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 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 products and trust products, which have surged in popularity.

 Trust products have the following attributes vis-à-vis wealth management products: 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 products than for wealth management products

 Trust products redemption amounts rose in Apr-Jun, especially for infrastructure-related

products, and refinancing pressures are expected to increase.

 The population of wealth management products and trust products 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 products are similar to US subprime products 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 products 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.

VOL9, No.1 June 11, 2014

(Original Japanese version released on April 30, 2014

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

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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 products going forward.

Of financial instruments that have grown in popularity recently, wealth management products and trust products 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 products and trust products, then addresses the possible impacts of a significant increase in default pressures among wealth management products and trust products on the financial markets and economy.

1. Wealth management products and trust products and China’s financial system

Wealth management products and trust products, 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 products and trust products 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 products and trust products.

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 products and trust products, 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 products and trust products are the focus of attention.

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Source: BTMU.

Figure 1: China's Financial System

lenders Financing Investments, loans

Corporations

Wealth management products・ Trust products

・・・ Bank deposits Households Borrowers Financial Sector Corporations Households Bank loans ・・・ Trust loans Corporate bonds

Supplemented by social financing Supplemented by monetary supply

data (cash + deposits + savings)

・・・

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 2013,

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 45.2% of all social financing (Figure 2). The balance of total social financing stood at RMB102 trillion as of end-2013. (New financing data is available from 2002, so the aggregate amount could be determined.) Non-bank lending stood at RMB34.5 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-2013. 0 2 4 6 8 10 12 14 16 18 20 22 24 26 2002 2004 2006 2008 2010 2012 0 5 10 15 20 25 30 35 40 45 50 55 60 65

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 2: Total Social Financing (new increased)

(RMB trn) (%) 0 10 20 30 40 50 60 70 80 90 100 110 120 2002 2004 2006 2008 2010 2012 0 5 10 15 20 25 30 35 40 45 50 55 60

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)

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2. Overview and current status of wealth management products and trust products

(1)Overview and current status of wealth management products

Wealth management products are asset management instruments intended for primarily individuals, and they are structured and sold by banks. (Companies may also buy these products.) Issuance terms are short, usually one to three months. Many products 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 2012.

There are two types of wealth management products, guaranteed principal and non-guaranteed principal products. Guaranteed principal products are included on bank balance sheets, while non-guaranteed principal products are not. Non-guaranteed principal products have been increasingly popular recently. There have been many reports of individual investors buying non-guaranteed principal products, mistakenly believing the principal to be guaranteed, apparently due to inadequate explanations offered at the time of purchase.

Wealth management products 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 products.

“Trust loan oriented type” are also called “bank-trust cooperation model”. Banks sell

these products and invest the funds to trust products. 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 2010 and 2011. 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 products, and SME lending (Figure 4). Further, “balanced type” do

not manage assets by each wealth management products, 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.

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Figure 4: Balanced (Portfolio) Wealth Management Product Framework

Source: Federal Reserve Bank of San Francisco, BTMU.

Asset pool

・・・・・・ Wealth management products

sold by banks

Wealth management product (1) Wealth management product(2)

Wealth management product(N)

Fund pool

Bonds Short-term financial instruments (repos, calls,

etc.) Private equity funds

Trust products

Real estate loans

Local government financial vehicle (LGFV)

Wealth management instruments may offer yields of approximately 5%. Deposit interest rates are regulated in China and because real interest rates remain low, demand for high-yields

products is strong. China’s central bank sets the deposit base interest rate, and the maximum

deposit interest rate is 110% 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 2013, the real maximum deposit interest rate is a low 0.7%.

Because of this, wealth management products are growing in popularity as bank deposits increase at a slower pace (Figure 5). Wealth management products sold by banks (which comprise the bulk of such products) stood at RMB9.9 trillion as of end-September 2013 (17% of nominal GDP), according to official figures (Figure 6).

0 10 20 30 40 50 60 70 80 90 100 110 120 2000 2002 2004 2006 2008 2010 2012 2014 0 5 10 15 20 25 30

Bank deposits (left axis) YoY change (right axis)

Source: People's Bank of China, etc, BTMU.

Figure 5: Bank Deposits

(RMB trn) (%) 0 1 2 3 4 5 6 7 8 9 10 11 12 2010 2011 2012 2013 2014

Wealth management products (Bank sales)

Trust assets

(RMB trn)

Note: Wealth management products is total of China Banking Regulatory

    Commission and China Banking Associaition figures from end-December

    2012, 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.

Figure 6: Wealth Management Products (Bank Sales) and Trust Assets

(2)Overview and current status of trust products

Trust products are managed instruments developed by trust companies and sold by trust companies and banks. Many such products have a minimum investment requirement of RMB1 million, and the main investors are high-wealth individuals. (Institutional investors are

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also buyers.) As of end-2013, investors held RMB10.9 trillion of trust products (equivalent to 19% of nominal GDP, Figure 6).

As of end-2013, trust products invested mostly in loans, at 47%. This was followed by long-term bonds at 19%, long-term stocks at 9%, and short-term financial products at 9% (Figure 7).

Trust products invest mostly in the following sectors (as of end-2013): “commercial and

industrial”(28%), “infrastructure-related”(25%), “real estate”(10%), “securities”(10%),

“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.

0 5 10 15 20 25 30 35 40 45 50 55 60 Loans Short-term investments Long-term bond investments Long-term stock investments Other End-2010 End-2011 End-2012 End-2013

Source: China Trustees Association, BTMU.

Figure 7: Trust products Investment Methods (% of trust instruments overall)

0 5 10 15 20 25 30 35 40 Commercial and industrial Infrastructure related

Real estate Securities Financial institutions

Other

End-2010 End-2011

End-2012 End-2013

Source: China Trustees Association, BTMU.

Figure 8: Trust products Investments (% of total)

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 products that have nearly defaulted over the past few years have been collective trusts. Collective trusts comprised 25% of trust assets as of end-2013 (Figure 9). Though lower than the 28.7% ratio in Apr-Jun 2012, this is still high.

Let’s look at different types of trust products by more detailed categories, based on type of scheme. First, the share of bank-trust cooperation trust assets stood at 20% as of end-2013 (RMB2.2 trillion). Since 2010, the share has been declining (Figure 10). Further,

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government-trust cooperation products (trust products developed through collaboration between governments and trust companies) comprised 8.8% of trust assets (RMB960 million). Since 2010, the ratio has remained flat (Figure 10). Government-trust collaborative instruments appear to be primarily for local government infrastructure-related projects.

10 12 14 16 18 20 22 24 26 28 30 2010 2011 2012 2013

Source: China Trustees Association, BTMU.

Figure 9: Collective Trusts as Share of Trust Assets (%) 0 10 20 30 40 50 60 70 80 2010 2011 2012 2013 Bank-trust cooperative Government-trust cooperative

Figure 10: Bank-Trust and Government-Trust Cooperative as Share of Trust Assets (%)

Source: China Trustees Association, BTMU.

There are 65 trust companies that issue such trust products. China’s trust industry employs

approximately 10,000 persons, and each trust company has an average of nearly 200 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 products and bank wealth management products, 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.

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Figure 11: Trust Company Business Model

Note: LGFV is local government platform. SMEs is small and medium-sized enterprises. Source: Federal Reserve Bank of San Francisco, BTMU.

Deposit Purchase Purchase Purchase Invest Invest Entrusted loans Bank acceptances Loans, Bank acceptances, Letters of credit, etc. Entrusted loans Trust loans Indirect extension of credit Informal lending Bank depositors (individual investors) Qualified investors (high wealth) Institutional investors, state-owned enterprises, LGFV, Banks Banks Loans LGFV Real estate developers SMEs state-owned enterprises Households Real sector Trust assets Bank-issued wealth manageme nt products Trust products Stocks, loans, ETFs, PEs...

(3)Wealth management products and trust products compared

Wealth management products and trust products have been rising in tandem, both to nearly RMB10 trillion. Trust products 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 products appear to have greater potential default pressures than wealth management products.

Wealth management products Trust products

Major investors Individuals High-wealth investors, institutional

investors

Major sellers Banks Banks

Amount issued Approx RMB10 trn Approx RMB11 trn

Minimum investment Approx RMB30,000 - 50,000 Approx RMB1 mn

Avg issuance period Approx 1-3 months Approx 2 years

Avg yield Approx 5% Approx 7 - 10%

Investor guarantee

Both guaranteed, not guaranteed (However, even not guaranteed types

considered guaranteed by banks)

No

(However, considered to be in fact guaranteed by trust companies) Investment

Primarily bonds and short-term financial instruments

→ many low-risk investments

Primarily corporate loans

→Many high-risk investments

Source: Various materials, BTMU.

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4Tightened regulations on wealth management products and trust products

Chinese authorities have been strengthening rules regarding wealth management products and trust products since 2010 following the sudden surge in product popularity and with increased development and trading of problem-ridden instruments (Table 2). Rules covering

bank-trust collaborative products were strengthened in 2010 and against “fund pools” in

2013. An official notice about monitoring of the shadow banking system was circulated at end-2013, and regulations and oversight of trust products were strengthened on April 8. Although oversight remains inadequate, authorities are working to improve the soundness of wealth management instruments in particular.

Date Instrument Authority Details

6-Jul-09 Wealth managementproducts China Banking RegulatoryCommission Clarification of wealth management product investments (not including unlisted shares)

12-Aug-10 Wealth management, Trust

Products

China Banking Regulatory

Commission Tighter rules for bank-trust composites (must include on balance sheets within two years)

9-Sep-10 Trust Products China Banking Regulatory

Commission

Capital regulations for trust companies introduced (requiring minimum net capital holdings of RMB200 million or 40% of net assets, whichever is larger)

28-Aug-11 Wealth management

products

China Banking Regulatory

Commission Tighter sales regulations of wealth management products

Nov-11 Wealth managementproducts China Banking RegulatoryCommission Prohibition of issuance of wealth management products of less than 1 month for individuals

Dec-12 Wealth management, Trust

Products

China Banking Regulatory Commission

・Investments sold to banks subject to internal monitoring (incl wealth management products, trust products)

・Detailed lists of investment instruments structured by third parties and sold to banks must be submitted

11-Dec-12 Wealth management, TrustProducts China Banking RegulatoryCommission Committee of experts to be formed by banking industry executives in order to monitor wealthmanagement products

25-Mar-13 Wealth managementproducts China Banking RegulatoryCommission

・Banks prohibited from investing in unlisted shares (non-standardized obligation assets) exceeding 35% of funds raised from wealth management products or 4% of total assets as of end of previous year

・Prohibition of fund pooling

10-May-13 Wealth management

products

China Central Deposity & Clearing, Shanghai Clearing

House

Prohibition of fund calling between own accounts and wealth management product accounts

21-Aug-13 Trust Products People's Bank of China Including all financing from trust companies in credit databases

22-Nov-13 Wealth managementproducts Overseeing authorities Mandating reporting on wealth management products held by domestic banks (to bedisclosed through registration system of central deposit clearing agency) Feb-13 Wealth management, TrustProducts State Council Internal notice No. 107 regarding monitoring of shadow banking (strict monitoring byauthorities required for bank wealth management business and trust company business)

26-Dec-13 Wealth management

products

China Securities Depository and Clearing Company

Limited

Acquisition of preferred shares allowed by bank wealth management products

13-Feb-14 Wealth management

products People's Bank of China

Establishing separate accounts for each instrument when wealth management instruments invest in interbank lending market

8-Apr-14 Trust Products China Banking Regulatory

Commission

・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 products to authorities by 10 days before sale Source: Various materials, BTMU.

Table 2: Regulatory Developments with Wealth Management Products and Trust Products

3. Current status of trust loans and entrusted loans

This section reviews trust loans and entrusted loans, the biggest investment vehicles of trust products. Entrusted loans are loans among companies brokered by financial institutions, and some wealth management products and trust products invest in these products. They are thus

considered a trust method. Entrusted loans are not on financial institutions’ balance sheets

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1Shares of trust loans and entrusted loans within overall credit

As of end-2013, trust loans comprised 4.6% (RMB4.7 trillion) of total social financing (RMB102.3 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 RMB10.9 trillion, as of end-2013. This is consistent with the balance of trust loans outstanding.

Of the new financing raised in 2013, 10.6% of new total social financing was trust loans (RMB1.84 trillion), while 14.7% was entrusted loans (RMB2.55 trillion). New trust loans peaked in Jan-Mar 2013, then started to decline, while entrusted loans have continued to increase since Apr-Jun 2012 (Figure 13). The upward trend of entrusted loans is being watched carefully. 0 1 2 3 4 5 6 7 8 9 10 2008 2009 2010 2011 2012 2013 2014 Trust loans Entrusted loans (RMB trn)

Figure 12: Trust Loans, Entrusted Loans (outstanding)

Source: People's Bank of China, BTMU.

-0.2 0.0 0.2 0.4 0.6 0.8 1.0 2008 2009 2010 2011 2012 2013 2014 Trust loans Entrusted loans

Source: People's Bank of China, BTMU.

Figure 13: Trust Loans, Entrusted Loans (New Increased, Quarterly) (RMB trn)

2Trust loans and entrusted loans by region

By region, new entrusted loans have been extended across a number of regions in 2013, while trust loans are used in the majority of regions (Table 3). Total new trust loan and entrusted loan increased (2013, 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.

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(RMB 100mn) Entruste d loans Trust loans Entruste d loans Trust loans

1 Beijing City 4,798 2,838 2,552 286 15% 59% 17 Hubei Province 2,866 1,877 781 1,096 8% 65% 2 Shanghai City 3,444 3,667 1,884 1,783 19% 106% 18 Yunnan Province 1,955 1,721 564 1,157 15% 88% 3 Heilongjiang Province 1,518 1,527 407 1,120 10% 101% 19 Chongqing Province 2,405 1,311 845 466 10% 55% 4 Shandong Province 5,023 2,264 1,329 935 4% 45% 20 Guizhou Province 1,801 971 485 486 12% 54% 5 Hebei Province 3,047 1,656 813 843 6% 54% 21 Qinghai Province 646 378 86 292 18% 59% 6 Shanxi Province 1,811 879 711 168 7% 49% 22 Tibet Autonomous Region 412 336 21 315 82% 7 Tianjin Province 2,465 1,081 552 529 8% 44% 23 Shaanxi Province 2,405 945 677 268 6% 39% 8 Fujian Province 3,484 2,584 1,022 1,562 12% 74% 24 Sichuan Province 4,125 2,142 1,449 693 8% 52% 9 Jiangxi Province 1,987 1,300 383 917 9% 65% 25 Hunan Province 2,459 553 417 136 2% 22% 10 Henan Province 3,155 846 577 269 3% 27% 26 Guangxi Autonomous Region 1,725 543 543 0 4% 31% 11 Anhui Province 2,876 1,158 607 551 6% 40% 27 Guangdong Province 8,516 2,846 1,960 886 5% 33% 12 Jiangsu Province 7,143 2,383 1,901 482 4% 33% 28 Gansu Province 1,621 264 253 11 4% 16% 13 Inner Mongolian Autonomous Region 1,644 646 245 401 4% 39% 29 Hainan Province 752 131 131 0 4% 17% 14 Liaoning Province 3,419 766 815 ▲ 49 3% 22% 30 Xinjiang Autonomous Region 1,996 195 ▲ 152 347 2% 10% 15 Zhejiang Province 5,793 2,089 1,365 724 6% 36% 31 Ningxia Autonomous Region 574 67 67 0 3% 12% 16 Jilin Province 1,529 341 280 61 3% 22% 87,394 40,305 23,570 16,735

Table 3: Entrusted Loan, Trust Loan New Increased by Local Government (2013)

②÷① ②÷① ② % of nominal GDP ① Bank loans ① Bank loans ② Entrusted loans, trust loans

Note:②% of nominal GDP - shaded figures indicate 10% bigger. ②÷①- shaded figures indicate 50% bigger. Source: People's Bank of China, BTMU.

Total ② % of nominal GDP ② Entrusted loans, trust loans

4. Trust products and local government debt

Local government infrastructure projects are major investments for trust products. Of the RMB17.9 trillion of debt held by local governments (most recent figure as of end-June 2013, including RMB10.9 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 products also invest in bonds, which comprised 10% of the total.

As noted above, trust loans totaled RMB4.12 trillion as of end-June 2013 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.

Note:Asset side figure as of end-2013. Liability side as of end-June 2013. Source: China Trustees Association, BTMU.

Figure 14: Trust Assets and Local Government Debt Trust assets

(RMB10.9 trn)

Trust loans (RMB 5.1 trn)

Local government debt (RMB 17.9 trn) Infrastructure

related (RMB 2.6 trn)

<Asset side> <Liability side>

Weight Bank loans 5.5 1.9 2.7 10.1 57% BT (build, transfer) method 1.2 0.0 0.2 1.5 8% bonds 1.2 0.2 0.5 1.8 10% Entrusted loans 0.8 0.3 0.4 1.4 8% Other 2.2 0.3 0.5 3.0 17% Total 10.9 2.7 4.3 17.9 100% Total Direct debt Guara nteed debt Contin gent debt

5. Repayment difficulty involving wealth management products and trust products

Two cases of repayment difficulty among trust products, in late January and mid-February, have been the focus of considerable attention recently. Even before this, a number of wealth

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management and trust products 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 RMB20 billion (0.27%) of trust products in 2012.

This section reviews details regarding the two major cases that arose earlier this year and coal industry.

Issuance

date Type

Structuring financial

institution Selling financial institution Investment Background

① Nov 2012 Wealth management

Zhongding Wealth Management Center

Hua Xia Bank Shanghai

Branch -

RMB140mn in principal and interest not paid. Principal returned in Jan 2013.

② Dec 2012 Trust CITIC Trust -

Hubei Province private steel

company

RMB1.33bn raised from investors, interest payments delayed. Local government also involved.

③ Dec 2012 Wealth

management Northeastern Securities

China Construction Bank

Jilin Branch -

Prices fell by 30%, customers sought redress from bank as a group

④ Jul 2013 Wealth

management -

Jiangsu Province investment

company -

RMB60mn raised from 400 investors, promising 18% annual return. Authorities arrested executives.

⑤Summer 2013 Trust International TrustShaanxi Province - Chemical

company

Shaanxi Province International Trust took over payments of principal and interest

⑥ Jan 2014 Trust China Credit Trust Industrial and CommercialBank of China Shanxi ZhenfuEnergy Group Principal repaid after third-party instrument purchased

⑦ Feb 2014 Trust Jilin Province Trust China Construction Bank Shanxi LianshengEnergy Co.

Source: Various materials, BTMU.

Table 4: Past Repayment Difficulties with Wealth Management Products, Trust Products (partial list)

(1)Case 1: Repayment difficulty in 2014

In late January 2014, 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 RMB3.0 billion from approximately 700 investors to invest in a privately-run mining company in Shandong province, Shanxi Zhenfu Energy Group Ltd. The Group failed in 2012, and the owner was arrested on charges of illegally collecting deposits.

According to press, the local government bore 50% of losses while the Industrial and Commercial Bank and originating trust company each bore 25%, 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 2014

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 RMB30 billion of debt in 2013 and has applied for restructuring of its debt. Details remain unclear, but the company has signed a strategic

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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 2013 because of the slowing economy and toughened rules on air pollution. Meanwhile, coal prices fell by 16% in 2013 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 products that invested in coal companies rose to 19 in 2014 from just five in 2013 (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 2013, the government of Inner Mongolia held RMB454.2 billion of debt (equivalent to 27% of nominal GDP), while the Shanxi government held RMB417.9bn (32%), and the Shaanxi government RMB609.2bn (38%).

6. Default pressures for wealth management products and trust products

This next section reviews the repayment schedules of trust products, as well as wealth management products and trust products that may be unable to repay debt. The default pressures on wealth management products and trust products can thus be gauged.

(1)Trust products redemption schedules

Based on data collected April 18 by research company Yanglee Trust, quarterly total scheduled repayments of trust products rose from RMB88.6 billion in Jan-Mar to RMB107.2bn in Apr-Jun (Table 5). 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 2013 (Table 6).

The data does not cover all trust products, 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

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used to illustrate overall trust products trends. Cases Amount (RMB 100mn) Avg term (years) Avg annual return (%) Cases Amount (RMB 100mn) Avg term (years) Avg annual return (%) Overall Jan-Mar 555 886 1.59 8.90 Overall Jan-Mar 1,243 2,284 1.69 8.98

Apr-Jun 629 1,072 1.45 8.83 Apr-Jun 1,448 2,765 1.58 8.61 Jul-Sept 494 881 1.45 8.59 Jul-Sept 1,421 2,751 1.62 8.77 Oct-Dec 564 954 1.52 8.74 Oct-Dec 1,784 3,493 1.56 8.84 Finance Jan-Mar 134 138 1.45 8.00 2014 Jan-Mar 1,706 2,601 1.60 8.84 Apr-Jun 171 172 1.17 7.85 Finance Apr-Jun 355 437 1.25 7.53 Jul-Sept 144 119 1.17 7.95 Jul-Sept 515 561 1.07 7.29 Oct-Dec 177 153 1.77 8.03 Oct-Dec 503 592 1.37 7.81 Real estate Jan-Mar 95 257 1.85 10.20 Jan-Mar 586 520 1.20 8.01 Apr-Jun 103 262 1.84 10.23 2014 Apr-Jun 570 485 1.47 7.96 Jul-Sept 92 193 1.95 9.69 Real estate Jul-Sept 240 704 1.97 9.78 Oct-Dec 104 316 1.57 9.35 Oct-Dec 267 920 1.90 9.34 Infrastructure Jan-Mar 105 172 1.85 8.97 Jan-Mar 296 1,082 1.89 9.50 Apr-Jun 130 354 1.85 9.48 Apr-Jun 302 1,250 1.84 9.60 Jul-Sept 69 213 1.63 9.11 2014 Jan-Mar 301 821 1.87 9.67 Oct-Dec 63 152 1.62 9.35 Infrastructure Jan-Mar 255 537 1.92 9.40 Jan-Mar 152 242 1.43 8.64 Apr-Jun 223 600 1.93 9.19 Apr-Jun 173 202 1.23 8.38 Jul-Sept 164 454 1.92 9.12 Jul-Sept 158 309 1.37 8.35 Oct-Dec 242 623 1.88 9.31 Oct-Dec 151 189 1.32 8.82 2014 Jan-Mar 262 463 1.87 9.29 Other Jan-Mar 69 77 1.45 8.91 Jan-Mar 217 339 1.55 9.00 Apr-Jun 51 82 1.30 7.93 Apr-Jun 268 461 1.53 8.65 Jul-Sept 31 47 1.37 8.73 Jul-Sept 307 431 1.42 8.67 Oct-Dec 68 142 1.22 8.18 Oct-Dec 291 375 1.39 8.69 2014 Jan-Mar 249 338 1.34 8.55 Other Jan-Mar 176 267 1.58 8.42 Apr-Jun 175 223 1.47 7.84 Jul-Sept 151 192 1.53 8.26 Oct-Dec 363 725 1.57 8.09 2014 Jan-Mar 322 491 1.46 8.32

Source: Use-trust.com, BTMU.

Table 5: Redemption Schedule, Trust Products (2014) 2013 2013 2013 2013 2013 2013

Source: Use-trust.com, BTMU.

Table 6: Recent Trust Products Issuances (2013-2014)

Commercial & industrial

Commercial & industrial

(2)Wealth management products, trust products repayment capacity

Information about investments for both wealth management products and trust products 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 products

that may not be able to make repayments may be estimated considerable (Figure 15) (Note).

(Note) The calculation was made as follows. A simple sum of wealth management products and trust products was not used, but rather the amount of bank-trust cooperation model products (highly likely to overlap) was subtracted from the amount of wealth management products. Publicly-released data on the balance of bank-sold wealth management products was used for the amount of wealth management products. However, the bank data is as of end-September 2013. 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 2013 regulation prohibiting wealth management products from investing more than 35% of funds in non-standardized assets, 35% of wealth management products (after excluding bank-trust composites) were deemed to be likely facing difficulty with repayment. Although the rule was introduced in 2012, the same ratio was used to make estimates for previous years.

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0 5 10 15 20 25 30 35 2010 2011 2012 2013 0 5 10 15 20 25 30 35

Other products (left axis)

Population likely to include products with doubtful ability to repay (left axis)

Population likely to include products with doubtful ability to repay as a percentage of nominal GDP (right axis)

Figure 15: Population of Wealth Management Products and Trust Products that Likely Include Products with

Doubtful Repayment Capacity

(RMB trn) (%)

Source: China Trustees Association, etc, BTMU.

7. Impact of large-scale defaults by wealth management products and trust products

As noted above, the number of wealth management products and trust products 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 products in drawing up our scenarios.

(1)Comparison with US subprime products

China’s wealth management products and trust products are similar to US subprime products 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 products differ in several ways: 1) by investor class; 2) wealth management products and trust products are not rated; and 3) there is no secondary market for wealth management products and trust products. Regarding the first difference, while institutional investors (including overseas) were the primary investors in subprime-related products, mainly individuals (domestic Chinese) invest in wealth management products and trust products. Further, although not a comparison of the products themselves, the US deposit protection system and bankruptcy resolution systems as well as government rescue capacity (the political system) are also big differences.

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China Wealth Management Products, Trust Products

US Subprime Products (pre-financial crisis) Investor Individual investors Institutional investors (primarily US, Europeanfinancial institutions)

Seller Chinese commercial banks US financial institutions

Guarantee Both guaranteed, non-guaranteed Non-guaranteed (priority/subordinate structure) Balance Sum of wealth management products and trustproducts is RMB21 trn (37% of nominal GDP)

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-2006.

Investments (backed

assets) Chinese corporate loans, local government loans US home loans

Instrument design, issues

・Banks may structure in order to skirt regulations. High ratio of problem-ridden investments ・Big mismatches in short-term financing and long-term investment

・Inadequate disclosure of investments, etc. ・Complex product design

・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

Monitoring body Even non-banks are under official oversight.

However, inadequate oversight due to turf battles. No monitoring oversight of nonbanks Bankruptcy

resolution system None Yes

Deposit protection

system None Yes

Central bank liquidity supply capacity

New short-term liquidity facility established in 2013, open market operations used regularly as major policy tool

FRB used emergency special items, supplying large amounts of liquidity, including to businesses Central bank risk

taking capacity

Central bank is not autonomous, but part of central government

Response uncertain if central bank experiences shortfall of assets if losses arise

Other Government rescuecapacity Communist party is one-party system, and policiesare very flexible and dexterous.

US is a democracy, and approval of Congress needed to establish TARP. Limited flexibility in actions, eg., failure to pass TARP.

Source: Various materials, BTMU.

Table 7: China Wealth Management Products and Trust Products vs US Subprime Products

Products compared Financial systems compared (2Future scenarios

We classified scenarios involving large-scale default pressures for wealth management products and trust products, 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 products principal is not guaranteed, the trust companies do not have sufficient scope (capital) to take on the losses. Trust companies have net assets of RMB255.5 billion. Of this, RMB9.06 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.

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Bearer of losses

Envisioned risks Outline

Degree of adverse impact on economy Scenario A Structuring/sel ling financing institution (to limit default) Financial crisis-like conditions erupt domestically

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

⑤ Capital regulations could limit the financial crisis's spread overseas

●●● Scenario B (Individual) investors Credit suddenly contracts, demonstrations stoke social unrest

① Invidual investors rush to cancel wealth management product and trust products contracts, and huge liquidity risk arises due to the big term mismatches of the products

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. ●● Scenario C Central/local government (to limit default) Fiscal austerity weighs on the economy, moral hazard fomenting issues are delayed and expand

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 products and trust products could become more popular, fomenting moral hazard.

Source: BTMU.

Table 8: Scenarios Under Various Increased Default Pressures

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-2013. Of this, RMB55.2 trillion was loans to companies. According to the China Banking Regulatory Commission, the non-performing loan rate (to companies) at commercial banks stood at 1.0%, or RMB592.1 billion (Table 9, Figure 16).

If the number of wealth management products and trust products in danger of failure to repay (estimated above) is extrapolated to all commercial bank NPLs (to companies), the NPL rate would surge from 1.0% to more than 10%.

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2010 2011 2012 Jun 2013 Sept 2013 Dec 2013 Commercial banks, all 4,336 4,279 4,929 5,395 5,636 5,921

SOCBs 3,125 2,996 3,095 3,254 3,365 3,500 JSCBs 566 563 797 956 1,026 1,091 City commercial banks 326 339 419 496 526 548 Rural commercial banks 271 341 564 625 656 726 Foreign banks 49 40 54 63 62 56 Commercial banks, all 1.13 0.96 0.95 0.96 0.97 1.00

SOCBs 1.31 1.10 0.99 0.97 0.98 1.00 JSCBs 0.70 0.60 0.72 0.80 0.83 0.86 City commercial banks 0.91 0.80 0.81 0.86 0.87 0.88 Rural commercial banks 1.95 1.60 1.76 1.63 1.62 1.67 Foreign banks 0.53 0.41 0.52 0.60 0.57 0.51

Note: Figures in shaded boxes are increase/decrease from end of previous quarter. Source: China Banking Regulatory Commission,BTMU.

Figure 9: Commercial Bank NPLs, Ratios

To tal a m o unt (R MB 100 mn ) Ratio ( % ) 0 5 10 15 20 25 30 35 40 1998 2000 2002 2004 2006 2008 2010 2012

Four major commercial banks All commercial banks

Note: Classification method of loan obligations changed from 2002 (from four

    Chinese categories to five international standard categories). Source: China Banking Regulatory Commission, BTMU.

Figure 16: Commercial Bank NPL Ratio (%)

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 products 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 40% of nominal GDP at end-2013 (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).

0 5 10 15 20 25 30 2007 2008 2009 2010 2011 2012 2013 0 10 20 30 40 50 60

Home mortgages (left axis) Consumer loans (left axis)

(Home mortgages + Consumer loans) as percentage of Nominal GDP (right axis)

Figure 17: Bank Loans to Individuals

(RMB trn) (%)

Source: People's Bank of China, BTMU.

0 20 40 60 80 100 120

China Japan South Korea US Australia Note: China is bank debt only.

Source: IMF, BIS , BTMU.

Figure 18: Household Debt, by Major Country (2012) (% of nominal GDP)

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

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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, 2012, 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-2013 (Figure 19). By sector, most bonds were issued by construction, public interest, metals and mining, and oil and gas companies (Figure 20).

0 1 2 3 4 5 6 7 8 9 10 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 0 30 60 90 120 150 180 210 240 270 300

Corporate bonds outstanding (left axis) YoY (right axis)

Source: People's Bank of China, BTMU.

Figure 19: Corporate Bond Outstanding

(RMB trn) (%) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 C on str uc tion P u blic int e re st Meta ls & min ing Pet ro leu m & gas R eal e sta te Mac h iner y Ins u ra nce Coa l Tr ans p ort Che m ic als Ot he r (RMB trn)

Figure 20: Corporate Bond Issuance, by Industry (as of end-September 2013)

Source: Reuters, BTMU.

Hiroshi Kurihara (hiroshi_2_kurihara@mufg.jp)

Economic Research Office, The Bank of Tokyo-Mitsubishi UFJ, Ltd. 2-7-1, Marunouchi, Chiyoda-ku, Tokyo 100-8388, 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 products. 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.

Figure

Figure 1: China's Financial System
Figure 4: Balanced (Portfolio) Wealth Management Product Framework
Figure 8: Trust products Investments
Figure 9: Collective Trusts as Share of Trust Assets
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References

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