March 13, 2014 12:00 am JST

Out from the shadows

MASAHIRO OKOSHI and NORIYUKI DOI, Nikkei staff writers

BEIJING -- China is embarking on another set of interest rate reforms that the government hopes will clear the fog rising from loosely regulated wealth management products, including trust funds, and rein in shady lending practices.

     Zhou Xiaochuan, governor of the People's Bank of China, the central bank, said March 11 that the monetary authority intends to allow banks to set their own interest rates on deposits. The liberalization will likely happen within one or two years, Zhou said, calling it his "personal view."

     Last July, regulators removed minimum interest rate requirements on loans. Restrictions on the interest rates banks can offer depositors are a key bit of unfinished business in the government's financial system reforms.

     Interest rates on deposits are currently capped at 1.1 times over the benchmark set by the central bank. The maximum rate for one-year term deposits, for example, is 3.3% a year. On the other hand, high-yielding financial products that play a central role in the shadow banking system often pay more than 6% in about just 3 months.

     Zhou said new financial services are bolstering the interest-rate liberalization effort. He hinted that by removing the cap on deposit rates, the central bank can remove distortions in capital flows in China.

Solid ground or quicksand?

The money that finds its way into high-yielding instruments is typically channeled into real estate, and regulators have only a vague sense of what is going on. In a recent interview, Li Lihui, a former president of state-owned Bank of China, estimated the size of the shadow banking system at about 20 trillion yuan ($3.26 trillion).

    Wealth management products, the epicenter of China's recent financial tremors, are not all handled by entities in the shadow banking system. Commercial banks, which are supervised by the financial authorities, also deal in these products. 

     The focus of concern is so-called trust products, which are a favored instrument of the shadow banking system, along with wealth management funds. Trust assets in China came to a record 10.9 trillion yuan by the end of 2013. These trusts gather money from investors and lend it out for capital-intensive projects or other sectors to which banks hesitate to lend.

     According to the China Trustee Association, a quarter of these trust assets have gone to infrastructure projects, while 10% are in real estate. Investment and loans to the industrial and commercial sectors, 28% of all trust assets, are also believed to include lending to real estate-related businesses.

     A series of defaults on these products has led to growing concern among investors and regulators alike. A trust company in Jilin Province nearly defaulted twice in the past two months. Its wealth management product, which promised annual yields of more than 9%, pulled in about 1 billion yuan in cash. But it missed the fifth principal payment deadline, set for the end of February. The previous month, the company just managed to avoid defaulting on another wealth management product. The money it collected went to coal mining operations in Shanxi Province that turned out not to be profitable.

Buyer beware     

After the eruption of the 2008 global financial crisis, the Chinese government pumped in 4 trillion yuan to stimulate the economy. That looked like a green light for the coal industry as coal prices were spiking at the time. Businesses and retail investors flocked to wealth management products, which placed big bets on companies or ventures through shadow banking transactions conducted without regulatory oversight.

     "Some of the products have problems," said Li Lihui, now a member of the Financial and Economic Affairs Committee of the National People's Congress. Asked about Jiling Province Trust's Songhua River No. 77, a trust product said to have failed to repay investors, Li said it should be allowed to default if the investment and loan prove difficult to restructure. He added risk management is possible for wealth management products as a whole, playing down the dangers of a broader meltdown.

     The market, however, is reacting to fears of tightening of credit.

     The Shanghai Stock Exchange Composite Index on March 10 fell below 2,000 for the first time since Jan. 20. Concern is growing over the state of the economy, including the potential for significant defaults in trust products and corporate bonds. The next day, the benchmark copper price on the London Metal Exchange, hovering around nine-month lows, fell to about $6,690 a ton during off-hour trading, down 7% from a recent peak in late February.