China's retail investors are leading grassroots financial reform

Interest rate liberalization

China's retail investors are leading grassroots financial reform

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Grassroots movements bring to mind angry petitioners on the streets or the little man fighting against the big, ugly institution. It doesn't conjure images of investors handing over their cash to bankers, who then pile that money into real estate or coal projects.

But in China, a grassroots financial movement fomenting off the balance sheet involves just that. And in some ways, it too is the story of a marginalized group of people, depositors, pushing back against an almighty, unmovable force, the People's Bank of China (PBOC).

China caps the interest rate banks pay to depositors at about 3.3%. Until July, it also kept a floor around 6% on the interest rate borrowers paid on loans. That almost three-point spread yielded big profits for banks while also helping the government channel the deposits of the masses toward state-owned firms.

That's a chunk of change being lost by depositors. In November, Chinese retail depositors had more than RMB43 trillion (US$7.1 trillion) sitting in the bank. Even a slight increase in the deposit rate would equal major gains for Chinese consumers as a whole.

Instead of waiting around for the central bank to scrap the cap on deposit rates, Chinese citizens have looked for other ways to get better returns on their savings. Many have taken their hard-earned cash out of bank accounts and given it to bankers who promised better – often wildly high – returns with wealth management products (WMPs). In doing so, they are putting increasing pressure on PBOC to liberalize deposit rates.

A better return

A wealth management product is not a deposit in a bank. Far from it, in fact. Bankers pool these funds, which are not on the bank's balance sheets, and then loan them out to businesses in desperate need of capital. This is China's infamous shadow-banking sector. Trust and securities companies are often used to “tunnel” the funds from the banks to the end borrower, who might be a factory owner in Wenzhou city or a coal miner in Shanxi province.

That's the problem with WMPs: The unhappy depositor doesn't know where the cash has gone. Yet they often think of WMPs as a deposit with the bank that will unconditionally yield high returns. The lofty rates promised by WMPs are attractive to people tired of seeing their savings abused by PBOC.

“WMPs are where China’s new middle class is meeting interest rate liberalization, and so far, households like what they see,” Standard Chartered said in a report this month.

WMPs and trusts have become so popular that the number of new loans as a share of total financing in China in 2013 fell from 52% to 51%. That means, in the world of Chinese finance, the amount of off-balance-sheet lending increased last year. For money market funds, assets under management jumped by 50% in the fourth quarter of last year, Fitch Ratings noted this month. That growth was driven by retail investors, many of whom were likely disgruntled depositors looking for a little bit extra.

The surge in retail investors in the industry is worrying the central bank. The cash pouring into WMPs is increasingly the deposits of real people, not funds from an investment company.

“It's definitely caught the attention of regulators but they're still waiting on the sidelines and watching this develop,” said Zhang Yundi, an analyst at Fitch Ratings in Beijing. “Regulators will watch how they [WMPs] will attract retail investors so they can gauge the appetite for these funds.”

Road to ruin

Why worry where ordinary people put their money? Because, if wealth management products begin to default en masse, China's Communist Party could have a spate of social unrest on its hands as people lose their life savings and homes. There are signs that the house of cards that is the WMP industry may experience major defaults in 2014.

A US$500 million product offered by China Credit Trust matures at the end of January yet it has little hope of repaying its more than 300 investors. Industrial and Commercial Bank of China, which sold the products, says it doesn't plan to bail out investors.

The bank and its state backers are not concerned that the investors in the China Credit Trust product will end up on the street if it defaults: They were mostly well off. However, about a third of the some US$760 billion in trust loans will mature this year, according to Bank of America Merrill Lynch. If the government allows defaults, many average Chinese people could watch their savings disappear.

It's this point that has applied pressure on the central bank to continue to liberalize interest rates. Standard Chartered noted that removing the cap on deposit rates would greatly decrease the demand for WMPs. In 2013, PBOC showed some willingness to move ahead with liberalization.

Last July, the central bank suddenly removed the floor on lending rates. That was a symbolic gesture to the market, however. At the time, most banks were not lending money at below the benchmark rate and ditching the floor had little impact on the market. Then, in mid-October, PBOC allowed commercial banks to issue negotiable certificates of deposit (NCDs), large deposits available to fund managers. PBOC said the market would decide the interest rates for the NCDs. Again, that had a negligible impact because only players in the interbank market can use the new instruments.

Feeling the heat

Still, both moves show that China is submitting to some pressure and inching closer toward freeing up its deposit rates. The level of pressure, though, is debatable. “We think this is a problem and it will bring some risks to the financial institutions and macro economy,” Chen Xingyu, a banking analyst at Phillip Securities, said about off-balance-sheet lending. “But for the short term, we think this risk is quite small and still under control.”

By exactly how much retail investment in WMPs will have to increase to push PBOC to uncap the deposit rate is unknown. The government has not issued a plan for this final step in interest liberalization and analysts are wary to predict when it will happen. “There's certainly a possibility that they could lift the cap on deposit rates but there is no timeline for this,” Zhang Yundi said.

Regulators have another option to rein in the WMP industry: Tighter controls. In March last year, China Banking Regulatory Commission (CBRC) issued a document targeting wealth management products. By April, the new rules, known as Document No. 8, had led to an 8.8% decrease in WMPs issued by banks, on paper a major victory for the iron-fisted CBRC. Still, in March, total social financing, China's broadest measure of credit growth, increased 22% year-on-year, a 21-month high. What's more, that lending was driven by off-balance-sheet loans, namely trust products, which are issued by non-bank trust companies and therefore not regulated by Document No. 8.

CBRC is reportedly crafting another regulatory antidote, Document No. 9. That has yet to be issued but it could crack down further on off-balance-sheet lending, especially interbank market funds.

The experience with Document No. 8 shows that, when regulators shut one door, investors open another. The bottom-up pressure that investors and everyday depositors are applying on the central bank will not ease under tighter control. Grassroots investors in China have shown a keen aptitude for skirting the rules. A new set could simply drive funds further into the shadows of the banking sector.