TRUSTING investors can easily be gulled by scams designed to relieve them of their savings. In China efforts to educate the unwary extend to the streets. Walls are daubed with murals illustrating the dangers of Ponzi schemes, which pay off early investors with money raised from a larger group of later ones. In one cartoon a swindler, hugging a big pot of cash, sits atop a human pyramid, representing the Ponzi principle at work.
The Ponzi principle has even tempted some of China’s banks, according to a widely cited article in China Daily, an official newspaper. The article was notable because its author, Xiao Gang, is chairman of one of China’s four big banks and may take over the central bank later in 2013. Mr Xiao is worried about the proliferation of wealth-management products (WMPs), which collect money from investors for a fixed term (usually less than six months) and plough it into a variety of financial assets, from short-term bills to long-gestation property projects.
Some of these products are issued by banks, although only a minority are explicitly guaranteed by them. Others are merely sold through the banks, which act as a distribution network. Mr Xiao frets that short-term products are financing long-term projects, creating a maturity mismatch. He also worries that some failed ventures are able to repay their bank loans only by raising fresh funds through WMPs, a form of Ponzi finance.
It is hard to count, or even define, WMPs. They probably topped 12 trillion yuan ($1.9 trillion) by the end of 2012, equivalent to about 16% of commercial-bank deposits, according to Charlene Chu of Fitch Ratings. But that figure counts only the products issued by banks, which typically offer pedestrian returns of about 4% on average. It does not include investments like the 160m-yuan product issued by Zhongding Wealth Investment Centre, which promised returns of 11-13%, according to Reuters, from investments in car dealers, a TV production firm and a pawn shop.
This now infamous product was sold to customers at Hua Xia bank in Shanghai by one of the bank’s employees. But the bank does not consider itself liable for its failure, as hundreds of aggrieved investors discovered when the product defaulted at the end of November. Unnerved by the Hua Xia case, China’s banking regulator has told banks to carry out urgent internal checks of all the third-party products they are peddling.
China has both a surplus of saving (almost half of GDP in 2012) and a shortage of suitable vehicles for that thrift. The bond market is small, especially for retail investors, and the stockmarket is suspect, thanks to shaky auditing and rampant insider trading. Property remains popular, but the government has tried to curb speculative home purchases. For many, bank deposits remain the default option. But they earn a meagre rate of interest, capped by the government.
Given these alternatives, it is easy to explain why investors are flocking to WMPs. It is harder to explain why the government tolerates them. Why does it impose a ceiling on deposit rates, even as it allows banks to issue close substitutes at whatever yield they can get? Why retain a regulation, then let banks work around it?
It appears paradoxical. But this approach to financial reform is in keeping with China’s approach to all economic liberalisation. It reforms piecemeal, crossing the river by feeling for the stones, as Deng Xiaoping, its former leader, put it. After 1978, for example, it kept many of the central plan’s existing quotas in place. But it also allowed farms and then firms to sell anything extra at whatever the market would bear. Rather than throwing out the plan, China grew out of it, as Barry Naughton of the University of California, San Diego, has put it.
Some analysts hope that WMPs will help China’s banks to grow out of the country’s financial plan, forcing them to compete for custom among choosy investors who will happily defect to a rival bank offering better terms. Through WMPs, lenders can dip their toes into competitive banking, just as farms and firms in the 1980s embraced the market even as they continued to fulfil their duties under the plan. But this approach works only if the government can continue to enforce its quotas and price controls. In the case of banking, this is a difficult trick to pull off. The government can control the price of deposits but it cannot control the quantity that firms and households are willing to provide. The rapid growth of WMPs suggests that depositors are switching to these products in increasing numbers. “China’s previously sticky deposits are losing their adhesiveness,” notes Ms Chu.
The problem is that the state may still have to pick up the tab if things go wrong. Although only 15-20% of the WMPs issued by banks are explicitly guaranteed by them, in practice banks would probably stand behind their own products. (Third-party products sold through banks are a different matter.) In pushing their WMPs, banks are trading on their own credibility. But this credibility is not theirs to sell. It is borrowed from the state.
China’s government has closed only one bank in the past 15 years. And deposits enjoy an implicit state guarantee. Until recently, Chinese banks enjoyed this state protection at the cost of limited freedom. The introduction of WMPs has granted banks more freedom without any obvious loss of protection. Because the state’s deposit guarantee is not explicitly stated it is not explicitly limited either. Many WMP-buyers probably take comfort from it. They might rethink if China introduced formal deposit insurance, limited in scope and financed by the banks themselves.
In the meantime, third-party products like the one sold in Hua Xia bank must be allowed to fail. The loss would provide a striking illustration of the risks of financial speculation, painting a picture even China’s muralists would struggle to match.
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