In Chapter 5 and 17 I briefly mention that due to the current legal and financial system on the mainland there are very few financial alternatives and investment vehicles to park funds.

As a consequence, wealth management products (WMPs) such as trust companies are a new type of wealth management service that collectively amounts to more than $1 trillion and is considered to be an integral part of a “shadow” banking system (e.g. off-balance sheet transactions).  According to Xiao Gang, chairman of Bank of China, there are 20,000 WMPs in circulation currently.

It should be pointed out that the term “shadow” has been hyped up and distorted by many analysts to mean the equivalent of “shady” and “fraudulent.”  In economic terms, while there may be illicit or fraudulent activity taking place (e.g., money laundering), all the “shadow” activity technically forms part of the larger informal economy.

That is to say, given continued financial reforms, some of these 20,000 WMPs could eventually integrate and become part of the formal economy.  While there may be any number of pyramid and Ponzi schemes in this segment, this is not to say that the entire $1 trillion under management will all collapse into nothingness (it could, but you cannot say it a priori).

How does it work?

I asked a Chinese friend, Kevin C, to briefly explain how he manages his assets in this alternative system.  Here is his response:

I began my first “shadow” investment in the early part of December 2012.  The “shadow” bank system offers different deposit terms ranging from 1 month to 6 months and sometimes up to12 months (which is the longest).  Most companies originally offered interest rates from 17% per year last year, however this has been reduced to 13-14% per year now.

There are more than ten public companies operating this kind of private investment path and promote it via their websites.  In order to open an account, you need to register a user ID and mobile number.  In addition, you need a Chinese National ID Number, plus your personal bank account number which will be used to transfer money back to your account.  In practice, I have placed 80% of my capital in the 1 month term,15% in a 3 month term and 5% for longer terms.

I try to choose the company carefully before make my own investment and of course there is no single website can guarantee 100% safety.  However, if it doesn’t look like a short term business for those companies which I believe, as long as they offer a one month product, I think it will be relatively safe to me.

As far as trying to fund it through debt like credit cards, I looked into taking out a simple loan and found out that the monthly interest rate that I would owe actually outpaces what I would receive in return from one of these private investment plans.  So I am actually using my own money to try this out.  So far so good.  And even though I still worry about the risk, as I said before, the one month term is the most attractive to me for this reason.

Again, I am not endorsing this service.  In fact, it is really hard to see how this particular service can provide these high rate of returns in the long term and may in fact be powered solely through speculation and exuberance.

Perhaps these 10+ firms Kevin mentions do not even reinvest the capital into actual productive projects but merely recycle the money to other customers cashing out each month.

Or perhaps other customers do fund a lot of their investments through debt (e.g., borrowing to reinvest it into one of these 10 firms) and have a great deal to lose in the event one of the companies goes bankrupt.  Either way, this was just an example to give you an idea of what the process is like.

For more on this topic see:

• Examining China’s ‘Shadow Stimulus’ from The Wall Street Journal
• In China, Hidden Risk of ‘Shadow Finance’ from The Wall Street Journal
• Regulating shadow banking from China Daily
• Uncertain foundations from Financial Times
• China to tighten shadow banking rules  from Financial Times
• China’s brokerages turn shadow banks from Financial Times
• Don’t Worry About Wealth-Management Products, Regulator Says from The Wall Street Journal