China: Current and Future Financial Risks Surrounding Wealth Management Products and Trust Products. Summary

Transcription

1 VOL9, No.1 June 11, 214 (Original Japanese version released on April 3, 214 ) China: Current and Future Financial Risks Surrounding Wealth Management Products and Trust Products Summary The first default in China s domestic public offering corporate bond market occurred in early March. Authorities appear to have reversed their stance and allow defaults of financial instruments. More defaults are expected to occur among wealth management and trust, which have surged in popularity. Trust have the following attributes vis-à-vis wealth management : 1) minimum investment amounts are high, and many investors are wealthy; 2) issuance periods are long; 3) yields are high (so investment risk is high); and 4) tougher regulatory oversight has lagged. The potential default risk is believed to be greater for trust than for wealth management Trust redemption amounts rose in Apr-Jun, especially for infrastructure-related, and refinancing pressures are expected to increase. The population of wealth management and trust that may not be able to make repayments may be estimated considerable. The possibility of huge defaults hurting the Chinese economy cannot be ruled out. Many Chinese wealth management and trust are similar to US subprime in terms of substantial term mismatches as well as difficulty in assessing the backed assets. However, there are also big differences, such as with investor class. Should default pressures among wealth management and trust increase dramatically because of a sudden worsening in China s economy, the impacts could vary considerably depending on the bearer of losses. A scenario in which the selling and structuring financial institutions bear the losses could lead to the risk of financial crisis-like conditions erupting in China. If individual investors bear the losses, credit could quickly contract and social risk could increase further. Under a scenario in which the central and local governments bear the losses, the short term financial and economic adverse impacts would be slight. If significant default pressures mount, the possibility of this scenario is high. However, Problems would probably be put off. 1

2 Introduction The first default in China s domestic public offering corporate bond market occurred in March. Authorities appear to have altered their stances prioritizing avoidance of default in order to limit the expansion of credit. Given the recent sudden expansion in credit and the slowing economy, defaults are expected to occur among corporate bond or other financial going forward. Of financial instruments that have grown in popularity recently, wealth management and trust in particular appear to be increasingly ridden with problems. We should closely monitor their developments. This report first reviews the current status of wealth management and trust, then addresses the possible impacts of a significant increase in default pressures among wealth management and trust on the financial markets and economy. 1. Wealth management and trust and China s financial system Wealth management and trust, like deposits, are a means of financing for the financial sector (see Figure 1). Given that non-bank deposits and loans are shadow banking, then wealth management and trust are a key means of finance for the shadow banking sector. These instruments are closely tied to various types of investments and loans in the shadow banking sector (see below). Therefore, credit conditions in the shadow banking sector can be broadly understood by examining developments with wealth management and trust. Furthermore, given their 1) huge balances, 2) short terms, and 3) close links with high-risk investments, if problems arise with issuance of wealth management and trust, the supply of funds for various types of investments and loans in the shadow banking sector could be squeezed. This could significantly impact the financial system as a whole. Both the number of defaults and selling conditions of wealth management and trust are the focus of attention. 2

3 Figure 1: China's Financial System Financial Sector Households Bank deposits Bank loans Corporations Corporations Wealth management Trust Trust loans Corporate bonds Households lenders Financing Investments, loans Borrowers Supplemented by monetary supply data (cash + deposits + savings) Supplemented by social financing Source: BTMU. Note that total social financing, generally used to gauge the scale of credit in China, reflects total investment and lending in the real economy from the financial sector loans and obligations. Let s review the current status of total social financing in China. In 213, RMB17.3 trillion in new social financing was extended. Of this, non-bank lending (such as entrusted loans and trust loans) totaled RMB7.8 trillion, or 4.2% of all social financing (Figure 2). The balance of total social financing stood at RMB12 trillion as of end-213. (New financing data is available from 22, so the aggregate amount could be determined.) Non-bank lending stood at RMB34. trillion, or 33.7% of all social financing (Figure 3). China s money supply (M2, or cash + deposits + savings) totaled RMB111 trillion as of end Figure 2: Total Social Financing (new increased) (RMB trn) (%) Other (left axis) Banker's acceptance bill (left axis) Trust loans (left axis) Entrusted loans (left axis) Corp bonds (left axis) Bank loans (left axis) Non-bank loan share (right axis) Note: Total social financing is all real economy funds from financial system (financial institutions like banks, securities companies, and insurance companies and securities market). Source: People's Bank of China, BTMU Figure 3: Total Social Financing (outstanding) (RMB trn) (%) Other (left axis) Banker's acceptance bill (left axis) Trust loans (left axis) Entrusted loans (left axis) Corp bonds (left axis) Bank loans (left axis) Non-bank loan share (right axis) Note: Total social financing is all real economy funds from financial system (financial institutions like banks, securities companies, and insurance companies and securities market). Source: People's Bank of China, BTMU

4 2. Overview and current status of wealth management and trust (1)Overview and current status of wealth management Wealth management are asset management instruments intended for primarily individuals, and they are structured and sold by banks. (Companies may also buy these.) Issuance terms are short, usually one to three months. Many with super-short terms of less than one month were available in the past, but these are now less common following the introduction of stricter financial regulations in 212. There are two types of wealth management, guaranteed principal and non-guaranteed principal. Guaranteed principal are included on bank balance sheets, while non-guaranteed principal are not. Non-guaranteed principal have been increasingly popular recently. There have been many reports of individual investors buying non-guaranteed principal, mistakenly believing the principal to be guaranteed, apparently due to inadequate explanations offered at the time of purchase. Wealth management are roughly divided by investment style: 1) fixed income oriented type ; 2) trust loan oriented type ; 3) balanced (portfolio) type ; and 4) other. Fixed income oriented type have relatively high liquidity and invest mainly in low credit risk obligations and short-term financial instruments. As such, they are considered low risk. These are currently the most commonly structured wealth management. Trust loan oriented type are also called bank-trust cooperation model. Banks sell these and invest the funds to trust. Banks have increasingly tended to use this type in order to avoid regulation of loan-deposit ratio, so the China Banking Regulatory Commission introduced a number of new rules and oversights in 21 and 211. Since then, the share of trust loan oriented type has declined, with the share of balanced type increasing instead. Balanced type invest in a wide range of assets, not only bonds and short-term financial instruments but also in high credit-risk areas including real estate lending, local government platform lending, trust, and SME lending (Figure 4). Further, balanced type do not manage assets by each wealth management, frequently using an fund pool style of management that handles all underlying assets together. Fund pools are increasingly considered to have many problems, including 1) unclarity regarding the allocation of losses upon default; 2) disproportionate investor risk and return; and 3) high liquidity risk. Stronger regulations are being introduced. 4

5 Figure 4: Balanced (Portfolio) Wealth Management Product Framework Wealth management sold by banks Wealth management product (1) Wealth management product(2) Fund pool Bonds Short-term financial instruments (repos, calls, etc.) Asset pool Trust Real estate loans Wealth management product(n) Source: Federal Reserve Bank of San Francisco, BTMU. Private equity funds Local government financial vehicle (LGFV) Wealth management instruments may offer yields of approximately %. Deposit interest rates are regulated in China and because real interest rates remain low, demand for high-yields is strong. China s central bank sets the deposit base interest rate, and the maximum deposit interest rate is 11% of that. The deposit base interest rate is currently 3%, so the maximum deposit interest rate is 3.3%. Given that inflation stood at 2.6% in 213, the real maximum deposit interest rate is a low.7%. Because of this, wealth management are growing in popularity as bank deposits increase at a slower pace (Figure ). Wealth management sold by banks (which comprise the bulk of such ) stood at RMB9.9 trillion as of end-september 213 (17% of nominal GDP), according to official figures (Figure 6). Figure : Bank Deposits (RMB trn) (%) Bank deposits (left axis) YoY change (right axis) Source: People's Bank of China, etc, BTMU. Figure 6: Wealth Management Products (Bank Sales) and Trust Assets (RMB trn) Wealth management (Bank sales) Trust assets Note: Wealth management is total of China Banking Regulatory Commission and China Banking Associaition figures from end-december 212, People's Bank of China figures before then. Source: People's Bank of China, China Banking Regulatory Commission, China Banking Association, China Trustees Association, BTMU. (2)Overview and current status of trust Trust are managed instruments developed by trust companies and sold by trust companies and banks. Many such have a minimum investment requirement of RMB1 million, and the main investors are high-wealth individuals. (Institutional investors are

6 also buyers.) As of end-213, investors held RMB1.9 trillion of trust (equivalent to 19% of nominal GDP, Figure 6). As of end-213, trust invested mostly in loans, at 47%. This was followed by long-term bonds at 19%, long-term stocks at 9%, and short-term financial at 9% (Figure 7). Trust invest mostly in the following sectors (as of end-213): commercial and industrial (28%), infrastructure-related (2%), real estate (1%), securities (1%), financial institutions (12%), and other (14%) (Figure 8). Over the past several years, the share of investment into commercial and industrial has risen, while the proportion of investment into real estate has declined. Although details of investments are unclear, the commercial and industrial category appears to include industries with excess supply capacity and that cannot easily get financing from banks, like the coal, steel, and non-steel sectors. Further, infrastructure-related investments appear to include many infrastructure-related projects in which local governments have a stake Figure 7: Trust Investment Methods (% of trust instruments overall) Loans End-21 End-212 Short-term investments Long-term bond investments Source: China Trustees Association, BTMU. End-211 End-213 Long-term stock investments Other Figure 8: Trust Investments (% of total) Commercial and industrial End-21 End-212 End-211 End-213 Infrastructure Real estate Securities Financial related institutions Source: China Trustees Association, BTMU. Other There are three types of trust instrument schemes, 1) single trusts sold to individual investors; 2) collective trusts sold to multiple investors; and 3) property trusts. The claim rights following default are unclear for collective trusts, and these instruments appear to be especially ridden with problems. In fact, the majority of trust that have nearly defaulted over the past few years have been collective trusts. Collective trusts comprised 2% of trust assets as of end-213 (Figure 9). Though lower than the 28.7% ratio in Apr-Jun 212, this is still high. Let s look at different types of trust by more detailed categories, based on type of scheme. First, the share of bank-trust cooperation trust assets stood at 2% as of end-213 (RMB2.2 trillion). Since 21, the share has been declining (Figure 1). Further, 6

7 government-trust cooperation (trust developed through collaboration between governments and trust companies) comprised 8.8% of trust assets (RMB96 million). Since 21, the ratio has remained flat (Figure 1). Government-trust collaborative instruments appear to be primarily for local government infrastructure-related projects Figure 9: Collective Trusts as Share of Trust Assets (%) Figure 1: Bank-Trust and Government-Trust Cooperative as Share of Trust Assets (%) Bank-trust cooperative Government-trust cooperative Source: China Trustees Association, BTMU Source: China Trustees Association, BTMU. There are 6 trust companies that issue such trust. China s trust industry employs approximately 1, persons, and each trust company has an average of nearly 2 employees. The China Banking Regulatory Commission oversees trust companies, and major banks and local governments are the main shareholders of many trust companies. Trust companies finance through trust and bank wealth management, and mainly manage these through trust loans and stocks and bonds (Figure 11). Furthermore, trust companies also participate in entrusted loans and bank bill acceptances. 7

8 Figure 11: Trust Company Business Model Deposit Banks Bank depositors (individual investors) Purchase Bankissued wealth manageme nt Invest Entrusted loans Trust assets Bank acceptances Qualified investors (high wealth) Institutional investors, stateowned enterprises, LGFV, Banks Purchase Purchase Trust Invest Entrusted loans Loans Trust loans Real sector Stocks, loans, ETFs, PEs... Indirect extension of credit Loans, Bank acceptances, Letters of credit, etc. Informal lending LGFV Real estate developers SMEs state-owned enterprises Households Note: LGFV is local government platform. SMEs is small and medium-sized enterprises. Source: Federal Reserve Bank of San Francisco, BTMU. (3)Wealth management and trust compared Wealth management and trust have been rising in tandem, both to nearly RMB1 trillion. Trust are characterized by the following: 1) high minimum investments, so many of the investors are high-wealth individuals; 2) long issuance periods; 3) high returns (and thus high investment risk); and 4) delays in tighter oversight (see below) (Table 1). Trust appear to have greater potential default pressures than wealth management. Table 1: Wealth Management Products and Trust Products Compared Wealth management Trust Major investors Individuals High-wealth investors, institutional investors Major sellers Banks Banks Amount issued Approx RMB1 trn Approx RMB11 trn Minimum investment Approx RMB3, -, Approx RMB1 mn Avg issuance period Approx 1-3 months Approx 2 years Avg yield Approx % Approx 7-1% Investor guarantee Investment Source: Various materials, BTMU. Both guaranteed, not guaranteed (However, even not guaranteed types considered guaranteed by banks) Primarily bonds and short-term financial instruments many low-risk investments No (However, considered to be in fact guaranteed by trust companies) Primarily corporate loans Many high-risk investments 8

9 (4)Tightened regulations on wealth management and trust Chinese authorities have been strengthening rules regarding wealth management and trust since 21 following the sudden surge in product popularity and with increased development and trading of problem-ridden instruments (Table 2). Rules covering bank-trust collaborative were strengthened in 21 and against fund pools in 213. An official notice about monitoring of the shadow banking system was circulated at end-213, and regulations and oversight of trust were strengthened on April 8. Although oversight remains inadequate, authorities are working to improve the soundness of wealth management instruments in particular. Table 2: Regulatory Developments with Wealth Management Products and Trust Products Date Instrument Authority Details 6-Jul-9 12-Aug-1 9-Sep-1 28-Aug-11 Nov-11 Dec Dec-12 2-Mar-13 1-May-13 Wealth management Wealth management, Trust Products Trust Products Wealth management Wealth management Wealth management, Trust Products Wealth management, Trust Products Wealth management Wealth management China Banking Regulatory Commission China Banking Regulatory Commission China Banking Regulatory Commission China Banking Regulatory Commission China Banking Regulatory Commission China Banking Regulatory Commission China Banking Regulatory Commission China Banking Regulatory Commission Clarification of wealth management product investments (not including unlisted shares) Tighter rules for bank-trust composites (must include on balance sheets within two years) Capital regulations for trust companies introduced (requiring minimum net capital holdings of RMB2 million or 4% of net assets, whichever is larger) Tighter sales regulations of wealth management Prohibition of issuance of wealth management of less than 1 month for individuals Investments sold to banks subject to internal monitoring (incl wealth management, trust ) Detailed lists of investment instruments structured by third parties and sold to banks must be submitted Committee of experts to be formed by banking industry executives in order to monitor wealth management Banks prohibited from investing in unlisted shares (non-standardized obligation assets) exceeding 3% of funds raised from wealth management or 4% of total assets as of end of previous year Prohibition of fund pooling China Central Deposity & Clearing, Shanghai Clearing Prohibition of fund calling between own accounts and wealth management product accounts House 21-Aug-13 Trust Products People's Bank of China Including all financing from trust companies in credit databases 22-Nov-13 Feb Dec Feb-14 8-Apr-14 Wealth management Wealth management, Trust Products Wealth management Wealth management Trust Products Overseeing authorities State Council China Securities Depository and Clearing Company Limited People's Bank of China China Banking Regulatory Commission Mandating reporting on wealth management held by domestic banks (to be disclosed through registration system of central deposit clearing agency) Internal notice No. 17 regarding monitoring of shadow banking (strict monitoring by authorities required for bank wealth management business and trust company business) Acquisition of preferred shares allowed by bank wealth management Establishing separate accounts for each instrument when wealth management instruments invest in interbank lending market Tightening restrictions on fund pools Requiring trust companies to construct framework to accept emergency support from shareholders when liquidity risk rises Reporting sales of new to authorities by 1 days before sale Source: Various materials, BTMU. 3. Current status of trust loans and entrusted loans This section reviews trust loans and entrusted loans, the biggest investment vehicles of trust. Entrusted loans are loans among companies brokered by financial institutions, and some wealth management and trust invest in these. They are thus considered a trust method. Entrusted loans are not on financial institutions balance sheets because they are fee businesses that do not involve trust risk. 9

10 (1)Shares of trust loans and entrusted loans within overall credit As of end-213, trust loans comprised 4.6% (RMB4.7 trillion) of total social financing (RMB12.3 trillion), while entrusted loans comprised 8.1% (RMB8.3 trillion). Both types of loans account for a large portion of China s overall credit (Figure 12). According to the China Trustee Association, loans comprised 47% of trust assets, or RMB1.9 trillion, as of end-213. This is consistent with the balance of trust loans outstanding. Of the new financing raised in 213, 1.6% of new total social financing was trust loans (RMB1.84 trillion), while 14.7% was entrusted loans (RMB2. trillion). New trust loans peaked in Jan-Mar 213, then started to decline, while entrusted loans have continued to increase since Apr-Jun 212 (Figure 13). The upward trend of entrusted loans is being watched carefully. Figure 12: Trust Loans, Entrusted Loans (outstanding) (RMB trn) Trust loans Entrusted loans Figure 13: Trust Loans, Entrusted Loans (New Increased, Quarterly) (RMB trn) Trust loans Entrusted loans Source: People's Bank of China, BTMU Source: People's Bank of China, BTMU. (2)Trust loans and entrusted loans by region By region, new entrusted loans have been extended across a number of regions in 213, while trust loans are used in the majority of regions (Table 3). Total new trust loan and entrusted loan increased (213, as a ratio of nominal GDP) has been particularly significant in Shanghai municipality, Qinghai Province, Yunnan Province, Beijing municipality, and Guizhou Province. Shanghai, Heilongjiang Province, and Yunnan Province also have high shares of trust loans and entrusted loans combined compared to bank loans. 1

11 Table 3: Entrusted Loan, Trust Loan New Increased by Local Government (213) 1 Bank loans 2 Entrusted loans, trust loans Entruste d loans Trust loans 2 % of nominal GDP 2 1 Entruste d loans Trust loans (RMB 1mn) % of nominal GDP 1 Beijing City 4,798 2,838 2, % 9% 17 Hubei Province 2,866 1, ,96 8% 6% 2 Shanghai City 3,444 3,667 1,884 1,783 19% 16% 18 Yunnan Province 1,9 1, ,17 1% 88% 3 Heilongjiang Province 1,18 1, ,12 1% 11% 19 Chongqing Province 2,4 1, % % 4 Shandong Province,23 2,264 1, % 4% 2 Guizhou Province 1, % 4% Hebei Province 3,47 1, % 4% 21 Qinghai Province % 9% 6 Shanxi Province 1, % 49% 22 Tibet Autonomous Region % 7 Tianjin Province 2,46 1, % 44% 23 Shaanxi Province 2, % 39% 8 Fujian Province 3,484 2,84 1,22 1,62 12% 74% 24 Sichuan Province 4,12 2,142 1, % 2% 9 Jiangxi Province 1,987 1, % 6% 2 Hunan Province 2, % 22% 1 Henan Province 3, % 27% 26 Guangxi Autonomous Region 1, % 31% 11 Anhui Province 2,876 1, % 4% 27 Guangdong Province 8,16 2,846 1, % 33% 12 Jiangsu Province 7,143 2,383 1, % 33% 28 Gansu Province 1, % 16% 13 Inner Mongolian Autonomous Region 1, % 39% 29 Hainan Province % 17% 14 Liaoning Province 3, % 22% 3 Xinjiang Autonomous Region 1, % 1% 1 Zhejiang Province,793 2,89 1, % 36% 31 Ningxia Autonomous Region % 12% 16 Jilin Province 1, % 22% Total 87,394 4,3 23,7 16,73 Note: 2 % of nominal GDP - shaded figures indicate 1% bigger shaded figures indicate % bigger. Source: People's Bank of China, BTMU. 1 Bank loans 2 Entrusted loans, trust loans 4. Trust and local government debt Local government infrastructure projects are major investments for trust. Of the RMB17.9 trillion of debt held by local governments (most recent figure as of end-june 213, including RMB1.9 trillion of direct debt, RMB2.7 trillion of guaranteed debt, and RMB4.3 trillion of contingent debt), trust loans comprised 8%, or RMB1.4 trillion (Figure 14). Trust also invest in bonds, which comprised 1% of the total. As noted above, trust loans totaled RMB4.12 trillion as of end-june 213 according to data on total social financing, and approximately 34% of all trust loans are extended to local governments. However, most of the trust loans extended to local governments appear to be categorized as infrastructure-related, though the classification of the China Trustee Association data is unclear. Figure 14: Trust Assets and Local Government Debt Trust loans (RMB.1 trn) <Asset side> Trust assets (RMB1.9 trn) Infrastructure related (RMB 2.6 trn) <Liability side> Local government debt (RMB 17.9 trn) Guara Contin Direct nteed gent debt debt debt Total Weight Bank loans % BT (build, transfer) method % bonds % Entrusted loans % Other % Total % Note:Asset side figure as of end-213. Liability side as of end-june 213. Source: China Trustees Association, BTMU.. Repayment difficulty involving wealth management and trust Two cases of repayment difficulty among trust, in late January and mid-february, have been the focus of considerable attention recently. Even before this, a number of wealth 11

12 management and trust had been on the brink of default (Table 4). The China Trustee Association announced on February 13 that various issues had arisen upon maturation with approximately RMB2 billion (.27%) of trust in 212. This section reviews details regarding the two major cases that arose earlier this year and coal industry. Issuance date 1 Nov 212 Type Wealth management Structuring financial institution Zhongding Wealth Management Center Selling financial institution Investment Background Hua Xia Bank Shanghai Branch 2 Dec 212 Trust CITIC Trust - 3 Dec Jul 213 Summer 213 Table 4: Past Repayment Difficulties with Wealth Management Products, Trust Products (partial list) Wealth management Wealth management Trust Northeastern Securities - Shaanxi Province International Trust 6 Jan 214 Trust China Credit Trust China Construction Bank Jilin Branch Jiangsu Province investment company - Industrial and Commercial Bank of China 7 Feb 214 Trust Jilin Province Trust China Construction Bank Source: Various materials, BTMU. - Hubei Province private steel company - - Chemical company Shanxi Zhenfu Energy Group Shanxi Liansheng Energy Co. RMB14mn in principal and interest not paid. Principal returned in Jan 213. RMB1.33bn raised from investors, interest payments delayed. Local government also involved. Prices fell by 3%, customers sought redress from bank as a group RMB6mn raised from 4 investors, promising 18% annual return. Authorities arrested executives. Shaanxi Province International Trust took over payments of principal and interest Principal repaid after third-party instrument purchased - (1)Case 1: Repayment difficulty in 214 In late January 214, originated by major trust company China Credit Trust Company nearly defaulted on payments to investors on trust product Credit Equals Gold No. 1. The Industrial and Commercial Bank of China, which sold the instruments, had raised RMB3. billion from approximately 7 investors to invest in a privately-run mining company in Shandong province, Shanxi Zhenfu Energy Group Ltd. The Group failed in 212, and the owner was arrested on charges of illegally collecting deposits. According to press, the local government bore % of losses while the Industrial and Commercial Bank and originating trust company each bore 2%, in order to avert default. Right before the redemption date of January 31, an outside investor bought the instruments. The principal was repaid to investors but without interest. (2)Case 2: Repayment difficulty in 214 In mid-february, Jilin Province Trust Company (in Changchun City, Jilin Province) nearly defaulted on payments to investors on trust product Songhua River #77 Shanxi Opulent Blessing Project. China Construction Bank had sold the instruments, and the total issuance amount was RMB972.4 million. The trust had invested in a private mining company, Shanxi Liansheng Energy Co., in Jilin Province. Shanxi Liansheng Energy Co. had RMB3 billion of debt in 213 and has applied for restructuring of its debt. Details remain unclear, but the company has signed a strategic 12

13 restructuring proposal with the Shanxi government. A default appears to have thus been averted due to the involvement of the local government. (3)Current conditions in the coal industry Both these cases involved investments in coal companies. Chinese coal companies are currently facing tough business conditions. Chinese consumption of coal rose only +2.6% YoY in 213 because of the slowing economy and toughened rules on air pollution. Meanwhile, coal prices fell by 16% in 213 to the lowest level in four years. Coal companies are expected to continue to struggle because of 1) oversupply capacity within the coal industry, and 2) the shift to other energy sources from coal due to heightened awareness of air pollution. Redemptions of trust that invested in coal companies rose to 19 in 214 from just five in 213 (Bloomberg survey). The ability of the local governments of China s three big coal producing regions Inner Mongolia Autonomous Region, Shanxi Province, and Shaanxi Province to take on the debt of struggling coal companies has been the subject of focus. As of end-june 213, the government of Inner Mongolia held RMB44.2 billion of debt (equivalent to 27% of nominal GDP), while the Shanxi government held RMB417.9bn (32%), and the Shaanxi government RMB69.2bn (38%). 6. Default pressures for wealth management and trust This next section reviews the repayment schedules of trust, as well as wealth management and trust that may be unable to repay debt. The default pressures on wealth management and trust can thus be gauged. (1)Trust redemption schedules Based on data collected April 18 by research company Yanglee Trust, quarterly total scheduled repayments of trust rose from RMB88.6 billion in Jan-Mar to RMB17.2bn in Apr-Jun (Table ). Repayment and refinancing pressures grew significantly in Apr-Jun. By investment type, Apr-Jun redemptions for the infrastructure sector rose significantly from Jan-Mar. Real estate sector redemptions were expected to be on par with Jan-Mar, while industrial and commercial redemptions were projected to decline. Furthermore, issuances of infrastructure-related and industrial and commercial trusts were limited in Jan-Mar compared to 213 (Table 6). The data does not cover all trust, so all redemption schedules and issuance amounts cannot be compared. However, the weightings of investments and terms within the repayment scheduled amounts are similar to other survey results, so this data may likely be 13

14 used to illustrate overall trust trends. Table : Redemption Schedule, Trust Products (214) Cases Amount (RMB 1mn) Avg term (years) Avg annual return (%) Cases Amount (RMB 1mn) Avg term (years) Avg annual return (%) Overall Jan-Mar Overall Jan-Mar 1,243 2, Apr-Jun 629 1, Apr-Jun 1,448 2, Jul-Sept Jul-Sept 1,421 2, Oct-Dec Oct-Dec 1,784 3, Finance Jan-Mar Jan-Mar 1,76 2, Apr-Jun Finance Apr-Jun Jul-Sept Jul-Sept Oct-Dec Oct-Dec Real estate Jan-Mar Jan-Mar Apr-Jun Apr-Jun Jul-Sept Real estate Jul-Sept Oct-Dec Oct-Dec Infrastructure Jan-Mar Jan-Mar 296 1, Apr-Jun Apr-Jun 32 1, Jul-Sept Jan-Mar Oct-Dec Infrastructure Jan-Mar Commercial & Jan-Mar Apr-Jun industrial 213 Apr-Jun Jul-Sept Jul-Sept Oct-Dec Oct-Dec Jan-Mar Other Jan-Mar Commercial & Jan-Mar Apr-Jun industrial Apr-Jun Jul-Sept Jul-Sept Oct-Dec Oct-Dec Source: Use-trust.com, BTMU. 214 Jan-Mar Other Jan-Mar Apr-Jun Jul-Sept Oct-Dec Jan-Mar Source: Use-trust.com, BTMU. Table 6: Recent Trust Products Issuances ( ) (2)Wealth management, trust repayment capacity Information about investments for both wealth management and trust is inadequate, and pinpointing the exact scale of repayments that may be in doubt is difficult. Based on some assumptions including product scheme categories, the population of that may not be able to make repayments may be estimated considerable (Figure 1) (Note). (Note) The calculation was made as follows. A simple sum of wealth management and trust was not used, but rather the amount of bank-trust cooperation model (highly likely to overlap) was subtracted from the amount of wealth management. Publicly-released data on the balance of bank-sold wealth management was used for the amount of wealth management. However, the bank data is as of end-september 213. The number of trusts that include investments with a likelihood of default was estimated using not only bank-trust cooperation and government-trust cooperation models, but also collective trusts as a whole. Some of these may overlap. Further, based on the March 213 regulation prohibiting wealth management from investing more than 3% of funds in non-standardized assets, 3% of wealth management (after excluding bank-trust composites) were deemed to be likely facing difficulty with repayment. Although the rule was introduced in 212, the same ratio was used to make estimates for previous years. 14

15 Figure 1: Population of Wealth Management Products and Trust Products that Likely Include Products with Doubtful Repayment Capacity (RMB trn) (%) Other (left axis) Population likely to include with doubtful ability to repay (left axis) Population likely to include with doubtful ability to repay as a percentage of nominal GDP (right axis) Source: China Trustees Association, etc, BTMU Impact of large-scale defaults by wealth management and trust As noted above, the number of wealth management and trust with dubious repayment capacity may be considerable, and the possibility of large-scale defaults (in the Chinese economy) arising cannot be denied. We examined the possible effects on the financial markets and economy if default pressures, including from an economic slowdown, increase substantially. We first made a comparison with US subprime in drawing up our scenarios. (1)Comparison with US subprime China s wealth management and trust are similar to US subprime in several ways: 1) liquidity risk is likely to arise due to the big mismatches in financial management terms and the frequency of redeemed funds being refinanced; 2) investor difficulty in valuating backed assets; and 3) the heavy weighting given to real estate investments (Table 7). The differ in several ways: 1) by investor class; 2) wealth management and trust are not rated; and 3) there is no secondary market for wealth management and trust. Regarding the first difference, while institutional investors (including overseas) were the primary investors in subprime-related, mainly individuals (domestic Chinese) invest in wealth management and trust. Further, although not a comparison of the themselves, the US deposit protection system and bankruptcy resolution systems as well as government rescue capacity (the political system) are also big differences. 1

16 Products compared Table 7: China Wealth Management Products and Trust Products vs US Subprime Products China Wealth Management Products, Trust Products US Subprime Products (pre-financial crisis) Investor Individual investors Institutional investors (primarily US, European financial institutions) Seller Chinese commercial banks US financial institutions Guarantee Both guaranteed, non-guaranteed Non-guaranteed (priority/subordinate structure) Balance Investments (backed assets) Instrument design, issues Sum of wealth management and trust is RMB21 trn (37% of nominal GDP) Chinese corporate loans, local government loans Banks may structure in order to skirt regulations. High ratio of problem-ridden investments Big mismatches in short-term financing and longterm investment Inadequate disclosure of investments, etc. Complex product design Subprime home loans totaled USD1.3 trn (9% of nominal GDP); home mortgages overall total USD8.8 trn (63% of US nominal GDP). Both figures as of end-26. US home loans Risk transfer through securitization assumed, and moral hazard arises during structuring Risk analysis difficult due to complex securitization schemes, high leverage instruments also exist Backing home mortgages have soft underwriting standards because of assumption that home prices would rise Financial systems compared Other Monitoring body Even non-banks are under official oversight. However, inadequate oversight due to turf battles. Bankruptcy resolution system None Yes Deposit protection system None Yes New short-term liquidity facility established in 213, Central bank liquidity open market operations used regularly as major supply capacity policy tool Central bank risk Central bank is not autonomous, but part of central taking capacity government Government rescue capacity Source: Various materials, BTMU. Communist party is one-party system, and policies are very flexible and dexterous. No monitoring oversight of nonbanks FRB used emergency special items, supplying large amounts of liquidity, including to businesses Response uncertain if central bank experiences shortfall of assets if losses arise US is a democracy, and approval of Congress needed to establish TARP. Limited flexibility in actions, eg., failure to pass TARP. (2)Future scenarios We classified scenarios involving large-scale default pressures for wealth management and trust, such as a sudden worsening of the economy, by the major loss-bearing bodies (Table 8). The major loss bearers would likely be 1) investors; 2) structuring and selling financial institutions; and 3) the central and local governments. Financial institution losses would be borne not by the structuring trust companies, but most likely by the seller banks. This is because, since trust principal is not guaranteed, the trust companies do not have sufficient scope (capital) to take on the losses. Trust companies have net assets of RMB2. billion. Of this, RMB9.6 billion is indemnity reserves (provisions), RMB111.7 billion is paid-in capital, and RMB84.9 billion is retained profits. Net assets are approximately 2.3% of trust assets. 16

17 Scenario A Scenario B Scenario C Source: BTMU. Bearer of losses Structuring/sel ling financing institution (to limit default) (Individual) investors Central/local government (to limit default) Table 8: Scenarios Under Various Increased Default Pressures Envisioned risks Financial crisislike conditions erupt domestically Credit suddenly contracts, demonstrations stoke social unrest Fiscal austerity weighs on the economy, moral hazard fomenting issues are delayed and expand Outline 1 Financial institutions bear huge losses and increase deleveraging 2 Inadequate disclosure and complex instruments cause counterparty risk to rise and financial markets to freeze 3 With no deposit protection system, depositers start a run on banks 4 The economy plunges, with negative growth ensuing Capital regulations could limit the financial crisis's spread overseas 1 Invidual investors rush to cancel wealth management product and trust contracts, and huge liquidity risk arises due to the big term mismatches of the 2 Financial institutions address liquidity risk through financing, but credit quickly shrinks overall, weighing on the economy 3 Individual investors who had believed their investments were guaranteed mount protests, and social unrest intensifies 4 Because of the many investors making investments limited to cash on hand, selling pressures of held assets is limited and big-ticket spending is limited. 1 Central and local government fiscal conditions worsen because of the losses, and austerity measures weigh on the economy 2 Government holdings of US Treasuries and other overseas assets could be sold off 3 Wealth management and trust could become more popular, fomenting moral hazard. Degree of adverse impact on economy Under Scenario A, in which the structuring and selling financial institutions bear losses after default pressures surge, there is the risk of a domestic financial crisis breaking out. As inadequate information disclosure and complex instrument attributes trigger a rise in financial institution counterparty risk, the lack of safeguards, including a deposit protection system, would be aggravated. On the other hand, capital regulations could limit an overseas flow of funds, which often happens during a financial crisis. According to the People s Bank of China, total bank lending stood at RMB71.9 trillion as of end-213. Of this, RMB.2 trillion was loans to companies. According to the China Banking Regulatory Commission, the non-performing loan rate (to companies) at commercial banks stood at 1.%, or RMB92.1 billion (Table 9, Figure 16). If the number of wealth management and trust in danger of failure to repay (estimated above) is extrapolated to all commercial bank NPLs (to companies), the NPL rate would surge from 1.% to more than 1%. 17

18 Total amount (RMB 1mn) Figure 9: Commercial Bank NPLs, Ratios Jun 213 Sept 213 Dec 213 Commercial banks, all 4,336 4,279 4,929,39,636,921 SOCBs 3,12 2,996 3,9 3,24 3,36 3, JSCBs ,26 1,91 City commercial banks Rural commercial banks (%) Figure 16: Commercial Bank NPL Ratio Four major commercial banks All commercial banks Foreign banks Commercial banks, all SOCBs JSCBs City commercial banks Rural commercial banks Foreign banks Note: Figures in shaded boxes are increase/decrease from end of previous quarter. Source: China Banking Regulatory Commission,BTMU. Ratio (%) Note: Classification method of loan obligations changed from 22 (from four Chinese categories to five international standard categories). Source: China Banking Regulatory Commission, BTMU. Under Scenario B, in which losses are borne by individual investors after large-scale defaults, not only would a credit squeeze weigh on the economy, there would be a risk of social unrest increasing further. If wealth management and trust default on a large scale, consumption would be cut back. However, deleveraging of other assets would probably be limited, because investors have been limiting investment outlays to funds on hand rather than borrowing in order to invest. Chinese bank loans to individuals stood at 4% of nominal GDP at end-213 (assuming the same level of household debt). The ratio to nominal GDP is rising every year, but still remains low compared to other countries (Figure 17, 18). 3 Figure 17: Bank Loans to Individuals (RMB trn) (%) Home mortgages (left axis) 6 12 Figure 18: Household Debt, by Major Country (212) (% of nominal GDP) 2 Consumer loans (left axis) 1 2 (Home mortgages + Consumer loans) as percentage of Nominal GDP (right axis) Source: People's Bank of China, BTMU. China Japan South Korea US Australia Note: China is bank debt only. Source: IMF, BIS, BTMU. Under Scenario C, in which the central and local governments bear losses, the losses and fiscal austerity would weigh on the economy. However, the short-term adverse impacts on the economy would likely be slight relatively. Issues fomenting moral hazard would occur. The probability of this scenario would likely be high if default pressures intensify. Under Scenario C, the Chinese Government would likely sell off its US Treasury holdings and other overseas 18

19 assets, which would roil international financial markets. Such developments would have to be watched carefully. Supplement: Corporate bond market trends Shanghai Chaori Solar Energy Science & Technology Company bonds (rated CCC), issued March 7, 212, defaulted in March. The five-year bonds had a coupon of 8.98% and the issuance amount was RMB1 billion. Corporate bonds outstanding in China reached RMB9 trillion as of end-213 (Figure 19). By sector, most bonds were issued by construction, public interest, metals and mining, and oil and gas companies (Figure 2) Figure 19: Corporate Bond Outstanding (RMB trn) (%) Corporate bonds outstanding (left axis) YoY (right axis) Figure 2: Corporate Bond Issuance, by Industry (as of end-september 213) (RMB trn) Construction Public interest Metals & mining Petroleum & gas Real estate Machinery Insurance Coal Transport Chemicals Other Source: People's Bank of China, BTMU. Source: Reuters, BTMU. Hiroshi Kurihara (hiroshi_2_kurihara@mufg.jp) Economic Research Office, The Bank of Tokyo-Mitsubishi UFJ, Ltd , Marunouchi, Chiyoda-ku, Tokyo , Japan This report is intended for information purposes only and shall not be construed as solicitation to take any action such as purchasing/selling/investing financial market. In taking any action, each reader is requested to act on the basis of his or her own judgment. This report is based on information believed to be reliable, but we do not guarantee its accuracy. The contents of the report may be revised without advance notice. Also, this report is a literary work protected by the copyright act. No part of this report may be reproduced in any form without express statement of its source. This report is also available for viewing online. 19