Doing business in China with Wealth Management Products (WMPs)

The benefits of investing in China’s markets are touted near and far. But there are often neglected risks to doing business in China. Our expert business advisors explore the risks inherent in the precarious, yet booming, shadow banking industry, and show you a more prudent way of looking at the much lauded Chinese market.*

How do WMPs function in China?

WMPs have become a popular way for lenders to attract funds. These financial products, issued by banks yet kept off their balance sheets, are investments across numerous industries in everything from bonds to property. While one-year bank deposits in China have a benchmark one-year deposit rate of 1.5%, these WMPs deliver yields of up to 3%-5%. Moreover, WMPs deliver remarkably steady rewards, unlike corporate bonds, stocks and real estate. Only a small number have been reported to have suffered losses.

WMPs have become a popular way for lenders to attract funds. These financial products, It is therefore no surprise that Chinese investors have poured their savings into these products which are seen as risk free. As a result, the market for such products has grown to $3.8 trillion in just three years. Assets of up to $4.2 trillion USD are currently held in WMPs. If you take into account other products that are kept off bank balance sheets, delivered by asset management firms, trusts, brokerages and private funds, then these investment products are worth upwards of $9 to $12 trillion USD a year. By comparison, the Chinese stock market is worth around $7 trillion while Australia’s is only worth $1.5 trillion.

Why do WMPs pose a risk?

Experts believe that this incredible confidence in WMPs and associated products is simply not warranted or sustainable. And, considering the size of this industry, should the ‘bubble’ burst the fallout will be significant to anyone doing business in China or thinking to invest in China.

Consider the following:

  1. WMPs are similar to the ill-fated mortgage backed securities in the USA, in that they largely don’t appear on bank balance sheets and financial capital is often poorly deployed in struggling industries and products.
  2. Only 18% of the funds invested in WMPs end up in deposits traditionally considered transparent and safe.
  3. WMPs can be handed over to non-banks and can be invested in other WMPs, thus multiplying product layers, linking products to one another, and connecting products to less than transparent lenders.
  4. Regulation is weak, clever financial engineering regularly dodges restrictions, and fraudulent activity has been rife in this sector.
  5. Investors have flooded money into WMPs with little regard to the recent slow-down in the Chinese economy.
  6. Many WMPs have terms of six months or less, and so, if investors turn cold, an ensuing liquidity crunch would infect numerous linked products.

An estimated 38% of China’s GDP is invested in products with these risks. But perhaps the greatest danger of all comes from the misplaced confidence in WMPs. Chinese investors have dismissed the risks above because of an implicit trust that WMPs cannot collapse – a confidence that is plainly based on a false premise.

Is this risk real, or just hype?

Hype about markets crashing is nothing new. But the risks prevalent in the shadow banking sector and the enormity of the impact of a potential collapse are not based on hysterical cries of doom. It’s drawn from analysis. The above weaknesses point to a considerable risk in WMPs that is impossible to ignore despite the consistency of returns and confidence from investors. And, should investors run into trouble with WMPs, the banks will only do so much to protect the reputation of these products before considering whether or not they will allow losses.

The Chinese government and central bank are well aware of the misplaced confidence in WMPs. They are selling the message that a government bailout on losses is not set in stone. They are increasing interest rates in order to discourage excessive leverage.

In the end, the hype does not surround the risk of WMPs. The hype exists in the misplaced confidence that when a market is booming, you cannot lose, or that if a bubble should burst, you will escape losses in the nick of time.

What is being done to limit the risk?

Chinese financial regulators are trying to clean up the shadow banking industry. But the effectiveness of such efforts remains to be seen.

Draft rules have been drawn up. These limit investments in non-standard assets, direct institutions to set aside 10% of fees to cover risks, and deny any implicit guarantee that the government will bail out investors. Risk management guidelines have been advertised that encourage investments that are transparent, distinct, and without excessive leverage. Yet if global experience is anything to go by, regulators will have a hard time putting such draft rulings into effect. Misguided confidence is hard to deflate. Moreover, the sheer growth and size of the shadow-banking industry, which covers other asset management products as well as WMPs, only makes the job of regulators even more difficult and increases the impact of these risks.

How could this impact your business?

There are many businesses and individuals who do not invest in China, and who have no funds in WMPs, but who can nevertheless be impacted. The risks inherent in the shadow banking industry in China mean you need to be more cautious when appraising the booming Chinese economy and market. It urges you to be smarter when doing business in China, and to prepare for a risks related to your tax obligations and transfer pricing which may be impacted by a hit on the Chinese and global economy.

While WMPs still remain profitable, it is wise to heed the warnings of a potential liquidity crunch in the next few years. Since the average WMP matures in 4 to 6 months, while the average Chinese corporate bond matures in 7.5 years, a downward spiral of plummeting asset prices could occur when the market swings and fresh cash is not raised in time. Some analysts even feel that this hit may occur sooner rather than later, with the Chinese government undergoing a transition in leadership.

For those doing business in China, now is a good time to explore ways their business might be effected by the risks of WMPs. Calibre’s business advisors are experts in the China market and can advise you on how to best manage your investments or business in China.

*Data largely relies on information found in Bloomberg Markets (11 April 2017 and 17 Jun 2016).

Important Disclaimer: Readers should not act solely on the basis of the material on this page. Items herein are general comments only and do not constitute or convey advice. Legislation and proposals of legislation are also subject to constant change. We therefore recommend that formal advice be sought before acting in any of the areas. This news article is issued as a guide to the readers. Calibre Business Advisory Pty Ltd and its associated entities disclaims any losses that may be incurred as a result of the reader undertaking any action based on this article.