A man walks along a steel beam

Within a few minutes of driving into Langfang, it is clear that China’s property boom is still going strong. At a traffic light, a tout knocks on the car window with a leaflet advertising a new housing development, Lion City. A second leaflet – for the sprawling 19 City States villa complex – is inserted under the windscreen wiper, followed quickly by a third, for Happy City.

A red-hot housing market might not seem unusual in China, where real estate prices have soared over the past decade. But what is happening in Langfang, one hour’s drive from Beijing, and other cities is new and potentially far riskier than anything that came earlier. Since 2010, the government has tried to cool the property market and made it virtually impossible for developers to secure loans from banks. Starved of cash, developers were forced to slow down.

But as the Langfang boom shows, property companies are finding funds again. The money is not coming from banks as the regulatory controls on loans to developers remain. Instead, developers are turning to China’s shadow banking system, a complex network of financing channels outside the formal banking sector.

Shadow banking is flourishing in China, helping to make non-bank institutions as big a source of credit as banks themselves since July – something that has never happened before. Chinese bankers, leading rating agencies and the International Monetary Fund have all warned about risks from the surge in loosely regulated lending, with some even pointing to parallels with developed economies before the global financial crisis. But the Chinese government itself has taken a permissive stance.

“The vast majority of the financial activities conducted by China’s non-bank institutions are regulated,” says Zhou Xiaochuan, China’s central bank governor. “It’s not like other countries where they completely escaped regulation.”

Despite this note of confidence, the depth and effectiveness of regulatory control is a matter of open controversy. The chairman of Bank of China, a big commercial lender, is far more candid about the potential hazards of shadow banking.

“To some extent, this is fundamentally a Ponzi scheme,” Xiao Gang wrote in the China Daily. “The music may stop when investors lose confidence.”

Shadow banking in China assumes various guises. The most basic are the illegal loan sharks who operate mainly in wealthy coastal regions, providing high-interest loans to small businesses that are often ignored by mainstream banks.

But most of China’s shadow banking is legal. The biggest of the non-bank institutions are trusts, companies akin to hedge funds. They cater to rich investors and promise high returns by lending to risky customers, especially property developers. A range of industrial companies, from shipbuilders to oil majors, also engage in shadow banking as a side business.

Estimates about the size of shadow banking vary widely depending on how it is defined. Tying together various threads of official data, UBS economist Wang Tao believes it is no smaller than Rmb13.6tn ($2tn), or about one quarter of this year’s gross domestic product, and could be as big as Rmb24.4tn, or nearly 50 per cent of GDP.

For all the difficulties of making a calculation, one thing is apparent: its rapid growth. Trusts, the backbone of the shadow sector, had Rmb6.3tn of assets under management at the end of the third quarter, up 54 per cent from a year earlier and five-times more than at the start of 2009. KPMG says trusts could surpass insurance this year as the second-biggest institutional component of China’s financial system, smaller only than banks.

A senior commercial banker who worked as a regulator until last year says the complexity of the shadow products was also increasing. “It has begun to get to a degree like we saw in the financial crisis in the west. Products are being created that regulators don’t fully understand, banks don’t fully understand and customers don’t fully understand,” he says.

When wealthy Chinese invest directly in trust products, it is clear that they are getting into shadow finance. That is far less clear with wealth management products, or WMPs – but these are the rocket fuel behind the surge in shadow finance.

Banks market WMPs to ordinary customers as higher-yielding alternatives to plain deposits. Even though these are highly visible mainstream lenders, they do not disclose in detail that these higher yields are obtained by putting much of the money to work in shadow finance.

Banks issued just Rmb800bn of WMPs in 2007 but are expected to surpass Rmb20tn this year, according to CN Benefit, a wealth management consultancy. In effect, for every three renminbi saved in ordinary banks, Chinese households and companies will soon be depositing one with shadow banks.

China Construction Bank, the country’s second-biggest bank by assets, is typical of its peers in marketing its WMPs. Outside one branch in the Chaoyang district of Beijing, a long screen stretches over the windows advertising the latest WMP deals. But a saleswoman is at a loss to explain what the WMPs actually finance: “It’s the investment banking department that manages these funds. Even we don’t know what they invest in.”

The IMF flagged the opacity as a concern in its global financial stability report in October: “As detailed information on those assets is not disclosed, it is difficult to gauge the underlying credit risk.

For this article, the Financial Times examined more than 50 WMPs available at Chinese banks. The vast majority gave hazy descriptions of how the money would be used. The Bank of Communications, for example, explained that 30 per cent to 100 per cent of the funds raised through one of its WMPs would be invested in bond, money-market instruments or the interbank market – and that up to 70 per cent might go to trust products. It provided no further details.

Of the WMPs surveyed, the FT identified only one that specified its target investment. When the Bank of Hebei sold a 5.5 per cent one-year WMP in October, the fine print said it would finance a trust loan to RiseSun Holding Company, the parent of RiseSun Real Estate Development, one of Langfang’s biggest property companies.

Langfang, a city of about 700,000 people, sits under a thick blanket of smog between Beijing and Tianjin, both of which have populations of more than 10m. At Green Mansion, a 10,000-apartment complex that is one of six RiseSun developments under construction in Langfang, a sales agent enthuses about the city’s potential as a commuter hub. But RiseSun is far from alone in pursuing the market, a fact shown by the touts handing out property advertisements.

To stay ahead of the competition, RiseSun has been scaling up quickly. Moneyweek, a Chinese financial magazine, said it had been “crazily buying up land”, funded by obtaining money from its parent company, which in turn had pledged equity as collateral to trust companies. The deal structure could allow RiseSun Real Estate, the listed entity, to appear less indebted since it is RiseSun Holding, the parent company, that is borrowing from outside sources.

Put simply, this means that customers at the Bank of Hebei who have been buying WMPs, reputed to be as safe as deposits, have actually been financing shadow loans to a property developer clocking up debt in a city with a frothy housing market.

Asked about the WMP, RiseSun Real Estate denied any knowledge of how the funds would be used: “The product invests in RiseSun’s stock rights held by our parent company. Thus it has nothing to do with our business.” The company added that its 78 per cent debt-to-equity ratio was safe and in line with the industry average.

Still, the most obvious risk in shadow banking is that of defaults. Shadow banks have generated good returns precisely by financing the businesses shunned by banks. The rates on the trust loans to RiseSun, for instance, have been as high as 12.5 per cent, roughly double the official lending rate at Chinese banks.

But the regulator has ordered banks to rein in their lending to property developers for a reason – their debts have soared over the past five years. There are signs that shadow banks could now be running into trouble.

China Credit Trust, the country’s third-biggest trust company by assets, said in June that it was struggling to obtain money from one of its borrowers, Zhenfu Energy, a coal company. A month later, Huarong International Trust was repaid only after a local government bailed out its client, LDK Solar, a maker of solar panels.

There are other problems as well. Chinese banks have long hewed to a dull lending model, making 80 per cent of their profits from interest margins guaranteed by regulatory controls. The rise of shadow banking is undermining that model as banks compete for customers by offering higher rates. “The drive to maintain profitability …could push the banks to increase lending to higher-risk borrowers,” Moody’s analysts write.

There is also concern about the stability of the funding base for shadow banks. The most popular WMPs have durations of one to three months. But the funds provide financing for much longer terms, often multi-year loans. A trader at one of China’s 10 biggest banks says his bank manages all the money raised from the WMPs in one large asset pool. The duration mismatch is not an issue so long as the bank can redeem maturing products with money flowing in to buy new ones. “There is huge demand for WMPs now, getting buyers is not a problem,” he says. “But if the asset pool stopped growing some day, it might explode.”

All the worries about shadow banking give rise to one big question. China does not shy away from using heavy-handed regulation to control the financial sector. So why is it allowing such a risky business to take off?

Ms Wang of UBS believes that an inherent contradiction in policy objectives has laid the groundwork for the shadow banking boom. On one hand, regulators have tried to keep banks safe by capping their lending.

On the other hand, the government still wants to maintain fast growth, which requires plenty of credit, and has therefore chosen to leave shadow financing channels open. “The risks will rise if the distortions are not addressed and non-bank financing gets more sophisticated,” she says.

But for the time being, regulators have displayed little inclination to halt the ascent of the shadow banks.

Shi Dawei, 59, an art teacher in Shanghai, says he has started shifting all his savings into wealth management products offered by Minsheng Bank, one of China’s biggest lenders.

“I don’t have the smarts or the time to invest in the stock market,” he says. “I don’t care where the WMPs are invested, so long as they are classified as low risk.”

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