China’s Ticking Debt Bomb

A real estate bust may push shadow lenders into default | “Trusts have become too large to fail”

Luo Jun and Bonnie Cao

Chinese savers helped fund construction of Kangbashi, the cultural district of Ordos, where buildings now sit empty


In the U.S. housing crisis, investors lost billions by buying into complex derivatives backed by subprime mortgages. In China’s version of the real estate bust, it’s a plain-vanilla financial product known as a trust that has been around since the 1970s that threatens to wreak havoc.

These investments that pool savings are at the center of a housing bust playing out in Ordos. The city of 1.9 million in Inner Mongolia, rich in coal and cashmere, is dotted with unfinished real estate projects. Among the more than 1,000 that have ground to a halt is the Purple Palace, a residential complex that contains a luxury hotel. Dozens of investors from across China put 445 million yuan ($71.2 million) into a trust to fund its construction. The sales prospectus promised an annual interest rate of at least 10 percent and return of principal by March 2013. The issuer, New China Trust, did not mention that work on the project had been halted for more than six months when it updated investors in October. The company didn’t respond to calls seeking comment, and a contact number for the developer, Ordos Jin’ao Property Development, couldn’t be located. An official who declined to give his name at Ordos Jinshan Property Development Group, identified in the prospectus as a former shareholder of the project, confirmed the project is on ice.

Trusts are the fastest-growing segment of China’s nebulous world of shadow banking, which encompasses all financial activity that takes place outside the formal banking system. These investment vehicles date back to the 1970s, when China’s central and local governments used them to raise funds. In their present incarnation they pool household savings to offer loans and invest in real estate, stocks, bonds, commodities — even bottles of sorghum liquor.

Trusts have flourished because more than 90 percent of China’s 42 million small companies don’t have access to bank loans. At the same time, most of the nation’s savers are starved for yield (interest rates on bank deposits are often negative once inflation is factored in) and are attracted to the double-digit returns the trusts advertise. The upshot: Trusts now account for more than a quarter of China’s estimated $3.35 trillion in non-bank lending, according to a UBS report.

The industry is set to overtake insurance as the second-largest financial business after banks by yearend, according to a KPMG report. Assets under management rose 47 percent in the 12 months through June, to 5.5 trillion yuan, according to the China Trustee Association. Trusts are also drawing the interest of global banks: Barclays and Morgan Stanley both own stakes in trust issuers.

Unlike other areas of shadow banking, trusts are supervised by the China Banking Regulatory Commission, which must approve every product. The agency requires trust companies to honor commitments to investors or have their business licenses revoked. To curb real estate speculation, the regulator last year directed firms to stop offering developers loans for working capital or land purchases. The government is also granting fewer new permits: Only 64 trusts are now licensed, down from more than 1,000 in 2002. “China’s nonbanking financial institutions are under strict regulatory supervision,” said Zhou Xiaochuan, the governor of the central bank, at a Nov. 11 press conference.

Despite such safeguards, the industry may be fast approaching a shakeout as China’s construction boom goes bust. In Ordos, the site of the Purple Palace, at least 1,000 construction projects have ground to a halt this year. China International Capital, a brokerage, estimates that as much as 15 percent of China’s property-linked trusts could default on payments by the end of 2013. Issuers may be forced to extend payment deadlines, sell new trusts to pay off old ones, or dispose of collateralized assets, the firm says. “Trusts have become too large to fail,” says Lian Ping, chief economist at Bank of Communications. “Something must be done by the government to stop potential defaults of property trusts from spreading nationwide.”

There have been failures in the past. In 1998, Guangdong International Trust and Investment, which borrowed domestically and overseas on behalf of Guangdong province, went bust. The bankruptcy marked the first time Chinese authorities didn’t bail out a state-owned borrower. Creditors, which included Germany’s Dresdner Bank and Bank One, which later merged with JPMorgan Chase, were stuck with $3 billion in worthless bonds.

Although the industry ultimately recovered, some money managers believe its glory days are behind it. Trusts weren’t even mentioned in the 12th five-year plan China’s top regulators drafted for the financial industry in September. The plan detailed development guidelines through 2015 for banks, brokerages, mutual funds, futures firms, insurers, and fledgling informal lenders such as loan guarantors and pawnshops. Says Fan Jie, an analyst at researcher Benefit Wealth: “This speaks loudly of regulators’ concern about the unruly expansion of trusts and their sustainability.”

The bottom line China’s booming business of trusts may be imperiled by a construction binge that has forced several developments into bankruptcy.


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