China's Hidden Risks: Shadow Banking and US Delisting
January 31, 2013
- A large number of US-listed Chinese companies could be delisted due to a dispute between the United States and China over audit standards.
- Banks, a large portion of the Chinese stock market, are not immune to risks from the shadow banking sector—which has surged as China's growth has stabilized. At this point, economic growth may be coming from unsustainable sources.
- Risks appear to be building that could impact Chinese investments.
Thanks in part to the development of ETFs, it's become much easier over the past decade to invest in emerging markets. However, easy and safe aren't the same thing, and it's important for investors to remember that businesses in other countries may not adhere to the same accounting standards and business practices as those in the United States. This can create risks both for investors and for economic growth.
A couple of risks are building that could impact Chinese investments in particular. A discrepancy between Chinese and American accounting rules has been an issue for some time, and now a large number of Chinese companies currently listed on US exchanges could be delisted due to a dispute over audit standards. Additionally, banks—the largest sector in China's stock market—may eventually need to shore up their capital reserves or pay back investors for losses in connection with troubles in the shadow banking sector. Lastly, unsustainable sources of growth could create vulnerabilities for China's economic outlook.
China may be able to avoid these risks, but it would require several convergent factors—including possible government intervention to fund banks and infrastructure projects, as well as an acceleration in Chinese and global growth.
Delisting risk for US-traded Chinese stocks
It is not uncommon for companies in different countries to use different accounting standards. However, in order to list on an exchange in the United States, companies must file annual financial statements that are audited by a qualified auditor registered with the US Public Company Accounting Oversight Board (PCAOB), and must allow audits to be inspected by the PCAOB. This presents a dilemma for Chinese auditors, because their national secrets laws bar the release of audit work papers (the documents that document the auditor's process and support its opinion that the company's financial position is fairly represented). China believes it should have exclusive jurisdiction over accountants that practice in China, and views US demands to inspect audits as a violation of its sovereignty.
Chinese and US regulators have yet to agree on a coordinated system of financial information and disclosure, leaving auditors stuck in the middle. The US Securities and Exchange Commission (SEC) recently accused the China subsidiaries of five global auditors—Deloitte, KPMG, PricewaterhouseCoopers, Ernest & Young, and BDO Seidman—of violating US regulations by withholding the audit documents of certain Chinese clients. The scope of the issue could be large because the five accounting firms audit 126 US-traded companies, according to a December 2012 report by The Wall Street Journal using data from the Public Company Accounting Oversight Board. The total number of US-listed Chinese companies is even larger.
The issue may extend to US multinationals with operations in China. Affiliates of the auditors listed contribute to audits of large US companies, a practice that may not be allowed if the affiliates are banned by the SEC from auditing US-listed companies. In particular, many technology firms have large operations in China. Jacob S. Frenkel, a former SEC enforcement attorney, noted in The Wall Street Journal that the consequences could be "monumental."
In terms of timing, no changes to audits are required immediately, because the SEC administrative law judge isn't expected to rule on the December 4 complaint until September 2013.
Investment implications of audit dispute
US-listed Chinese firms could be delisted if China-based auditors lose their authorization to prepare financials required by US regulators.
In the meantime, US-listed Chinese companies will likely continue their trend toward going private, consolidating, or switching exchanges. Following a spate of short-seller attacks in 2011, it has become more common for Chinese businesspeople and institutions flush with cash to take US-listed Chinese companies private. Several mergers in the Chinese internet and technology space have resulted in the natural delisting of some firms. Also, some companies are looking to switch exchanges, hoping to escape the discounted valuations due to weak sentiment in the United States.
The rift between Chinese and US regulators could keep a lid on enthusiasm for US-listed Chinese firms, already diminished due to prior accounting concerns. Ultimately, we believe a compromise between the US and China is the most likely outcome, although China has increasingly asserted itself globally in recent years, and there's an outside chance that the two countries won't reach an agreement.
Shadow banking is growing—and so are risks
Official bank loans have fallen as a percentage of overall new credit for a number of reasons. Banks may be reluctant to lend because of regulatory restrictions and the increased credit risks of some borrowers. Additionally, according to BCA Research, some older loans are being allowed to roll over at maturity rather than default, locking up capital that banks would otherwise be able to loan out for new uses. Lastly, the largest banks are primarily state-owned and mainly lend to state-owned enterprises, while small- and medium-sized enterprises have limited sources to raise capital.
With official bank lending in decline, a higher percentage of credit now originates outside the formal banking sector, according to China's National Bureau of Statistics. While some of the non-bank sources of funds are legitimate, a growing portion is in the unregulated, unsupervised and off-balance sheet areas of the system: the so-called "shadow banking" sector. As a result, the International Monetary Fund (IMF) warns of the risk of "new challenges to financial stability."
Surge in credit from outside the formal bank sector
Source: FactSet, Bloomberg. As of January 15, 2013.
Shadow banking fills the void in lending left by the official bank system, and offers the allure of potential double-digit returns (albeit with the considerable downside of total loss of investment on questionable loans). Compare this with bank deposits which, when including the effect of inflation, often offer negative returns; a still-nascent bond market; a volatile stock market; and property investments that have been stymied by government restrictions.
Sectors of shadow banking include peer-to-peer lending, off-balance sheet bankers' acceptance notes (short-term debt guaranteed by a bank), entrusted loans, private lending, financing trusts, private equity and venture capital, letters of credit and factoring loans, financial leasing, and trust beneficiaries. The size of the overall shadow banking sector is unknown, but FT China Confidential estimates it may have been as large as $5 trillion at the end of 2012, equating to 48% of the $10 trillion in formal bank loans outstanding, up from 36% in 2010.
An increasingly popular form of shadow bank lending is actually marketed through official banks as wealth management products (WMPs), which collect money from investors for short periods of time with banks either directly investing the funds or acting as an intermediary between lenders and borrowers. Roughly half of the WMP money is directed to off-balance sheet bankers' acceptance notes, financing trusts and trust beneficiaries, according to FT China Confidential. Ultimately, the money is funneled into loans to small and medium-sized enterprises (SMEs), property developers and local governments, as well as investments in stock and bond securities. Loans to companies was the fastest growth destination for trusts in 2012, growing over 80% during the first nine months of 2012, and it now rivals the size of loans to infrastructure projects. Loans to companies, infrastructure projects and real estate represent more than half of the ultimate destinations for trust investments.
Fastest growth destination for trusts is loans to companies
Source: FactSet, China Trustee Association. As of January 15. 2013.
FT China Confidential believes WMPs accounted for as much as 20% of shadow bank lending ($1 trillion) in 2012, while Fitch Ratings sizes the WMP market at possibly over $2 trillion. While any market this large may contain good investments, there are likely to be bad or risky investments as well. David Cui, a strategist at Bank of America Merrill Lynch, believes that some banks have used new WMP proceeds to cover losses from previous products sold.1
Additionally, WMPs present numerous risks to investors. Marketing materials often fail to adequately detail where the money is ultimately invested, making credit risk analysis difficult, according to the IMF. Many investors believe the investments are guaranteed by the banks who market the products, but that isn't always the case.
The shadow banking sector is showing signs of distress. In the first half of 2012, more than 58,000 lawsuits involving disputes over 28.4 billion RMB ($4.4 billion) in private lending were filed in the entrepreneurial base of Zhejiang province, up 27% from the same period in 2011 and the most in five years, according to the provincial supreme court. In December 2012, a WMP sold at a Shanghai branch of Huaxia Bank failed to repay investors at maturity; a WMP sold by the country’s second-biggest lender, China Construction Bank Corp, lost 30%; and CITIC Trust, run by one of China’s largest investment firms, delayed an interest payment. Investor lawsuits and complaints have picked up.
Growth coming from unsustainable sources
Several indicators suggest that China's growth rebound is coming from sources that may not be sustainable in the long term:
- The surge of credit outside the formal banking sector (see shadow banking above).
- Short-term loans growing as a percentage of overall loans, which could be a sign companies are facing short-term cash shortfalls and are pulling back on longer-term investment in building, equipment and new projects. Short-term and bill financing were 64% of new loans in 2012, versus 52% in 2011 and 20% in 2010, according to the People's Bank of China.
- Increased reliance on vendor financing to drive sales. In 2012, accounts receivable grew faster than sales in some industries, such as textile and apparel, electronic parts, and coal mining, with the machinery and equipment industry posting the largest amount of accounts receivable in this risk area, according to FT China Confidential. Essentially, these industries may be funding their own growth—something that can't continue forever.
- A high dependence on infrastructure spending, which has funding headwinds. China's turnaround in economic activity in 2012 was likely due to a return of infrastructure spending, which is funded by local governments. For income, local governments rely heavily on land sales, which waned in 2012 but could pick up in 2013. However, the central government wants to dampen housing speculation and could implement new restrictions at signs of overheating. Other sources of funding are bank loans and, increasingly, the bond market—although these sources have at times been difficult to tap because local governments are viewed as a higher credit risk, due to high levels of leverage and difficulty repaying prior loans.
What could go wrong?
China's economic growth could be restricted if distress in the shadow banking sector grows to a large scale, sales enticed by debt financing and pulled forward reduce corporations' ability to grow, and local governments are unable to find sufficient sources of funding for infrastructure projects.
A fallout could cause strain in the following areas, which could restrict economic growth:
- Consumer confidence could fall if individuals experience losses from investments in the shadow banking sector, reducing spending and home buying.
- Funding sources could dry up for growth areas of the economy such as small- and medium-sized enterprises (SMEs), local governments (and by extension, infrastructure-related companies) and property developers.
- Banks could have contingent liabilities. Banks don't disclose their on-balance sheet risks clearly and may have off-balance sheet exposure. They may also be held liable for investor losses on unguaranteed debt to protect their reputation or in the case of government directives to quell social uprising. The need to hold capital aside could restrict banks' ability to lend. If depositors continue to favor products outside the formal banking sector, banks could face reduced access to an inexpensive source of funding from deposits. Additionally, if banks need to raise additional capital, bank stock prices could dip, and banks are a large portion of the Chinese stock market. Of the two indices that most closely represent broad Chinese ETFs, financials constitute about 60 percent of the Hang Seng China Enterprises H-share Index (shares of companies incorporated in mainland China but trading on the Hong Kong exchange), and 36 percent of the S&P BMI China Index.2
- Bank regulations could increase, as China's government will likely have to tighten oversight, which could lead to a growth slowdown. In December, sources indicated to Reuters that the China Banking Regulatory Commission said that WMPs should be brought onto bank balance sheets if they are capital guaranteed (but those that are not capital guaranteed can continue to be kept off balance sheets).
What could go right?
China requires more debt than before to keep economic growth in motion, and for now, its high savings rate can continue to fund debt issuance. While future growth could face headwinds, risks from unsustainable sources of growth could be pushed out to the future if:
- Chinese and global growth continues to accelerate, allowing loans to be repaid without major incidents and delaying the need to recognize bad loans until the next cycle.
- China's central government joins local governments to fund infrastructure projects.
- China's central government funds bank or WMP bailouts.
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1. New York Times, August 7, 2012.
2. Bloomberg, as of January 15, 2013.
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