Surge in China internet money funds is risky

The money market fund offered by Alibaba, China’s leading ecommerce company, has gathered the equivalent of $65bn in less than one year. During that period, the assets of all money funds sponsored by internet companies have soared to the equivalent of more than $100bn.

In response, the governor of the Bank of China recently suggested that this new online product needs to be supervised closely. What are the benefits and risks of these internet money market funds, and how should they be regulated?

Chinese savers have rushed to internet money funds because they have much higher yields than the interest rates on bank deposits. Internet money funds offer yields of around 6 per cent per year, almost twice the average interest paid on a one-year bank deposit.

Internet money funds are quite convenient for the millions of Chinese savers already signed up for internet payment services, such as Alipay or WeChat. These savers can buy internet money funds through apps on their mobile phones and can then make withdrawals the same way on any business day.

Chinese savers have long been frustrated by low interest rates on bank deposits, which are capped by regulators. These caps were designed in part to promote economic growth by allowing state-owned banks to make cheap loans to local enterprises, often at the behest of the government.

Despite general promises in the past to deregulate interest rates, the Chinese government has not actually lifted interest caps on bank deposits. Last week, however, the boom in internet money funds led the Bank of China to publicly commit to “interest rate liberalisation” within two years.

Similarly, the rise of US money market funds led to the removal of interest rate caps on bank deposits in the late 1970s. These caps were doomed when funds offered yields above 15 per cent.

The higher rates offered by internet money funds allow the average Chinese citizen to earn reasonable investment returns without enduring the sharp volatility of the domestic stock market. These funds also provide much more liquidity than investments in property, where the government has been concerned about the bursting of a bubble.

Internet money funds have put a lot of their assets into interbank loans and deposits, which are not subject to interest rate caps. But some state-owned banks have started to refuse investments from such funds, while others are beginning to launch their own money market funds.

At the same time, internet money funds provide an alternative source of loans to small and medium-size enterprises. China’s banking sector is dominated by huge state-owned banks, which lend mainly to state-owned enterprises. Neglected by the large state-owned banks, SMEs are glad to borrow from internet money funds.

Despite all these benefits, there are legitimate concerns that should be addressed by regulators. Most importantly, Chinese savers need clear disclosures about the risks involved with such funds – prominently displayed on the website of fund sponsors, right next to any promotional material.

Specifically, regulators should insist on several disclosures by internet money funds: that they are not bank accounts and are not guaranteed by the government; that they are invested in commercial loans, banks deposits and certain bonds; and that these investments may result in significant losses to the funds.

Moreover, internet money funds should disclose that their interest rates will fluctuate over time. Although the yields on these funds exceeded 7 per cent at their peak, they are now in the range of 6 per cent. And their yields could drop as low as 4 per cent as market conditions change.

In addition, to ensure that they can meet redemption requests, internet money funds should maintain a specified percentage of their assets in cash equivalents and limit the average maturity of their portfolios to a specified number of days. As competition heats up, some funds will reach for yield by making longer-term loans.

In short, the internet money fund is a financial innovation with tremendous potential benefits to Chinese savers, business enterprises and the whole economy. Nevertheless, innovations can be abused, as we saw in the last financial crisis. So regulators should promptly adopt disclosure and liquidity requirements to protect investors.

Robert Pozen is a senior lecturer at Harvard Business School. This article was co-authored by Theresa Hamacher, president of Nicsa