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Bloomberg: Trust Me

October 9, 2011

I mentioned in a recent blog post that a reporter had called me up to ask “what I thought about a Hong Kong-listed baby formula producer that was loading up on loans and relending the money to non-ferrous metals, tungsten, and highway companies.”  That reporter — I can now disclose — was Shai Oster from Bloomberg, who published an article on this story on Friday which is important reading for anyone who wants to understand the rapidly evolving risks to China’s financial stability.

The story, in a nutshell:  Hong Kong-listed Ausnutria Dairy Corp. (HK:1717), based in Changsha, is China’s 13th largest producer of baby formula, using quality-ensured milk imported from Australia.  In April, it invested RMB 200 million (US$31 million) — roughly two years’ worth of profits — in Yunnan International Trust Co., which used the money to buy four loans from China Merchants Bank:  two loans to Hunan Nonferrous Metals (HK:2626), which mines and refines zinc, lead, tungsten, and antimony, and one each to Chenzhou Diamond Tungsten Products Co. and Hunan Bismuth Industry Co.  After fees, Ausnutria hopes to earn at least RMB 11 million ($1.7 million) in interest on the loans, and says that it already earned RMB 10 million on loans to a Hunan highway company it bought in a similar transaction with Hunan Trust and Investment Co. 

But the returns are not guaranteed, and neither Ausnutria nor the trust hold any collateral on the loans.  This worries a growing number of observers, who fear that many Chinese companies like Ausnutria may be taking bigger risks that they realize in search of higher yields.  But the alternative — seeing their ordinary bank deposits eaten away at regulated rates that are at least 3% less than inflation — is pushing more and more companies into the arms of trusts promising far more attractive rates of return (on essentially the same assets).

The result has been an explosion in trusts and similar investment vehicles (see my previous post on this subject).   As Shai notes, non-bank lending has grown from just 4% of loans in China in 2002, to an estimated 55% this year — which means that the supply of credit in China is more than double the official reported figures.  This is actually the second “trust boom” that China has seen in recent years.  The first one came to an ugly end in the late 1990s, when numerous trusts imploded, including the Guangdong International Trust and Investment Co. (GITIC) which defaulted on $200 million in bonds, many of them held by foreign investors — the largest bankruptcy China has seen to date.  The current one, which really only gathered steam at the beginning of this year, is being driven by the pressure to find ways around tighter bank lending controls in an economy that has become dependent on cheap and unlimited credit to drive investment-led growth:

“If you limit what banks can do, there’s still demand for loans,” said Zhang Liwen, president of Suzhou Trust, sitting in an office on the second floor of a cement-and-glass building on a leafy street in Suzhou, 50 miles west of Shanghai. “The market still needs capital.”

As Shai points out, almost half the money managed by Chinese trusts is invested in infrastructure and real estate projects, and trust loans to real estate developers has catapulted 150% from RMB 235 billion in March 2010 to RMB 605 billion today.

The big concern the chain-reaction that could unfold if those developers run out of ready financing and go bust:

There are signs the real estate market is already cooling . . . Hungry for cash, some developers are borrowing at 12 percent to 25 percent . . . “Medium-sized property developers appear to have borrowed heavily for short-term and bridge loans,” said Il Houng Lee, the IMF’s senior representative in China. “Property developers’ strains could hit trusts.”

Any sign of weakness in China’s real estate market could have a chilling effect on trusts and their investors, said Jason Bedford, a manager at KPMG LLP in Beijing.  “Imagine that you have a real estate product and suddenly the real estate markets start to plummet,” Bedford said. “What was a liquid product suddenly becomes very illiquid as investors pull out and can’t be replaced.”

“It will cause a significant amount of wealth destruction,” [Michael Werner at Sanford C. Bernstein & Co. in Hong Kong] said. “The party goes on until someone turns on the lights and you can’t roll over these assets. There will be wealth destruction. The question is how much.”

I particularly noticed Jason Bedford’s comments, because in my past interactions with him here in Beijing, I always found him relatively confident concerning the financial condition of both the banks and the trusts, compared to chronic skeptics like myself.

In my initial conversation with Shai, I noted the parallels between what’s happening right now in China and the role that trusts played in triggering the “Panic of 1907” on Wall Street, and forwarded an article on the latter subject by former Fed economists Ellis Tallman and Jon Moen.  I was very gratified to see that he reached out and contacted and contacted one of the authors for comment.  In their article, the authors conclude that in 1907:

Unequal regulation among financial organizations, the authors find, led to a concentration of riskier assets in less regulated intermediaries, primarily trusts.  Trusts’ riskier asset portfolios made them the focal point from which the crisis spread to other segments of the financial market.

If you have any serious interest in the topic, I highly recommend you read the whole article, which you can find online here, and decide for yourself if “this time is different,” or whether we really have seen this movie before and know how it ends. 

In all of the recent articles I’ve seen on China’s credit climate, it’s always the little things that speak volumes.  The one that caught my eye in Shai’s article was this (my own bold italics added):

There is no sense of panic at the headquarters of Noah Holdings Ltd. (NOAH) in the Pudong section of Shanghai, where customers sip coffee and browse glossy brochures while sitting on leather and chrome sofas . . . It offers wealth-management products including those issued by trusts to clients who the company says invested an average of $1.3 million last year. On Noah’s website is a quotation from Chairman and CEO Wang Jingbo: “The world revolves around money, and it makes its own rules.”

8 Comments leave one →
  1. Ben permalink
    October 10, 2011 1:05 am

    Another excellent piece, Patrick. Always enjoy your insights on China.

    Knowing the Chinese, I think they will do everything they can to save face by kicking the can further down the road. But for how much longer? Are the Chinese at the end of their rope?

  2. October 10, 2011 4:53 am

    Great article, but Trust solvency depends on the quality of the loans. Lending money to companies with healthy balance sheets and high returns on capital is safe and smart investing. If a Trust is packaging junk, but misleading investors with a safe label, then it’s only a matter of time until collapse. If this is widespread practice, then systematic contagion is around the corner. That said, with credit from banks now tightly rationed, alternative forms of lending fill the void. The bond market is very small in China. Aren’t the Trusts just an interim step towards a more liquid and securitized credit market?

    ps – first time to your website. Exceptional. Thanks.

  3. Joe permalink
    October 10, 2011 5:08 am

    It would be great if you would offer a reading list on financial/economic history for those of us with little or no background in finance/economics. I, for one, would profit enormously. The book “This Time Is Different” was revelatory. Further recommendations from you – China specific or not – would be much appreciated. Thanks for the link to the Tallman/Moen essay.

  4. Hua Qiao permalink
    October 10, 2011 8:38 am

    I do some work with mainland financial institutions and I can tell you that the people serving on most of these investment committees are not risk people. Does anyone really think that these loans are analyzed and documented as well as the banks’ loans?
    This will get interesting. These trusts are illiquid and therefore are not in a position to extend and pretend. They therefore may be forced to take whatever actions they can more quickly than the banks. If there is real estate collateral supporting those loans and the trusts move aggressively, this might create significant downward pressure on property values.
    Additionally, there are the second order effects on bank loans to the SOEs that are investing in these high yield shadow loans. I would bet that most holders of these investments will make every effort not to write them off. There will be in the very least, a need for more working capital to support operations and even SOEs may become desperate for new loans.

  5. patrick permalink
    October 10, 2011 8:31 pm

    Copper shenanigans again!

  6. Peter permalink
    October 10, 2011 10:53 pm

    Hi Patrick,

    Good post (as usual).

    I work on large development plans in different parts of China and what you’ve explained here about trusts seems to fit what I see regularly. My clients always tell me that money is not a problem. If the banks won’t lend, then they can still get financing. If anything, though, you’ve underplayed the seriousness of the problem.

    1) lack of investment sophistication: for many (most??) new ventures being planned with local government entities, the financial models are abysmally simple-minded. Growth rates only go one way (up) for both sales values and leases. I’ve never once been asked to justify a discount rate or evaluate alternative scenarios in case of market weakness. In fact, I’ve never seen as little interest in the financial assumptions as in China – and I’ve worked in about 12 different countries. This fact makes me fear the shock absorption capacity of many recent investments (making a run to trust companies a necessity when the market weakens).

    2) profits: when I’ve done work for private businesses that were ostensibly profitable, much of their profits are derivative from either loose credit conditions (there’s a lot of money floating around the economy and they seem to be getting their share) or real estate in one way or another. This fact makes me skeptical of the real, demand-stressed, profitability of many businesses in China. In fact, if memory serves, weren’t most US banks profitable pre-Lehman?

    3) collateral: both my private and government clients tell me not to worry about their loan balances because they have a) land, b) some buildings, or c) both, that are more than sufficient to support the debt that they’re taking on. Didn’t I see how much 1 mu just sold for?! This attitude reminds me that hubris precedes the fall.

    If the trusts are the last group willing to fund many businesses, then are we not closer to the long-dreaded China economic bust (or whatever the proper language is for a rapid economic deceleration, backed up by a reinforcing feedback loop of deteriorating collateral values feeding capital calls on outstanding loans)?

    Too pessimistic?

  7. Hua Qiao permalink
    October 11, 2011 6:14 am


    I can’t agree with you more. I see the same things too. Defying gravity. What’s different about this time around (from 1999 or 2005) when the banks just sold the bad stuff at par to the asset maagement companies is that this kind of credit is not institutionalized and therefore out of the control of the regulators. The pain will come in direct losses to people’s savings as opposed to “socializing” the problem by spreading the pain over millions of bank depositors through low deposit rates.

    The banking sector can diversify its risks and spread the pain slowly. Trusts and other shadow lenders are very undiversified and have limited alternatives. There will be many stories in the future like those from the Wenzhou area: bosses disappearing, demonstrations by village creditors on borrowers as well as on the trust arrangers or credit aggregators. In desparate attempts to collect, we will see lots of shady and illegal loan shark like tactics (leg breakers). Could really get ugly.

    This disintermediation of the banking system is another adverse consequence of the inflationary pressures within the economy. While many think that foood price impact will cause social unrest, a big problem in this shadow banking sector could be very harmful.

  8. Ben permalink
    October 11, 2011 7:06 am

    Great comments, Peter and Hua Qiao.

    Peter Hessler, one of my favorite China observers, wrote the following in his latest book, Country Driving:

    “”In China it’s common for people in restaurants complain about food. Chinese can be passive about many things, but food is not one of them; I suppose this is one reason they have ended up with a first-rate cuisine and a long history of political disasters.”

    I wish more of Patrick’s comments can be read and debated by the common Chinese, and maybe, just maybe, China will avert another economic and political disaster.

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