.
Reuters recently published a study of 50 of the most popular wealth management and trust loan products and found that “all, except two, failed to explain or display the underlying asset.”
The lack of disclosure has led to abuses. In one case, the link between a $35-million savings product and the country’s largely insolvent Railway Ministry was carefully hidden in the small print of the disclosure documents. The Railway Ministry suffered losses of ¥7-billion ($1.13-billion) in the first quarter of 2012, making it a remarkably poor credit risk for a money market-like product.
Reuters says that banks also began transferring bad debts, on which customers had stopped making payments, to trust companies, which in turn packaged the debt into investment products that were sold back to retail customers.
Many wealth management products have maturities of less than three months. Their short-term nature means they are constantly maturing and must be replaced by new issues. For Tsinghua University economics professor Patrick Chovanec, this raises concern.
“The danger, of course, is that banks are successfully paying investors high returns not from the real returns being generated by the money invested, but from money coming in from new investors — the very definition of a Ponzi scheme,” writes Mr. Chovanec.
As long as money continues to pour into wealth management products, any credit issues will remain submerged. The lesson of the 2007 financial crisis, however, is that this type of structure can function for a considerable period, but collapse all at once.