In the third season of the British TV drama Downton Abbey, the Earl of Grantham loses the bulk of his wife’s fortune investing in a bankrupt Canadian railway. In desperation he suggests to his family that he might be able to recoup the losses by putting the remaining funds into a scheme operated by Charles Ponzi. He notes that the American has been delivering fantastic returns.
Ponzi, of course, wasn’t really a great investment manager. Instead he created a huge pyramid scheme using cash from gullible new investors (like Grantham) to pay out earlier ones.
As long as new money kept being pumped in, business flourished. But when the money stopped, Ponzi’s scheme collapsed spectacularly, leaving only its name for financial posterity.
So it raised eyebrows late last year when one of China’s most senior bankers referred to the country’s wealth management products as “fundamentally a Ponzi scheme” (see WiC172).
These products offer investors (both individuals and corporates) the chance to earn returns far in excess of standard bank deposit rates, although the underlying assets generating these outsize earnings are often unclear. Many of the product names – Golden Elephant No.38, for instance – give little indication of the investment strategy.
The man who raised the ‘Ponzi’ red flag in November – the head of Bank of China, Xiao Gang – is evidently concerned by the rapid growth of this asset class. According to the Financial Times around $2.5 trillion of wealth management products have been issued in the last couple of years. Now the fear is that much of the funds have been sunk into risky or dud projects for which there will be no payback.
Another worry: a large proportion of wealth management products have been issued by China’s trust companies (see WiC98), another hard-to-fathom patch of China’s financial ecosystem. They have grown in importance in recent times (often filling the void where banks have been instructed not to lend). But analysts worry that the trust firms (and their wealth management products) could provide an explosive element to China’s financial landscape – much as toxic CDOs made the American system vulnerable.
Perhaps it also explains why there was such a hoopla when the boss of a solar panel firm seemed to skip the country in late December. In what has the potential to become an embarrassing scandal, several trust companies have been identified in the Chinese press as being heavily exposed to the troubled firm and its owner.
According to 21CN Business Herald, news broke on December 27 that the chairman of Chaori Solar and his daughter had left China. Trading in the Shenzhen-listed stock had been suspended just over a week earlier. In the ensuing days speculation had grown about the viability of the solar panel maker, with its stock already down 65% on its listing price. Of course, investor nerves are fraying in respect to China’s solar sector as a whole. As reported in WiC169, a senior Chinese policymaker has described the industry as “a patient on life support” due to reduced global demand for solar panels and a glut of local supply. So the media coverage on Chaori tended to suspect the worst. As 2012 came to a close, 21CN and other newspapers were reporting that Chaori’s chairman and majority owner Ni Kailu had deserted the company and fled overseas with Rmb2 billion.
On December 29 the company then issued a statement claiming that Ni had resigned as general manager, but had travelled abroad collecting receivables owed in Europe and the US. The Shanghai Securities News reported that Chaori had Rmb380 million in bank borrowings overdue, and was in payment dispute with various suppliers. The company admitted that it had shut down its production lines in Jiujiang and Luoyang, and only two lines were operating at ‘normal’ capacity at its headquarters in Shanghai. But Chaori said it was also talking to Shanghai’s local government about receiving financial support.
National Business Daily then painted a bleak picture of the firm’s financials. Since 2011 Chaori’s receivables had increasingly turned into a “black hole,” it claimed. At Rmb3.34 billion ($537 million) they now exceed the company’s net assets, and had more than tripled over the past three years. The newspaper noted that although 85% of the outstanding invoices were owed by foreign firms, the bulk of these entities were controlled by Chinese individuals, making the situation even more opaque. It also questioned Chaori’s “incredible generosity” in continuing to offer credit to these customers in spite of their poor track record in paying for the solar panels they had received.
Chaori’s survival as a going concern now looks to depend on the recovery of these receivables from customers – or perhaps on some some form of local government bailout plan.
So what’s the connection to the trust companies?
Chaori is much less well known than some of the other Chinese solar firms, like Suntech. But what makes it significant is the financial exposure it has created for some of the country’s bigger trust firms.
Trusts occupy a unique position in China’s financial system and the scope of their activities can be hard to define fully. Unlike banks, trusts are not deposit-takers but in recent years they have been able to grow their financing capacity by attracting funds through wealth management products. They then lend this capital out, often in areas where the conventional banks fear to tread. By definition it’s riskier lending, and offers a higher return.
The area where the trusts have got into particular trouble with Chaori relates to the major shareholders. Specifically they have been making loans to Ni and his daughter, with their Chaori stock serving as collateral for the lending.
The Ni family owns just under 44% of Chaori, an amount worth Rmb9.07 billion when the company listed in November 2010. However, the Ni stock isn’t tradable under an IPO lock-up that lasts until later this year. But Ni wanted personal funds to invest in other areas, so he approached the trust companies. Beginning in February 2011, his daughter pledged 0.68% of her equity to Guoyuan Trust, reports 21CN. At this point the stock was worth Rmb47.44 per share (after its suspension in late December it was trading at Rmb5.11), and she was loaned Rmb34 million. In what the newspaper terms a “capital juggle” a series of larger transactions followed with Union Trust, Minmetal Trust, Suzhou Trust, Xiamen International Trust and Industrial International Trust.
But in terms of the scale and number of pledges, two trusts stand out: Zhongrong Trust and Shangdong International Trust. Just over half of Ni’s equity stake was converted into loans by these two institutions, with the latter undertaking a transaction as recently as November, only a few weeks before the stock was suspended.
21CN reckons the capital chain was already showing signs of fraying last year as Ni borrowed from one trust to repay stock-pledged loans coming due from another (the loans were typically for a one-year duration, carrying a 10% interest rate).
But lender disquiet worsened late last month when the trusts saw their own collateral on the loans – the stock – suspended, and started asking questions about where their debtor had disappeared to. Suddenly it looked like the pair were exposed to Ni for Rmb760 million, almost all of which could go bad (given Chaori’s finances).
What’s the latest?
On January 3, Ni returned to China and the Shanghai Morning Post reported that he was “required” to participate in a meeting with the Shanghai Securities Regulatory Bureau the next day, as well as the Shanghai Banking Regulatory Bureau and the Finance Office of Shanghai.
Ni later spoke to a journalist from Century Weekly, saying that his trip abroad was mainly for loan arrangements and negotiations with power plants. He admitted that local banks had called in their loans and that a dispute over Rmb90 million owed to suppliers was ongoing.
When asked about his pledges of stock to trust companies, he replied: “It is for the development of other projects and I hope they benefit the company’s future.”
Sounding upbeat, Ni then hinted at asset sales by month end.
Meanwhile, for the trust companies, his return is a welcome one but it still leaves many questions unanswered. For example, Ni made no mention of whether he had been able to recoup Chaori’s receivables, an announcement that might open the way for the stock to trade again. Likewise, the issue of repaying the trust loans remains unaddressed.
Could Ni’s bad debts crush the trusts?
No, in themselves the amounts are not debilitating. But they have triggered broader worries about the none-too-transparent activities of many of the trusts, including whether the Chaori situation is indicative of a wider culture of lax lending and mounting bad debt across their portfolios.
Another fast-growing fear is the trusts’ exposure to real estate. When banks started being told by the central government to reduce lending to property developers in 2011, the trusts were often the default financiers that stepped into the breach. With some of those developers facing a sales crunch, much of that now appears to have been high-risk lending. In other cases the trusts purchased real estate assets to develop themselves.
Once again, Zhongrong Trust is in the frame here. As Investor Journal points out, it has enjoyed stunning growth in recent years. In 2008 its assets under management – i.e. assets purchased with funds raised from wealth management products – stood at Rmb70.8 billion but by the end of 2011 the total had soared to Rmb178.3 billion. Zhongrong has been the most “vigorous” of the trusts in targeting the real estate market, the Investor Journal suggests, with property as is its largest asset class.
So Zhongrong’s problems in Qingdao are now garnering attention. In an attempt to raise funds, it tried to auction off 96 units last month in the upscale Qingdao Hyatt apartment complex (only six were eventually sold by the auctioneer). The investment evidently hasn’t gone well but in an effort to maintain confidence in its wealth management products, the trust allowed investors to cash out of the Qingdao structure without a loss. In short, Zhongrong is warehousing the losses. Investor Journal calculates that Zhongrong terminated 12 other wealth management products in the second half of last year, also allowing investors to get out without a financial hit.
The spotlight is on Zhongrong, which also happens to be one of the better-connected players. One of its key shareholders is Jingwei Textile Machinery, a Beijing-based state-owned enterprise. Its background leads some to think it will probably enjoy some measure of government assistance should further trouble emerge. If the current news flow is any guide, it looks to be the trust with the most delicate asset situation. The worry for its management: will the negative publicity stifle its ability to sell fresh wealth management products and raise cash?
The weakest link?
The Chinese media has been getting rather excited about the trusts. It’s important to grasp why.
Bank lending fell last year. However, the central bank reports that ‘total social financing’ rose. It reached around Rmb15.4 trillion, says HSBC, with bank loans making up about 55% of this total. The rest came partly from equity finance, but mostly from corporate bonds, and trust lending.
WiC suspects – along with swathes of the Chinese press – that the trusts and their wealth management products have now intertwined to become the weakest link in the Chinese financial system. In recent weeks it’s become clearer that these obscure institutions have waded into some wayward financial positions – with Zhongrong seemingly at the vanguard. The question now is whether this might lead to a broader crisis. On balance that may still be a way off. As long as the economy expands at close to 8% a year and property prices maintain their recovery, the trusts may be able to ‘grow’ out of their bad assets. But if one of the major players collapses, the dynamic may be much more explosive. As Charles Ponzi well understood, confidence is everything.
The broader concern for international fund managers and economists: if a wave of NPLs hits the trust industry, will there by a subsequent impact for the banking sector too? After all, the relationship between the trusts and the local branches of the big banks remains one of the murkier nodes of the Chinese financial system.
This worries the regulator too. On Thursday Capital Week and 21CN reported that the big four state banks have now ceased selling trust company products to their clients in Beijing. They are also scaling back sales in Guangzhou. This may indicate that the official clampdown on the trusts might already have begun.
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