If you think that shadow banking is all the rage in China right now then you’re behind the times.
While it appears the Chinese government and market have combined to potentially solve the issue of shadow banking’s loan sharks with five experimental private banks that could offer credit to small and medium sized enterprises at a rate that undercuts loan sharks but is more accessible than the major banks, China has a new problem that is quickly emerging.
Alibaba is one of three emerging mobile internet companies in China (the other two being messaging app WeChat’s owner Tencent and Google-like search engine Baidu). Alibaba’s main claim to fame used to be Alipay, which was a mobile payment application similar to Paypal in the US.
Now, thanks to Chinese business regulations requiring a minimum capital reserve equal to 10% of daily transactions, Alibaba’s namesake has become its roughly eight month old internet finance company Yu’E’Bao. In order to avoid the issue of the capital reserve, Alibaba created Yu’E’Bao to attract a capital flight from Alipay. It did so by letting investors invest any amount of money and allowing them to withdraw that money whenever they please. Additionally, and most importantly, they offer a return of 6% whereas banks are limited to offering a measly .35% for the same deal (called demand deposits). Even if investors want to suck it up and agree to leave their money in the bank for a full year they can only get 3% returns. The choice here is obvious.
What Alibaba has done is revolutionize the investing game in China. Now anyone, regardless of how much money they have, can invest in Yu’E’Bao and get 6% returns. Additionally, because more of the youth in China is engaged with mobile internet, most of the money invested in Yu’E’Bao is believed to come from their pockets. Thanks to growing incomes fueled by 20 years of greater than 7% GDP growth and the one-child policy, these “little princes” are beholden to more cash than maybe ever before in history. They’re also inheriting their parents’ health care costs thanks to a lack of government-provided social welfare. What does this mean? They’re saving lots of money, most likely now on Yu’E’Bao and other similar platforms.
So now that we see that the savings of the youth are all being moved to these internet finance companies, let’s see where the trouble lies.
Yu’E’Bao (actually Tianhong Asset Management company, of which Alibaba owns 51% and handles all of Yu’E’Bao’s investment decisions) has publicly admitted that it invests close to 90% of its savings in interbank loans (loans that are extended to banks, from other banks). Right now, thanks to shadow banking and related wealth management products, the major banks have begun to invest in riskier investments (evidenced by the recent bankruptcy of the Jilin trust loan, sold through Chinese Construction Bank, to heavily indebted Liansheng coal company), which in turn have required more emergency funding via the interbank loans.
Last year the Chinese government allowed interbank loan rates to freely fluctuate four times, each time watching rates rocket to levels that were close to causing bankruptcies among major banks before the government interfered. This is part of what has been fueling Yu’E’Bao’s high rates of return.
However, we all know that once supply is high, demand drops and prices slump. Well, as Yu’E’Bao has grown to be the 4th largest money market fund worldwide, supply has also largely grown. This means that there is now more money sitting in the interbank loan markets, and rates will most likely not continue to float so high. Subsequently, Yu’E’Bao will not be able to continue to offer such high returns. Thus is the nature of the economic equilibrium.
It is perhaps the cooling nature that Yu’E’Bao brings to the interbank loan market that keeps the government from interfering in the internet finance domain. The government has plans to eventually allow deposit interest rates at major banks to rise (most likely in the next two years), which will also decrease demand for Yu’E’Bao. It appears that one of the first steps the government plans to take towards this end is that of freeing their hold on the interbank loan market and therefore no longer implicitly backing banks’ risky lending.
The problem is that at the rate that Yu’E’Bao has been growing (it now caters to more investors than the Chinese equity market), the interbank market could become flooded before the Chinese government floats major banks’ deposit rates. This would lead to a lowering in the rate of return for Yu’E’Bao, and if the rate fell enough that there were better alternatives, it eventually could lead to a massive withdraw of funds (bank run). Yu’E’Bao is not subject to the same rules as banks, and does not have capital reserve requirements. Therefore, a bank run on Yu’E’Bao could lead to problems with liquidity and a massive bankruptcy that shakes the entire Chinese economy and therefore the entire world.
Is that the only problem? Nope. As money leaves traditional banks (who are dependent on short-term, or demand deposits, for 50% of its total deposits) and enters Yu’E’Bao, banks have to find ways to increase returns. The easiest way to do this is through shadow banking channels, which leads lending to high-risk debtors who have now started defaulting. This means that the minority of people who choose to invest in banks to supposedly stay safe from risk are actually also putting their money at risk of default.