By staff reporters Zhang Yuzhe, Zhang Man and Fang Huilei

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(Caijing Magazine) Shortly after a rural bank in Hebei Province launched a 30 billion yuan wealth investment product in early May, regulators cried foul and barred it from the market.

The canceled product was designed to work through equity investments in infrastructure projects in the Hebei capital of Shijiazhuang. Overseeing the process was a firm created and sponsored by the city government, Shijiazhuang Development Investment. The rural bank and a trust fund, CITIC Trust, were also involved.

Despite this regulatory crackdown, however, local investing for infrastructure rolls on in Hebei – and across China. From Guangdong Province to Inner Mongolia Autonomous Region, new investment channels are providing a variety of government project funds through cooperating banks, trusts, local governments and investors.

Trust funds with investments that mature in two to three years are playing a crucial role in Shijiazhuang's push to improve its infrastructure. The city has 146 projects on the drawing board funded through investments of 111.1 billion yuan.

The Shijiazhuang government's state-owned assets administration, Shijiazhuang Construction Investment and Zhongrong International Trust recently signed a financing contract to raise 5 billion yuan through trust funds. The money will be used to invest in a range city projects involving construction, fixed assets and industrial expansion.

At the moment, six government financing platforms operate with local banks and trusts in Shijiazhuang, including Shijiazhuang Development Investment Co. and Shijiazhuang Construction Investment. Four of these platforms own investment companies, and each provides funds in a specific area of land development, city construction and state-owned assets management.

Financial Troikas

Bank-trust-government troikas are powerful in Hebei and across China. In recent months, their popularity has grown dramatically.

According to a source at the China Banking Regulatory Commission (CBRC), these cooperative financiers have sold more than 100 billion yuan in investment products so far. In particular, their wealth products have become major revenue sources for trusts.

China's banking law prevents banks from making "equity capital loans," -- providing an initial capital base that allows projects to borrow from the bank -- and trusts cannot take in deposits. But the two can work together. A bank can sell a trust company's wealth products to customers and entrust the funds to the trust, which then injects the funds as equity into a local government's financing platform.

Meanwhile, a local government that receives funding can issue a "letter of comfort" to relevant banks and trust companies, promising an equity injection.

This working model brings equity capital to city financing platforms and their projects, winning local government favor. Some projects are tied to the central government's 4 trillion yuan economic stimulus program, which is designed to carry China through the current economic slump. But others are not.

A source at Shijiazhuang Construction Investment said local projects include a bridge, a roadway and an industry. Most projects were authorized by local governments but have little to do with the stimulus package.

As for banks, the bank-trust-government structure not only bypasses a law that says banks cannot make "equity capital loans," but also provides a safe shelter amid a downturn in credit writing.

But the risk, tied to high leverage and short-term debt for long-time projects, has attracted more regulatory attention. Since April, for example, CBRC has started to trim the scale of such wealth products while sending warning signals to trust companies. It was no big surprise that the Hebei rural bank failed to carry out its financing plan, for example.
 
Working Together

Trusts and local governments collaborate in three ways. Trusts can issue products and inject funds as equity into local government investment platforms, which allocate funds to government projects. After a lock-up period, a government-designated entity can buy back the equity at a premium.
 
The collaborative process takes another form when a trust raises public funds and then lends the funds to city investment companies. Local governments extend guarantees for the trusts.
　
Bank-trust-government products enjoy annual returns of 3 to 4 percent, far higher than bank savings accounts and government bonds can offer. Not surprisingly, these wealth products are popular with investors -- and sell fast.

Typical are a pair of wealth products issued by Industrial and Commercial Bank of China (ICBC) in April. Money raised was invested in three trusts, which in turn injected funds as equity into three city financing investment companies in China's southern Guangdong Province. These platforms in the cities of Zhongshan, Huizhou, and Foshan plan to spend the money on infrastructure construction. Meanwhile, the local SASAC has promised a future equity injection through buybacks at an agreed-upon price. Capital for future equity injections will be considered with local fiscal planning.
 
And the money can come quickly. The investment company in Zhongshan opened three months ago but has already raised 5 billion yuan.

Enthusiastic Banks

An ICBC source noted that bank-trust-government arrangements on the surface function as trust companies that extend lending through trusts to local investment companies. But they are more like banks that use local investment companies to specify financing needs and then look for trust partners.

Local commercial banks are in the first pool of participants because local banks are usually associated with and controlled by local governments, according to China Chengxin Financial Consultancy President Liu Hong.

Moreover, the wealth products they offer do not require fixed returns and enjoy loose oversight, since only local banking bureaus have to track their records. Public officials often favor this arrangement.

"If the central government tightens up credit policy, this model will not be able to continue," said a city government official who asked not to be named. "Now, everyone is busy making money."

Local financing demand started blossoming this year, prompting China's Big Four banks -- ICBC, China Construction Bank, Bank of China, and Agricultural Bank of China -- to get into the game.

ICBC gave nine local branches permission to sell bank-trust-government products. "Guangdong, Jiangsu, Inner Mongolia and Hunan are all engaged in these products," a source at ICBC's Guangdong branch said. "Jiangsu does a lot in particular."

According to data from market analysts, each of the Big Four issued more than 100 wealth products between January and April. Nearly 30 percent of these products were used for infrastructure investments.

Flashing Yellow

A key worry for regulators, however, is the rapid growth in bank-trust-government projects at township levels, where fiscal revenues are modest. According to an industry report released by Bridge Trust, townships accounted for 11 of the 26 infrastructure projects received funds from trusts during the first quarter. The others included two in municipalities, seven in cities and six in districts.

Specialist Wang Zengwu at the Chinese Academy of Social Sciences argues that risks are involved in bank-trust-government products, although he acknowledges they broaden financing channels for local governments and offer new wealth products to investors. Wang said mentioned the risks involved in regulating guarantees, fraud, repayment obligations.

Infrastructure projects can be financed through government investments, bank loans, corporate bonds and trusts. With short maturations and capital limitations, trusts carry the highest costs and are the least competitive avenue for financiers working on major city or provincial infrastructure projects. As a result, trust strategies work best for smaller projects in places such as townships.

But trusts working with small governments have to shoulder more risks. Townships, for example, may not enjoy stable income, making repayment problematic. Thus, product design and cash flow management are crucial to balance risks.

When deciding a fund's size, local fiscal income from the previous two years and anticipated fiscal growth during the product's lifespan are important. The Bridge Trust report notes, "Local governments may wish for more, but it is unreasonable when a local government overextends itself and can't guarantee repayment."

In the first quarter 2009, the report said, every trust fund that supported local infrastructure projects provided financing at levels no greater than 5 percent of the local fiscal income.

Local government guarantees usually involve land. And in the current property market downturn, that poses risks as well.

"The real estate market is not good, so fiscal pressure is high for local governments," said the ICBC source.

Currently, some district and fourth-tier city governments are taking on huge amounts of debt. Adding to the risk is that banks and trusts do not know the true depth of the debt among the small governments with whom they cooperate.

"They do not think at all about their local governments' position with intangible debts," said the ICBC source.

In the bank source's view, mandatory taxation provides good cash flow for guaranteeing interest payments. But to repay the principal for investment products, many pin hopes on future economic growth.

Regulators are becoming more aware of snowballing risks. CBRC released a risk warning to trust companies in late April, saying trusts must be cautious when partnering with local government investment companies. Capital strength, credit ratings and payback capacities should be checked, the regulator said.

"The first step for now is a risk alert," a CBRC official said. "If nothing improves, we will have to take action on a case-by-case basis and follow up with regulations."

1 yuan = 14 U.S. cents