Are developers ending their affairs with China’s shadow banking system?
“Debt disguised as equity investment” loophole has been widely used by banks to skirt regulations
As they say in China, whatever policies the central government introduces, the lower levels of power will find a means to counter them.
Look no further than Beijing’s uphill struggle to cool the country’s surging home prices.
While the China Banking Regulatory Commission has ordered banks to tighten lending to developers, those homebuilders and institutions have found ways, even before the curbs gained traction, to skirt the rules to secure funding for aggressive land purchases.
Just last week, regulators moved in to close a loophole that enabled the rampant practice of using equity investment as a cover up for debt through trust loans.
“If developers can borrow from banks directly, they wouldn’t bother to use trusts [firms]to design such a complex structure,” said Yuan Jiwei, an analyst with Huarong Trust.
This is how a trust loan works, according to a financing proposal by developer Hubei Changtou Shiye, seen by the South China Morning Post.
To raise funds to pay for a site in Wuhan in central China, Changtou Shiye has proposed to sell a 75 per cent stake in the project company that will develop the property on the site for 3.9 billion yuan (US$574 million).
Changtou Shiye is not eligible for a bank loan because under CBRC regulations, developers who apply for loans for development after the land is acquired must have obtained four key certificates including the land use rights and construction permits.
Changtou Shiye wouldn’t be able to provide the permits as it has not acquired the site. In its proposal, the company pledges to inject 1.3 billion yuan into the project company and take the subordinate investor role, meaning it bears larger risk, and possibly takes a bigger return of the project.
Investors who contribute to the 3.9 billion yuan will be senior investors, and Changtou Shiye promises to buy back the 75 per cent equity after three or four years at an unspecified premium price when the development is finished and sold, and to deliver an annual return of 8.5 per cent.
The senior investors will be pooled into a trust scheme set up by a trust, and institutional investors, mostly banks, would buy into the scheme and become the “trustees”.
The arrangement allows banks to skirt around the restrictions to lend to unqualified developers and to invest in non-financial companies. In theory, trustees are shareholders of the project company who will bear the risks of the project.
But by including the buyback clause in the proposal, banks are spared the risks. Such arrangements are widely known as “debt disguised as equity”, which also lowers the borrowers’ debt ratio, that could also facilitate further borrowings.
In some cases, an additional layer of a limited partnership fund is introduced to the project company, which invites other financiers to become limited partners of the fund, while an asset manager (usually a subsidiary or related company of the developer) becomes the general partner. The extra layer can obscure the real ownership, and the general partner can collect management fees.
Until the regulatory crackdown, previous land fundings had fueled land price rises last year, which created many “kings of land” – developers who acquired sites at record prices.
In June last year, Cinda Real Estate paid for a site in suburban Shanghai at four times the starting bid price, with support from its parent company China Cinda Asset Management, one of China’s big four distressed asset managers.
In response, China’s securities regulators reinstated last October a restriction on bond financing, shutting off a major funding channel for developers. In February this year, the restriction was broadened to banning asset managers from channelling funds to developers in 16 key cities.
The authorities sent shudders through the trust industry in April when the Shanghai office of CBRC fined the Shanghai branch of China Merchants Bank 4.2 million yuan for its interbank investment towards an asset manager that helped a developer acquire a land site.
What had also deterred trust firms is a landmark verdict last November that denied New China Trust’s claim after the borrower – the developer – went under. The trust held 80 per cent of the project company and had been guaranteed a return for the loan.
More recently on May 24, the CBRC confirmed that it is conducting on-site inspections to check whether trust firms are financing land acquisitions.
An executive with a Hebei-based trust firm, who requested anonymity, said all the trust firms that he knows had stopped such practices after the inspections.
The trust firm which had shown the Post the Changtou Shiye proposal, said it had decided not to bid, due to possible regulatory risk.
Beijing’s measures seemed to have taken effect as residential land sales in 300 Chinese cities in May fell 23 per cent from April to 146.2 billion yuan, according to the China Index Academy. Average premiums in first-tier cities had fallen to 20 per cent, the lowest in the past five years.
On the demand side, buyers were hit by a rise in mortgage rates in first-tier cities. Rates for first-time buyers in Beijing, Shanghai, Guangzhou have been raised to 10 per cent over the benchmark rate in recent days. For second-time buyers rates are at least 20 per cent over the benchmark.
Is the cosy relationship between developers and shadow banking genuinely coming to an end? Probably so, until the lower level players find another loophole.