1. Chinese Real Estate Securitization issues
Abstract
China’s real estate has created many distortions in the economy. The housing market is being inflated by
several factors including government policies and cultural reasons unique to China. Due to local
government’s development methods, large swathes of land are converted for urban and infrastructure
development. This method was pioneered by China Development Bank and its financing vehicles can be
found all over China. This report will look at the conditions regarding land rights issues for local
governments as well as national economic preferences for development that helped spawn such
financial instruments as Local Government Financing Vehicles (LGVF) and Wealth Management Products
(WMP). The financial vehicles that CDB used to assist local governments sell land will be explained.
Finally high profile defaults of these products will be examined.
China’s economic development over the past decades has lifted millions out of poverty and created
billions of dollars of new wealth. One of the largest drivers of China’s economy has been construction,
both real estate and infrastructure. China has very strict regulations regarding land usage and rights,
which erects complex regulatory and bureaucratic obstacles for local governments to navigate in order
to make use of local land.
When the PRC was first formed in 1949, the Soviet Union’s socialist property rights were co-opted into
China’s first five year plan. All property and industries were nationalized to be brought under state
control. Beginning in the 1970s, China began to shift away from highly central “public” ownership and
started to allow more private ownership of property. In 1982, the constitution was amended which
paved the way for legalizing ownership of lands use rights. The 1988 Amendment of the Constitution
was an additional step towards recognizing private owned land and the right to transfer or sell because
it permitted “the private sector of the economy to exist and develop within limits prescribed by the
law…the lawful rights and interests of the private sector of economy”.1
Some years later in 2004, an
amendment was introduced that recognized and protected private property rights. Based off the 2004
amendment, China adopted its first property law in 2007, which went into effect October 1, 2007. The
property law has provisions for four types of property rights: granted, allocated, collective, and leased.
All land use rights must be obtained from the State, a process that is difficult for foreign investors while
being more simplified for State Owned Enterprises and domestic firms. International developers were
initially encouraged to invest in real estate to help kick start growth and provide needed expertise in
development. Chinese regulators have changed foreign direct investment in real estate from
“encouraged” to “restricted”, due to distortions that became visible after the 2008 financial crisis.
Restricted investment into real estate included: Development of pieces of land for construction and
1
Constitution of the People’s Republic of China, 1988 amend., 11

2. operation of high-class hotels, villas, high-class office buildings and international exhibition centers in
addition to real estate transactions in secondary market by real estate agencies and brokerage
companies.2
In addition to these changes, the Chinese government created tax incentives for
developments to build more economical housing and commercial real estate.3
While foreign
development of high end real estate played a part in the distortion of China’s property market, domestic
firms had also overbuilt.
As China began to open up its economy after Deng Xiaoping’s 1992 “southern tour”, local governments
were encouraged to boldly invest in infrastructure. In 1992, bank lending for investment grew by almost
50 percent, and two years later, inflation was over 20 percent.4
Zhu Rongji would later began a
campaign to restrict borrowing to local governments. The 1997 Asian financial crisis and the bankruptcy
of Guangdong International Trust and Investment Corp. was damaging to foreign investor confidence.
Around this time, China Development Bank began to offer local governments financial assistance to both
alleviate bad loans and continue investing in needed infrastructure. CBD set up local-government
financing vehicles (地方融资平台) that would allow local governments funding through commercial
bank loans and bond sales. CBD would assist local governments by setting up companies which it would
then finance with initial long-term loans. The LGFV could then attract short-term loans from commercial
banks or sell bonds directly to banks and securities companies. In 2004, CDB set up Chongqing Yufu
Asset Mangement Group. Much of Chongqing’s prime central real estate was being occupied by
inefficient State owned factories that were unable to service their debt to ICBC. CDB loaned Yufu 15
billion RMB to purchase local toxic assets from ICBC. Yufu then relocated the distressed factories to the
suburbs, demolished the factories in the center of the city and used the prime real estate land sale
proceeds to finance the deal.5
LFGV’s initial assets are land and local government subsidies for bond
issuance, which allow them to sell to commercial banks. Commercial banks then package these bonds
into wealth management products and sell to investors.6
Similar schemes were used in cities like Tianjin,
Wuhan, and Shanghai to allow local governments to continue to finance needed investments.
Some LGFVs have borrowed money imprudently. Many took on more debt after the financial crisis when
the government stimulus funds were flooding the Chinese financial system. The city of Huanghua’s
(Hebei) LGFV sold 1 billion RMB worth of bonds in May 2011. The bonds are backed by five tracts of
stagnant salt marsh that are valued at more than 1.54 billion RMB, a sum which is three times the price
it paid the government for in 2009. According to the bond prospectus, Huanghua’s LGFV borrowed 5.08
billion RMB in 2010, equal to about one-third of the local GDP.7
A Shanghai LGFV borrowed 2 billion
2
Amendments to the Catalogue for the Guidance of Foreign Investment Industries, Ministry of Commerce (2007)
3
Several Opinions of the General Office of the State Council on Promoting the Healthy Development of the Real
Estate Market, Circular 131 (Dec. 20, 2008)
4
Sanderson, Henry, and Michael Forsythe. China's Superbank: Debt, Oil and Influence : How China Development
Bank Is Rewriting the Rules of Finance. (New York: Bloomberg, 2012), 4
5
Sanderson, 10.
6
Sanderson, 16.
7
Sanderson, 27.

3. RMB of loans for high speed train projects but actually used half of the funds for property development.
HSBC analyst Zhang Zhiming found that 33 percent of the LGFV generated insufficient cash flow to make
their debt payments and about 68 percent report return on capital less than the benchmark lending
rate.8
The banks sold many wealth management products to clients with bonds packaged from LGFV
which has worried investors and regulators alike after high profile defaults.
Although China has a highly regulated financial sector, basic market behavior can be observed, that is,
Chinese look for higher yields than the stock market or the bank interest rates can provide. Many
Chinese invest savings into property but it is too expensive for many to afford. In major cities like Beijing
and Shanghai, the combined domestic and international demand for property crowds out all but high
net-worth investors. Even in smaller cities the demand for housing is greater than the supply. This is
partly because much of the real estate is luxury high end property. It should be noted that Chinese
marriage culture also plays an important role. Chinese newlyweds traditionally begin their new life
together in a house, usually purchased by the husband’s family. Many buyers are also looking to invest
in hard physical assets instead of the stock market or bank savings accounts. Due to tight regulations on
deposit rates, banks have seen many customers’ withdrawal their funds to chase higher yields. The
banks started to offer Wealth Management Products to entice customers to keep deposits in the bank,
which the bank can then use to finance high yield bonds. The average yield of WMPs was 4.11% in 2012,
compared to the benchmark one-year deposit rate of 3%.9
Customers quickly began to purchase large
quantities of the bank’s new innovative WMP products.
The PBOC reported that China’s WMP market totaled CNY3.57 trillion at the end of June 2011, which
accounted for 4.5% of bank deposits.10
Many WMPs are short term, maturing in three to six months. 97%
of WMP have a tenor of less than a year.11
WMPs must be at least 50,000RMB a share.12
Three of the
“Big Four” banks are the largest issuers of WMPs. LGFV and property developments are the largest
recipients of WMP funds from the banks. Although the offering bank informs customers of risks involved
in WMPs, it is presumed that they will be guaranteed, much like bank deposits. Investors assume WMPs
are risk free and continue to push funds into WMPs. Recently a high profile default of a Huaxia Bank
WMP rattled the markets and caught the attention of Chinese regulators.
Huaxia Bank is the 13th
largest bank in China based on assets.13
In late 2011 it offered a WMP to its VIP
customers at 500,000RMB a share. Tongshang Guoyin, the Beijing investment firm that bundled the
WMP, raised 119 million RMB to finance four projects for a Henan business man named Wei
8
Sanderson, 29.
9
Bloomberg News. China Banks Drop on Tighter Savings Product Rule. http://www.bloomberg.com/news/2013-
03-28/china-citic-industrial-bank-lead-financials-lower-in-shanghai.html, (March 2013).
10
Liu, Ligang and Zhou, Hao. China's Shadow Banking Revisited: Size, Implications, Risks, and Reform, Caijing,
http://english.caijing.com.cn/2012-12-05/112336663.html (May 2012).
11
http://english.caijing.com.cn/2012-12-05/112336663.html
12
The Economist. China’s shadow banks: The credit kulaks. http://www.economist.com/news/finance-and-
economics/21578668-growth-wealth-management-products-reflects-deeper-financial-distortions, (June 2013).
13
Back, Aaron and McMahon, Dinny. China Tightens Regulations on Wealth Management. Wall Street Journal.
http://online.wsj.com/article/SB10001424127887324685104578386033143145140.html#articleTabs%3Darticle
(March 2013).

4. Chenyang.14
Mr. Wei defrauded two of the companies the WMP was invested in by faking the company
chop. The car dealership did not have knowledge of the investment and the pawn shop never received
said funds, neither company authorized the use of their company chop for a WMP. An entertainment
KTV club never received funds promised for renovations while another car dealership went bankrupt
shortly after the WMP funding was raised. Mr. Wei has fled town and has not be found, while the police
in Zhengzhou continue to investigate. Zhongfa Investment Guarantee Co. Ltd., the Beijing company that
guaranteed the WMP, refused to repay investors because Mr. Wei illegally used the money outside the
contractual agreement. As it became increasingly clear that the product would default, Huaxia moved to
minimize their exposure to the Henan fraud.
Huaxia bank fired Pu Tingting, who sold the WMP to the bank’s VIP clients. The bank argued that Pu
Tingting did not have authority to sell such a product. Pu was fired on November 25, the same day the
first repayments of the WMP were due.15
Ms. Pu has argued that she was a scapegoat and that the
branch president Jiang Li, gave the green light to sell the WMP. He even invested 1.7 million RMB in the
product himself, and informed other clients about it, including his younger sister. Clients were told that
there was no risk because “the bank’s president has bought into it, so has his younger sister”.16
When
customer’s returns failed to materialize and were unable to even to receive their principal, they began
to protest outside Huaxia’s Liujiazui office in Pudong’s financial district. For over a week protesters with
signs gathered outside the office demanding their funds back. Protesters placed speakers on both of the
company’s stone lions that blared “Huaxia Bank, give the money back” on a continuous loop.17
Huaxia
held meetings with the investors, admitting management oversight and lack of due diligence. Ultimately,
Zhongfa Investment Guarantee Co. Ltd., was held liable and was forced to repay investors’ principal back.
The fallout from the default caught the attention of the Chinese financial regulators in addition to raising
questions about the size and scope of China’s shadow banking by international investors.
China’s banking regulators responded quickly by crafting regulations limiting banks holdings in WMPs
which were then promptly implemented in March 2013. The China Banking Regulatory Commission
(CBRC) stated that banks must limit investment of clients’ funds in debt that isn’t publicly traded. The
CBRC rules decree that WMP sales be capped at 4% of the lender’s total assets and that no more than
35% of a bank’s total issued WMPs should be invested in debt or used to make loans.18
In addition, the
CBRC injected needed transparency: Banks must link WMP to specific assets, disclose who will ultimately
use the funds, and individually audit each product. Banks will now be required keep separate accounts
and set aside capital for each WMP. The implicit guarantee from WMPs is now gone, as the CBRC has
ruled that lenders cannot provide guarantee on such non-traded debts or promise repurchases. Despite
14
Shen Hu and Li Xiaoxiao. A Wealth Management Product Fails in China. So Who Pays?
http://english.caixin.com/2012-12-06/100469425.html , Caixin. (June 2012).
15
http://english.caixin.com/2012-12-06/100469425.html
16
http://english.caixin.com/2012-12-06/100469425.html
17
Wall Street Journal. Fear and Loathing in China’s Banking System.
http://blogs.wsj.com/chinarealtime/2012/12/06/fear-and-loathing-in-chinas-banking-system/ , (December 2012).
18
China Banking Regulatory Commission. 中国银监会关于规范商业银行理财业务投资运作有关问题的通知.
http://www.cbrc.gov.cn/govView_2B22741AFBC446CF890636DACAB71166.html . (March 2013).

5. the swift response and thoughtful regulations by the CBRC, China’s shadow banking is increasingly
worrying investors.
In the fallout of the Huaxia default and the CBRC’s new regulations, many investors are observing the
situation closely. At a news conference after the announcement of the CBRC’s new regulations, Yang
Kaisheng the President of ICBC, said that his bank’s WMPs are invested in a way that is slightly over the
new requirements.19
The “Big Four” Chinese banks are all now trying to trim the size of their WMP
holdings. International investors have also more closely scrutinized WMP markets. Moody’s Investors
Service lowered its outlook for China’s credit rating to stable from positive because “we are doubtful of
the banks’ ability to isolate themselves from a significant increase in defaults in the shadow banking
domain”.20
Fitch Ratings Ltd. has also cut its long-term local currency debt rating on the country because
of threats to financial stability. The effects of China’s shadow banking industry are most visible from the
coastal city of Wenzhou.
Wenzhou is a large metropolis located in eastern Zhejiang province. It is been known historically for
entrepreneurial businessmen, private lenders and a local dialect that is said to be the most difficult to
understand in all of China. The city experienced a great investment boom after the financial crisis due to
the stimulus spending. The stimulus funds eventually quit flowing and Wenzhou was hit by a wave of
defaults and factory closures. Unable to pay back underground loans, over 80 businessmen committed
suicide after falling into bankruptcy.21
The government announced a project to allow Wenzhou to
liberalize financial laws in an attempt to bring private lending out of the shadows. Many new policies
were proposed including allowing small firms to issue bonds and easing regulations for lending and
raising capital. Although the reforms were approved by the State Council at the National People’s
Congress, they have yet to be implemented. Wenzhou remains in regulatory limbo as small businesses
continue to suffer while reforms go no-where.
China’s recent financial innovation has allowed for massive investment in needed infrastructure and
urban development. Market forces combined with strict regulations have distorted many aspects of the
Chinese investment environment. Although the regulators are keeping vigilant eye for systemic threats
to China’s financial system, more reforms are needed to allow market forces to operate with minimal
distortions and increased transparency that will allow the Chinese economy to continue to grow at a
sustainable pace in the future.
19
http://online.wsj.com/article/SB10001424127887324685104578386033143145140.html#articleTabs%3Darticle
20
Bloomberg News. China Shadow Banking Poses Systemic Risks to Banks, Moody’s Says ,
http://www.bloomberg.com/news/2013-05-13/china-shadow-banking-poses-systemic-risks-to-banks-moody-s-
says.html (May 2013).
21
Bloomberg News.
Shadow Loans Hard to Squelch in China City Hit by Suicide. http://www.bloomberg.com/news/2013-03-
26/shadow-loans-hard-to-squelch-in-china-city-hit-by-suicide.html, (March 2013).