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[BEIJING] China's clampdown on borrowing for purchases of the world's most-volatile equities has missed shadow-banking activities that allow investors to take even greater risks.
Investors have ramped up bets on rallying shares by borrowing through structures known as "umbrella trusts," which allow for more leverage than brokerage financing. Goldman Sachs Group Inc estimated up to 500 billion yuan (US$80 billion) has entered stocks through wealth-management products. Use Trust data show 43.1 billion yuan of securities investment trusts were set up last quarter, 92 per cent up from a year ago.
"Umbrella trusts definitely need regulation, but I'm not sure how it can be done practically," said Ivan Shi, a Shanghai-based senior manager at investment consulting firm Z- Ben Advisors Ltd. "Trust operations are very flexible, so it's easier for them to dodge regulations." The higher leverage allowed by the products exposes individuals to larger losses in the event of stock-market drops, which can be exaggerated as investors scramble to repay debt during a selloff. The Shanghai Composite Index tumbled the most in six years on Jan. 19 after regulators punished brokerages for irregular lending and forbade banks from lending to companies that borrow to invest in equities. The benchmark has since recouped most of the losses as the value of shares purchased with borrowed cash rebounded to an all-time high.
The Shanghai composite has gained 41 per cent in the past three months, even as data showed the economy grew at its slowest pace since 1990 last year. Companies with equity listed in both China and Hong Kong are 29 per cent more expensive on the mainland, the Hang Seng China AH Premium Index shows.
In umbrella trusts, private investors take up the junior tranche, while cash from trusts and banks' wealth-management products form the senior tranches. The latter receive fixed returns while the former take the rest, so private investors are effectively borrowing from trusts and banks.
The funding cost in these structures are about 8 to 11 per cent, according to Goldman. The maximum leverage ratio is three to one, compared with two to one for brokerage margin lending. China Everbright Bank Co will lower its ratio for umbrella trusts to 2.5 to one from next week, the Securities Times reported yesterday.
China is trying to control credit expansion while protecting an economy that expanded 7.4 per cent last year, the least in 24 years. Moody's Investors Service said in a Jan 22 report that shadow-banking assets reached 45 trillion yuan at the end of 2014, rising to 71 per cent of GDP from 66 percent, with stock market financing accelerating in the second half. It said that banks had been indirectly financing margin loans of securities firms through short-term purchases of the credit.
"Besides the rapid growth of such financing, risks arise from the potential to generate stock-market volatility and from pressure on bank asset quality," the report said. "However, margin financing is subject to prudential limits, and still represents a small portion of funds raised from banks' WMPs." The amount invested in wealth-management products surged 24 percent in the first half of 2014 to 12.7 trillion yuan. WMPs are issued by banks to lure cash from investors at rates above the legal maximum of 3.3 per cent in order to facilitate off- balance-sheet lending.
In times of crises, banks have stepped in to bail out such products, fueling speculation they enjoy an unspoken guarantee. While sellers are no longer allowed to promise returns, many buyers still consider the advertised expected return a sure thing, according to Z-Ben Advisors' Shi.
Citic Securities Co, Haitong Securities Co and Guotai Junan Securities Co were banned for three months from adding securities lending accounts following rule violations, the China Securities Regulatory Commission said Jan 16. The China Banking Regulatory Commission banned banks from lending to companies that borrow to invest in equities, bonds and derivatives. So- called entrusted loans extended by banks increased to a record 458 billion yuan in December.
Entrusted loans, insurance policies and other form of lending became a major source of funds for umbrella trusts, according to Deutsche Bank AG analyst Yuliang Chang. The CBRC wasn't immediately available for comment when reached by phone.
The outstanding balance of margin debt on the Shanghai Stock Exchange climbed to a record 771.4 billion yuan (US$123 billion) this week, up from about 751 billion yuan on Jan 20.
Like margin financing, leveraged structures also amplify losses in a plunging market as they often come with stop-loss agreements. A gauge of 30-day volatility on the Shanghai Composite rose to 42.3 on Jan 19, the highest among the 15 biggest global benchmark indexes tracked by Bloomberg and up from a decade-low of 9.4 in July.
"When the stock market falls, many of the margin-trading accounts and much of the leverage will be blown up," said Hao Hong, a strategist at Bocom International Holdings Co in Hong Kong. "They'll be forced to pay and to liquidate their accounts."
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