Friday Letter: Cracking China

A difficult operating environment isn’t stopping non-bank lenders and more informal banking channels making their mark in the People’s Republic of China.

Some interesting insights into ‘shadow’ banking emerged from PDI’s Corporate Debt in China event in Hong Kong last week.

A report from S&P in June set alarm bells ringing when it said corporate debt sourced from China’s shadow banking sector had reached between $4 and $5 trillion in 2013, or roughly 30 percent of the $14.2 trillion total.

Sound like a systemic risk disaster waiting to happen? Maybe not. For a start, state-owned and therefore regulated banks still dominate the market. Also, most debt in China is domestically created, thus shielding the country from the risk of capital flight in the event of bubbles bursting in any over-leveraged parts of the economy.

And in any case, more shadow banking in China isn’t necessarily a negative development, Shaun Roache, resident representative in Hong Kong SAR of the International Monetary Fund, told the PDI Forum. If done correctly, it will in fact broaden access to credit for many. With non-performing loans rising “very quickly”, China is also going to need a bigger distressed market, Roache said.

In fact, what shadow banking there is in China looks more like ‘traditional’ banking with loans linked to deposits. The fast growing ‘trust loan’ sector and high yield bonds, a few of which have experienced defaults this year, have seen their creditors bailed out by the state-backed monetary system. High yield bond pricing in particular doesn’t reflect the risk attached, industry sources remark.

Amid this back drop, fund managers currently lending in China include SSG Capital Management, Double Haven and Adamas Asset Management. In the non-performing loans segment, Shoreline Capital and DAC Financial Management are breaking ground, and recent comments from Howard Marks, suggest his firm Oaktree might also enter.

While some of these incumbents are making returns of around 20 to 25 percent according to market sources, Greg Donohugh, chief executive of Double Haven Capital (Hong Kong) expressed concerns that these numbers could create a false impression with investors abroad who think returns like this are linked to debt risk when in reality it is equity. 

In light of this, investors seeking exposure to the segment clearly ought to tread carefully. Unsurprisingly, LPs speaking during the Forum’s investor panel said that they would only allocate to private debt in China by way of a multi-credit strategy, as the asset class was still young with an unproven track record. Here the message was that longer duration specialist credit platforms make a lot of sense but they need people with the right skill set and local presence. On non-performing loans, LPs and managers alike noted that it was a cyclical business and therefore often a waiting game.

The upshot from the conference was this: lending in China is a risky business but the allure of high returns persists, pushing investors to seek opportunities in the region. The legal framework, the relationships between local and central government and the movement of currency in and out of China are just a few of the high barriers to entry. To make a successful yet safe debt investment in China, a thorough understanding of all the nuances is essential – as well as plenty of patience.