Why China's regulators are taking on local governments over their financial asset exchanges

BEIJING (CAIXIN GLOBAL) - As infamous corporate raider Shenzhen Baoneng Investment Group searched for ways to fund its ultimately doomed expansion into finance, property and new-energy vehicles, its own employees were encouraged to invest.

The group, which collapsed last year under a 200 billion yuan (S$42 billion) mountain of debt, set up a platform on its internal network called "Employees Win."

Clicking on the icon gave staff direct access to five local financial asset exchanges (FAEs) across the country where they could buy wealth management products (WMPs) issued by Baoneng-linked companies.

Baoneng wasn't the only cash-hungry company to tap these relatively low-profile but popular local exchanges. HNA Group, China Evergrande Group and UCF Holdings Group each raised billions of yuan on these markets, according to a Caixin analysis, adding to the buildup of unsustainable debt that eventually crippled them.

HNA, which is undergoing a bankruptcy restructuring and has liabilities of more than 1.1 trillion yuan, has more than 30 billion yuan in outstanding privately offered financing products (POFPs) listed on several exchanges, while UCF Holdings has around 45 billion yuan of outstanding products, Caixin has learnt from sources with knowledge of the matter.

How these companies, and many more, used FAEs to sell POFPs, including WMPs, often to unqualified investors, highlights the regulatory flaws of a well-intentioned policy to provide an open and transparent venue for local state-owned enterprises, bad-debt management companies and banks to sell nonperforming assets.

Local exchanges "deviated (from their original purpose) and turned into channels for illegal financing … for those wanting to raise money, and some even became illegal self-financing channels for individual companies," a source close to regulators told Caixin. "They have turned into a new kind of hidden risk."

Now, after years of playing whack-a-mole, financial regulators are planning a decisive strike to end the chaos. On Dec 17, a nationwide cleanup of local FAEs was announced by an inter-ministerial committee (IMC) consisting of dozens of government agencies led by the China Securities Regulatory Commission (CSRC).

The committee was set up in 2012 to oversee work to improve supervision of the exchanges. The measures include: a ban on local government financing vehicles (LGFVs) and real estate companies or property projects using them to raise money; reinforcement of an existing requirement that limits each provincial-level region to one exchange; restatement of existing bans on the sale of products to retail investors and on cross-province business.

News of the cleanup was followed on Dec 31 by the publication of a draft of long-awaited rules to strengthen coordination between financial supervision bureaus controlled by local authorities and central government financial regulators including the People's Bank of China (PBOC) and the banking and insurance watchdog.

The Regulations on Local Financial Supervision and Administration aim to clarify the responsibilities of central and local financial watchdogs, and set up a unified regulatory framework. The rules, which cover local FAEs, should help to improve supervision of the exchanges and stop illegal financing activities and scandals that have dogged them, industry insiders say.

Local FAEs have a relatively short history - the first two were set up in 2010, in Tianjin and Beijing. With insufficient oversight from the provincial-level governments responsible for approving and supervising them, the number of exchanges mushroomed.

Many degenerated into unruly free-for-alls where funds were frequently raised illegally and where collusion among some local officials, intermediaries and the companies raising money was not uncommon.

At the peak in September 2020, there were around 74 registered local FAEs scattered across the country, He Qiang and Qian Jing, lawyers with Hiways Law Firm, wrote in an analysis published in the Shanghai Legal Studies that year.

By July 2019, the outstanding debt financing products on local FAEs across the country had reached 851.7 billion yuan, involving some 1.2 million individual investors, CSRC Chairman Yi Huiman revealed that month at an IMC meeting to discuss rectification of irregular financial exchanges. "The decline in the size of the market has been slow, and the risks cannot be ignored," he said.

The government and regulators have been slowly putting in place a supervision mechanism for the exchanges since 2011. But the authorities struggled to keep up with the innovative ways local governments and the exchanges themselves skirted rules aimed at improving supervision and stamping out illegal fundraising activities.

The exchanges became an increasingly important source of funding for real estate companies and LGFVs after the government started its financial deleveraging campaign in 2016 to contain the country's rapidly growing debt-to-GDP ratio.

The campaign cut off many of their traditional financing channels - the unruly and scandal-hit peer-to-peer (P2P) lending industry was gradually shut down starting in 2016 and an overhaul of the country's US$16 trillion (S$21.55 trillion) asset management industry kicked off in 2018. In 2020, the campaign fixed its attention on the trust sector to rein in the hidden debts of local governments and stop ineligible real estate developers from using trust loans as a source of financing.

The campaign forced these cash-strapped companies to look for other sources of money and they flocked to the lightly regulated local FAEs, where they were able to raise billions of yuan selling POFPs out of sight of central regulators.

Illegal fundraising and financial activities became rampant, often fueled by the implicit or explicit support of local governments, according to Guo Feng, an associate professor specialisingg in investment at the Shanghai University of Finance and Economics.

Local FAEs boomed because they seemed to be a win-win for everyone. Local governments had a vested interest in promoting their FAEs and ensuring their success. They were an important channel for LGFVs to raise money to invest in local projects and for real estate companies to fund their local housing projects, which created jobs and generated fiscal revenue through land purchases and property-related taxes and fees.

Retail investors were happy because the exchanges allowed them to buy investment products even though the rules banned them from doing so. The POFPs they bought gave far higher rates of return than what was available elsewhere. Some products offered expected annualised returns of 8 or 9 per cent, with some as high as 14 per cent, according to a Caixin analysis. That compares with an annualised return of around 2 per cent on China's biggest money market fund platform, Yu'e Bao.

Locals buy these products because they know that if there's any problem with repayment they will be first in line to get their money back because the local government needs to maintain social stability, a person at a local exchange told Caixin.

The exchanges also had far lower entry thresholds than products sold by other types of investment platforms that offered high returns. Trusts, for example, usually demand a minimum investment of 1 million yuan per investor, but the exchanges had a threshold as low as 50,000 yuan and they also offered products with shorter maturities of six months to a year, making them very attractive to retail investors.

The exchanges themselves were eager to attract business because they earned commissions from companies auctioning assets or selling financing products.

Before allowing any product to be sold, exchanges were responsible for carrying out due diligence to ensure the credibility of the issuer and assess the risks. But many skipped the process and turned a blind eye to problems with paperwork submitted by the companies.

"Many exchanges don't care," the person at a local exchange said. "They don't investigate the issuer's qualifications or supervise whether the products are privately placed and who they're sold to. They just care about registering and listing the products to earn commission."

A person familiar with regulators' plans told Caixin that of the 372 companies selling products on an FAE in Yinchuan, the capital of the Ningxia Hui autonomous region in Northwest China, 250 had no credit history in the PBOC's credit reporting system and many were just shell companies.

The actual controller of the Yinchuan exchange was internet tycoon Feng Xin, the founder of online video services company Baofeng Group, who was detained by police in July 2019 on unspecified bribery allegations. The lack of accountability and supervision fueled illegal financing activities and corruption.

In one case, both the chairman and general manager of an LGFV used a local exchange to skirt rules on salary limits for SOE executives. The company issued a POFP through a private placement that paid an interest of 15 per cent and the two executives bought the product themselves, the source said.

In March 2021, an LGFV controlled by state-owned Tianjin Municipal Construction Group missed a deadline to repay 4 million yuan on a 300 million yuan POFP that was registered in April 2019 with a trading institution set up a year earlier in Jinan, the capital of East China's Shandong province.

The institution's second-largest shareholder was Shandong Huazhong Wealth Management, which was placed under investigation in February 2019 on suspicion of "illegally absorbing public deposits."

In March 2021, the trading institution was included in a blacklist announced by Shandong's provincial financial supervision bureau.

Many players in the now defunct P2P sector also got involved in the FAE space. Zeng Keqing, for example, the president of the Nanjing Financial Assets Exchange in Jiangsu province, was heavily involved in Wenzhou Wendu Financial Information Service, a P2P lender. He was detained by police in mid-2020 on suspicion of illegally taking deposits from the public as part of an investigation into Wenzhou Wendu's activities, according to a police statement and sources familiar with the matter.

Some companies were even approved by local governments to set up exchanges to sell their financing products. Public records show that one of the five exchanges listed on Baoneng's "Employees Win" portal, Tianan (Guizhou Province) Internet Financial Assets Trading Center, was set up with the support of the Guizhou government in November 2015 and was approved by Guizhou's financial supervision bureau in 2016. Its registered address is in a government compound in Guizhou's Zunyi city.

The exchange listed a WMP that was connected to Baoneng through a web of subsidiaries that provided various services and credit guarantees for the product. The underlying assets of the WMP, which could only be bought through the internal portal, were debt owed by one Baoneng subsidiary to another subsidiary, Caixin confirmed with several sources at the group.

Exchanges have also been adept at circumventing government efforts to improve the management and supervision of local FAEs, through measures such as changing their names to avoid scrutiny.

A source close to the IMC told Caixin that while the number of formal exchanges has dropped from more than 70 to just over 40, many platforms, such as the filing agencies that help companies register their products, are carrying out exchange business even though their official names don't contain the word "exchange."

But even phrases such as "assets trading centre" and "assets registration" are disappearing from names in favour of more nebulous descriptions as companies try to avoid the need to obtain approval from the State Council or a provincial-level government to run their businesses.

One exchange, Zhejiang Nashua Financial Assets Trading Centre Co. Ltd., was established in September 2016 and is controlled by China Reform Holdings, a stated-owned asset management company under the direct supervision of the central government.

In July last year, it changed its name to Zhejiang Nanjin Information Consulting Service, public records show. Another, Hunan United Credit Assets Registration and Filing Centre, which was set up in 2020, changed its name to Hunan United Economic Information Consulting Service in August last year. An investigation by Caixin shows that Hunan United has on its books 2.1 billion yuan of outstanding POFPs issued by Evergrande Wealth, a unit of China Evergrande Group.

Efforts to stamp out illegal fundraising and other irregular activities at local FAEs have been hampered by the lack of laws and regulations promulgated at the central government level, which means local governments have no guidance to follow. Local financial supervision bureaus, who are mainly responsible for policing local financial institutions, are controlled by local governments rather than the regulatory agencies in Beijing and lack the power or the motivation to act.

"Local governments and regulatory authorities have insufficient understanding of the exchanges and haven't dealt with them as part of the financial infrastructure," a source close to monetary regulators told Caixin. "To attract investment and improve the performance of the economy, local governments have bent the rules to approve exchanges, which has led to repeated misconduct and rectification."

The source with a local FAE told Caixin, "If I am supervising myself, what's the motivation for supervision? If you don't restrain local officials, you'll never solve this problem. There will always be performance impulses and rent-seeking impulses at the local level."

The draft of the Regulations on Local Financial Supervision and Administration issued on Dec 31 is part of broader efforts by the State Council's Financial Stability and Development Committee, which oversees financial sector regulation, to improve coordination between local supervision bureaus and national regulators and to identify and control local financial risks.

These rules, which are also aimed at enhancing supervision of local financial institutions and FAEs, will put pressure on local watchdogs to deal with illegal activities in exchanges under their jurisdiction. It remains to be seen, however, whether the latest round of directives will be enough to root out problems that have become endemic at many local FAEs.

An official at the Beijing Local Financial Supervision and Administration said that cleaning up the exchanges will be a challenging task because no one wants to kill a goose that's laying golden eggs.

"The trouble is that the players involved - the local governments, issuers, and investors - all want to be part of this (FAE space), so it's a really sticky situation," he said.

This story was originally published by Caixin Global.