China default chain reaction threatens products worth 35% of GDP

[BEIJING] The risk of a default chain reaction is looming over the US$3.6 trillion market for wealth management products in China.

WMPs, which traditionally funneled money from Chinese individuals into assets from corporate bonds to stocks and derivatives, are now increasingly investing in each other. Such holdings may have swelled to as much as 2.6 trillion yuan (S$545.4 billion) last year, based on estimates from Autonomous Research this month.

The trend has China watchers worried. For starters, it means that bad investments by one WMP could infect others, causing a loss of confidence in products that play an important role in bank funding. It also suggests WMPs are struggling to find enough good assets to meet their return targets.

In the event of widespread losses, cross-ownership will create more uncertainty over who's vulnerable - a key source of panic in 2008 when soured US mortgage securities triggered a global financial crisis.

Those concerns have become more pressing this year after at least 10 Chinese companies defaulted on onshore bonds, the Shanghai Composite Index sank 20 per cent and China's economy showed few signs of recovery from the weakest expansion in a quarter century.

"There's abundant liquidity in the financial system, but a scarcity of high-yielding assets to invest in," said Harrison Hu, the chief Greater China economist at Royal Bank of Scotland Plc in Singapore.

"All the risks are accumulating in an overcrowded financial system."

Issuance of WMPs, which are sold by banks but often reside off their balance sheets, exploded over the past three years as lenders competed for funds and fees while savers sought returns above those offered on deposits.

The products, which offer varying levels of explicit guarantees, are regarded by many as having the implicit backing of banks or local governments.

The outstanding value of WMPs rose to 23.5 trillion yuan, or 35 per cent of China's gross domestic product, at the end of 2015 from 7.1 trillion yuan three years earlier, according to China Central Depository & Clearing Co.

An average 3,500 WMPs were issued every week last year, with some mid-tier banks, such as China Merchants Bank Co and China Everbright Bank Co, especially dependent on the products for funding.

Interbank holdings of WMPs swelled to 3 trillion yuan as of December from 496 billion yuan a year earlier, according to figures released by the clearing agency last month.

As much as 85 per cent of those products may have been bought by other WMPs, according to Autonomous Research, which based its estimate on lenders' public disclosures and data on interbank transactions. The firm speculates that in some cases the products are being "churned" to generate fees for banks.

"We're starting to see layers of liabilities built upon the same underlying assets, much like we did with subprime asset-backed securities, collateralised debt obligations, and CDOs-squared in the US," Charlene Chu, a partner at Autonomous who rose to prominence in her former role at Fitch Ratings by warning of the risks of bad debt in China, said in an interview on May 17.

Most WMPs have a duration of less than six months and some can be as short as one month. A search of 1,300 products listed on the website of government-run Chinawealth.com.cn showed the highest annual yield on offer was 8 per cent, compared with a one-year deposit rate of 1.5 per cent. Typical yields range from 3 to 5 per cent.

"WMP investments between banks are dangerous," said Andrew Collier, managing director at Orient Capital Research on Bloomberg TV Monday. "Where they are going in the fundamental economy is dangerous, and there are other investment products that are also dangerous."

While individual products don't disclose their underlying assets, bonds represent the largest exposure for WMPs as a whole, clearing agency data show. WMPs are now the biggest investors in Chinese corporate debt, according to China International Capital Corp. That market suffered its biggest losses in 16 months in April after a wave of defaults at state-owned enterprises spooked investors.

"My concern is that bond defaults might trigger some losses that will lead to WMP impairments or WMP investors being unwilling or unable to roll over the funding, which then leads the bank to take some of these assets back onto the balance sheet," said Matthew Phan, credit analyst at CreditSights in Singapore.

"If this happens in a large scale, it could cause some issues, given the mismatch between the duration of the WMPs and the bonds."

Some WMPs have already encountered trouble. Dozens of investors in a product sold through a former employee of Beijing-based Huaxia Bank Co protested in 2012 after losing money when the issuer, a private-equity firm, defaulted.

It was the first failure of such a product, and investors said they believed Huaxia was the distributor and affiliated with the issuer. The principal was repaid in full after regulators stepped in and a guarantee firm bought the assets. Seven months after that episode, Bank of Communications Co compensated investors for a WMP whose value had dropped 20 per cent in two years.

Still, a vast majority of WMPs have been profitable for both investors and the institutions who manage them. Chinese lenders earned 117 billion yuan from the products last year, according to the nation's clearing agency.

"The exposure as a proportion of banking system assets is relatively small and is more concentrated at the mid- and small-sized lenders," said Nicholas Yap, a credit analyst at Mitsubishi UFJ Securities HK Ltd in Hong Kong.

The industry's ability to meet its return targets thus far may overstate its stability. The most common source of funds for repayment of WMPs is the issuance of new WMPs, Fitch analysts Jack Yuan and Grace Wu wrote in March.

That leaves the products vulnerable to any sudden drop in demand, a risk alluded to in 2012 by Xiao Gang, then chairman of Bank of China Ltd, when he warned of "Ponzi scheme" dangers for the industry.

"The worst scenario will be if investors stop rolling over," said Ms Wu, who works for Fitch in Hong Kong. That "could cause a liquidity crunch for banks," she said.

BLOOMBERG