Following the credit and investment binge of 2009 and 2010, China’s 18-month long quantitative tightening campaign has been aimed at reining in consequent inflationary pressures.
On the supply side, large amounts of new credit are still entering the system. New renminbi loan growth has moderated but remains around RMB500 billion ($79 billion) per month. The downstream capital restrictions have driven funds into shadow sectors such as trust company investments, inter-company entrustment loans, and commodities-related speculation. On the demand side, the quantitative lending restrictions have disproportionately impacted SMEs, forcing them to seek alternative sources of financing in the shadows.
This rapid growth in “informal lending” has alarmed some while reports of stress in the shadow lending market fuelled fears of a China “hard-landing.” But practitioners seem less concerned as they see limited risk of contagion and argue the trust sector is among the most well-managed and innovative areas of China’s financial sector, and presents an opportunity for foreign partners.
Distinguishing between types of informal lending
In recent discussions, the term “informal lending” has been used to refer to a wide range of financing structures. These institutions range from some of the most innovative companies in its financial sector, to semi-legal intermediary lending and to traditional black money markets, with many shades in between.
Trust companies have emerged as one of the most creative forces in the China asset management space. The sector’s total AUM has increased rapidly from RMB2 trillion by end-2009 to RMB3.8 trillion by June 2011, meaning they have now overtaken traditional fund products on a pooled AUM basis. Trust companies offer single-unit or collective investment products, and these had largely been exempt from macro tightening regulations until recently. They are also a preferred product type for Chinese institutional and high net-worth investors alike.
Joel Rothstein, a Beijing-based partner specialising in real estate and investment funds at Paul Hastings LLP, says: “The growth of the trust sector goes hand-in-hand with a high-growth economy. Capital is needed for investment, and wealthy individuals and corporations need investment opportunities. In China, options are limited and so there is a lot of interest in trust companies because they fill a void in the financial sector.”
The trust companies don’t face the same government-imposed lending quotas as the state banks. This makes them one of the few types of firm that can push the envelope on product demand and respond to emerging investment trends. “Fixed income markets and securitisation are very limited, while private equity remains in its infancy, so trust companies have become popular because they are actually there,” Rothstein says.
This freedom also gives trust companies a superior ability to evaluate and price risk, according to Jason Bedford, Head of Financial Services with KPMG China. Recent regulations imposed an upper limit to trust company lending rate of four times the benchmark rate. This was an attempt to prevent exorbitant rates in the market, which in some cases were as high as 70% per year.
The trust sector also has considerably more freedom than the state banks when it comes to building out products. “Generally, trust companies are actually quite well managed,” Bedford argues. “They are more flexible and capable in their ability to manage the risk of a product, for example through risk-based pricing of interest rates or the provision of hybrid financing.”
In this sense, trust companies may suffer from their association with other types of informal lending, when a key distinction is that, risk is often priced in a relatively sophisticated way.
Coming in from the shadow
Recognising the need for reforms, the banking regulator has been attempting to bring trust companies further into the formal lending sector and improve their professional standards.
2011 has seen the implementation of net capital requirements which oblige trust companies to report on and apply risk weightings to their AUM in financial statements. The new requirements significantly increase sector transparency and introduce standardised risk controls.
“The regulators are making a concerted effort to introduce international best standards throughout the financial sector and trust companies are no exception,” Rothstein says. “There’s more knowledge, oversight and guidance than previously on the part of the regulators.”
The regulator has also built-in safeguards to control the risk of contagion to the formal sector, according to Bedford. “I think there has been a bit of an over-reaction in the market. There are issues to be addressed, but the situation is far from critical. There are not too many overlapping risks between trust companies and the formal banking sector.”
Another area which has caught the regulator’s attention is loan tracking, with the authorities increasingly channelling funds through custodian accounts to ensure it is used for the stated purpose.
Investor opportunities expand
Attempts to standardise the trust sector may further boost the attraction of its products to China’s choice-starved, but increasingly risk-savvy investors. The regulator substantially expanded the sector’s asset management business lines. In June, a pilot scheme was announced for trust companies, hedge funds and local fund houses to apply for Index Futures trading licenses.
Trust companies’ flexibility allows them to establish market share in the very competitive wealth management space, tailoring products to suit a customer’s specific risk-reward profile. More nimble than their competitors, they are able to have to shifts in demand toward alternatives such as real estate, mining and private equity by Chinese investors of all stripes.
In another significant reform, the regulators have begun accepting trust companies QDII license applications. These products will represent a new avenue for Chinese outbound investment and could present opportunities for foreign investors in advisory or third-party management roles.
Inbound investment by foreign investors remains limited, according to Rothstein. “Foreign exchange controls are still a problem. There is no way to circumvent SAFE restrictions, so some foreign investors have invested directly into the ownership of trust companies through a joint-venture structure but have not invested directly into trust products from offshore.”
Broader reforms needed
Bringing trust companies into the light and expanding their asset management capabilities is one aspect of the reform but must be matched in other areas.
“The government will never be able to stop informal lending so developing alternative sources is the only sustainable solution. This means developing not only trust companies but also bond markets, PE, smaller regional banks, government financing programs and so on,” Rothstein says.
Trust companies’ flexibility and profit-over-politics approach gives them a distinct advantage when it comes to meeting differentiated investor demand and dealing with foreign partners. As such, they are a key component in China’s attempts to deepen and diversify its financial markets.
“It will take time, but everything in china happens at an accelerated pace and I don’t doubt the process will be rapid - but we’re not quite there yet,” Rothstein concludes.