- A speech at a luncheon The Slow Bull Capital hosted in Guangzhou for a group of foreign investors on 20 October 2012.

Ladies and gentlemen, thank you for giving me the opportunity to speak to you today. My name is Joe Zhang, and I am a director of Wansui Micro Credit in Guangzhou. I'd like to speak about China's banks and shadow banks from a regulatory perspective, and then highlight a few investment opportunities.

Broadly, my take on the subject is this:

First, I think the biggest problem facing China’s banking sector is a huge efficiency loss due to interest rate controls. However, I do not believe an NPL problem is looming on the horizon.

Second, the fact that the economy has survived two years of severe credit crunch on the real estate sector shows just how resilient the economy has become. Note that this has happened against the backdrop of a thirty-percent decline in the stock market index.

Finally, while you all worry about shadow banks in the form of micro credit companies and unorganized lenders, I think the real shadow banks are trust companies and banks’ wealth management products.

Since 1978, China’s real GDP has grown by a compound annual rate of 7.8%, while bank credit has grown by almost 19% CAGR. The gap between the two growth rates can only be explained away by monetization of a planned economy, and inflation. While it is hard to quantify the two factors separately, we can safely assume that inflation is a big component of the gap. With persistently high inflation in these 33 years, real interest rate on bank credit has often been too low and even negative. Whoever gets credit rations gets a huge subsidy. No wonder it is usually SOEs, the well-connected and ‘the brave’ who gets credit rations. It is also little surprise that the most successful businessmen in China today are usually in real estate, as the leverage here is the highest.

On the one hand, small businesses (and needy consumers), deprived of bank credit, have turned to unorganized credit market. On the other hand, savers, dissatisfied with low rates of interest on bank deposits, have chosen to lend to small businesses directly, bypassing banks. When I was a junior officer at the People's Bank of China in the 1980s, part of my responsibility was to monitor and clamp down on underground lenders. In recent years, while this informal credit sector has been decriminalized, it is still subject to discrimination on the part of the public and the government.

How big is this sector? No one knows for sure, but some put it as high as one trillion renminbi. While a big number, it is equivalent to only 1.6% of total bank credit as of last June. In the meantime, the officially licensed micro credit sector and pawnshops control a total of only Rmb600 billion in outstanding credit balance.

In contrast, the so-called wealth management products managed by 60-odd trust companies have surged from merely Rmb1.2 trillion as of end-2008 to Rmb5.54 trillion as of June 2012. That is equivalent to as much as 9% of total credit in the bank sector! In addition, banks have sold many similar wealth management products without the imprimatur of trust companies. They typically pay savers 7-16% p.a. and charge fund users 10-20% p.a.. To put these numbers in perspective, the official benchmark deposit rate at banks is only 3% p.a.and benchmark lending rate 6%. These so-called wealth management products typically go to fund real estate projects, local governments’public works projects, and businesses in distress. To me, they are truly shadow banks!

What about micro credit firms, pawnshops and the unorganized credit sector? To start with, their combined size is less than one-seventh of the wealth management products operated by trust companies and banks. Secondly, I have every reason to believe that this sector is significantly more prudent and thus safer than banks when it comes to lending because people mainly use their own money, and lending decisions are decentralized. In contrast, wealth management products are other people's money as far as trust companies and banks are concerned, and credit decisions are far more centralized (read: more risky).

The Chinese government is obsessed with keeping interest rates low. This has contributed to inefficiency in resource allocation by making bad investments seem viable. Today's industrial overcapacity is just one symptom of our ills. Keeping interest rates low has also made corruption much worse as there are gains to be had as long as you can obtain credit. Finally, the ill-advised interest rate policy is a major factor in the country's growing inequality between those who have access to credit and those who do not.

As you know, the Chinese government is very good at making rules and then finding ways to violate them. In the 1980s, the government created a monster in trust and investment companies (so-called itics). These 200-plus itics took corporate deposits, made reckless loans, played financial derivatives and drank expensive Maotai. They did not have to comply with the interest rate controls imposed on main street banks. In the end, they caused havoc to the economy. They even made sub-prime lenders in the US seem overly prudent. In the 1990s, this sector went bust, and the Chinese government resuscitated it into today's 60-odd trust companies. But I think they are just as dangerous as their predecessors.

Why does the Chinese government strictly control interest rates at banks, while allowing trust companies to openly attract funds via wealth management products at whatever interest rates? I do not understand it, but that is consistent with its bad regulatory tradition. As if the loophole officially created for trust companies were not big enough, the government also allows banks to sell wealth management products, for third parties (like trust companies) and for themselves. Defenders of this ‘innovation’ may argue that these wealth management products are no deposits. But are they really not? To me, and to millions of customers, they are just deposits in another name, and at much higher interest rates. Whenever there is a trouble in the return of the money, it is the banks, and the trust companies that will be called upon to foot the bill. In this respect, they are no different from the Lehman Brothers Bonds sold in Hong Kong in the lead-up to Lehman's collapse in 2008.

In case there is still any doubt, let's make this point clear: the huge pool of money in wealth management products (equivalent to 9% of total bank credit, and counting!) has not gone to fund the safest pursuits in the economy.

Speaking of shadow banks, one has to mention China’s sprawling private-equity and hedge-funds industry. While no one knows the real size of the sector, I am of the view that they can generally take care of themselves and that they will pose no threat to the rest of the economy. In the past ten to fifteen years, private equity funds of various shapes and forms have made a killing thanks to the Chinese government's heroic efforts to keep the stock market valuation inflated. Even if the next decade proves to be disastrous, I think the private equity people can still laugh all the way to the bank. As to hedge funds, they have always looked after themselves, and since they have already survived a decade of bear market (with the only exception of 2006-2007), I think they are nimble enough to be harmless to the economy.

How is the Chinese economy? While I do not pore over all sorts of statistics these days the way I used to do when I was a stock analyst, I want to point to two data points. First, bad debts are rising not just at the three micro credit companies I have personally invested in, but also at banks. My comrades and I have also found that it has become harder to find good quality borrowers. This trend will continue for a while until our industrial overcapacity problem somehow gets mitigated.

Do I sound bearish? No. I am actually quite optimistic on the Chinese economy in the next few years. I am very surprised how well the economy has adapted to the official clampdown on the real estate sector. It is now over two years since the government imposed a wide range of restrictions on the real estate sector, including turning off credit tap, controlling home prices, and preventing residents buying second or third homes. All this has happened against the backdrop of a two-year decline in the domestic stock market that wiped out one-third of the equity market value.

Still, you see crowded restaurants, busy shops, packed flights and rising exports. In this age of diminished expectations, we should be happy about what we have.

In the past few years, I visited a large number of banks and non-bank financial institutions, and get to know some of them well. I saw a huge disparity in their operational efficiency. Now, let's talk about several well-managed shadow banks  ...