This Banking Fraud Shows How Shady China’s Economy Remains

Beijing promises reforms, but won't take the steps that really matter.


At the World Trade Organization, China regularly makes the claim that its private economy is a market system—one where supply, demand, and price discovery allow for fair competition. But no market economy is healthier than its banks, and China’s banking channel is stuffed with thousands of seemingly routine, and mundane, financing transactions that, in reality, are little more than fraudulent window dressing.

The interstices of a tiny corner of the banking system—in industry parlance, the market for banker’s acceptance drafts—can serve as a proxy for the overall health of Chinese banking. They show that China’s financial system is not yet the transparent engine that its highest-level policymakers would like. Instead, it’s still riddled with shadow banking—illicit or quasi-legal financial services that make up the gaps in the formal system—and dictated more by the need to hit politicized targets that market demand.

Banker’s acceptances were back in the news at the beginning of this year precisely because, as evidenced by an unusually public disagreement between Chinese Premier Li Keqiang and the People’s Bank of China (PBOC), regulators feared that the sector was contaminated by fraudulent behavior. During December and January, bill financing—shorthand for banker’s acceptances and related instruments—swelled by over 1.3 trillion yuan ($190 billion).

According to Li, the economy’s billowing stock of banker’s acceptances had little to do with the real economy. At a Feb. 20 meeting of the State Council, the premier—who despite his exalted title is not believed to be a particularly powerful political actor—warned against excessive issuance of such notes, saying that many of them amounted to “arbitrage or an empty transfer of funds, which might bring other hidden risks with them.” The numbers had spiked, as they always do, in December and January.

Bank Acceptance Drafts, 2017-2019

Source: People’s Bank of China

The PBOC rose to defend the integrity of the banker’s acceptance market. According to the bank, arbitrage potential was not especially large, and most of the notes were going to fund real economic activity. A subsequent crackdown on banker’s acceptances settled the issue in favor of the premier, indicating deeper problems with the market.

In principle, banker’s acceptance drafts are a low-risk instrument of commerce. They amount to a post-dated check that is backstopped first by a securitized deposit, second by an underlying commercial transaction, and finally by a bank guarantee. If a grocer wanted to receive 100 yuan worth of potatoes but did not have sufficient cash in hand, they might post 60 yuan in cash as security along with proof of an order for potatoes. In return, the bank would issue them 100 yuan in banker’s acceptances—that is, in paper guaranteed by the bank itself. The grocer could then pay their suppliers with these bills, enabling them to restock their inventories on credit.

By the time the bills came due (generally after 30 or 60 days, but sometimes as long as 6 months), the potatoes would ideally have been sold and the grocer would pay cash to settle the bill. If in the interim the grocery store were to go bust, the bank that issued the banker’s acceptance would pay out instead, making the notes whole. In short, banker’s acceptances function like a letter of credit—they lubricate the wheels of commerce by allowing buyers to purchase inventory with their own paper, while sellers can have the comfort of a bank guarantee backstopping that paper.

Because banker’s acceptances are short-term, low-risk instruments, they are also highly liquid. If the holder of a draft needs hard cash, they can “discount” them at a bank. For example, after the grocer pays its potato suppliers in banker’s acceptances, some of those suppliers may decide they can’t wait the whole month (or two or six) for the drafts to reach term. Maybe they need to disburse salaries, build a new warehouse, or restock their own russet reserves. In this case, they take the draft to a bank and sell it at a discount to face value. The seller gets yuan, and the draft hits the discounting bank’s (not necessarily the same as the issuing bank) balance sheet as a “discounted bill,” a kind of bank loan. The bank earns a profit from buying the banker’s acceptance at a discount and collecting the total face value when the draft comes to term. The effective interest rate it earns from discounting them is known as the “discount rate.”

In the United States, as in most economies, banker’s acceptances flow as a function of the demand for real commercial transactions—particularly by small and medium enterprises. But in China, many of the commercial transactions underlying them are fraudulent. The grocer’s potatoes—and perhaps even the grocery itself—never existed. This is a symptom of an economy in which officials and nominally private businesses alike are under enormous institutional pressures to meet quota-driven targets. It is no surprise that they frequently resort to fraud in order to do so. Indeed, in a political economy capable of fabricating fiscal receipts, billion-dollar forestry concerns, and entire social media platforms, a few phony commercial transactions seems but a venial sin.

These banker’s acceptances are shell games between counterparties whose only real motive is to get access to cheap credit. Meanwhile, the proceeds from acquiring the drafts are invested in structured deposits whose interest rates often exceed the discount rate. This is precisely what Li meant by “arbitrage or an empty transfer of funds”: i.e. arbitrage facilitated by transactions with no real commercial content.

The premier’s statements set off a dispute as to whether banker’s acceptances reflect demand for arbitrage or real economic recovery. Those who see them as a vehicle for arbitrage note that the drafts were subject to similar (and perhaps worse) abuse several years ago. (See, for example, reporting done by the Wall Street Journal and my own research from roughly five years ago). Others, including the PBOC, were more skeptical, saying that banks have strong internal controls to prevent such abuse and noting certain patterns in the data that suggest most of the new banker’s acceptances are being put to commercial purposes. On the other hand, a PBOC announcement in late February was oddly equivocal: “Financial regulators encourage the growth of notes with real underlying trade, and at the same time will not tolerate bill financing arbitrage.” Under the traditional way of reading Chinese official statements—assume any claim is the reverse of the truth—the PBOC’s statement can be read as an admission of serious lapses in oversight.

I spoke to a banker’s acceptance draft arbitrageur in the major east coast city of Tianjin to get a sense of the reality on the ground. The Tianjin shadow banker’s profile is broadly representative. He spent the first two decades of his career at a sleepy, state-owned local bank before striking off on his own. Since then, he has been trading off his decades of built-up connections to do business in China’s gray market. He does a brisk business in financial leasing, auto loans, and bid-fixing, among other quasi-legal enterprises. But in December and January, he was “busy mostly doing bills financing.”

According to this shadow banker, there was no real trade underlying the bills that he transacted in. The fake transactions used to generate the banker’s acceptances were organized by him and his associates. First, he raised capital from local investors; in the past, gray-market schemes might have been bold enough to raise money from the retail market, but now, because of stricter policing of gray-market retail fundraising, they must be more circumspect. Then, the arbitrageur placed this money in structured deposits.

At the same time, he used related parties to mimic transactions that look like trade. With the structured deposit as security and enough phony transactions, he was able to obtain banker’s acceptances from a bank. The bank probably suspected that something was amiss, but around year-end, bankers are often under severe pressure to meet deposit quotas. Hence, in December and January they are often willing to turn a blind eye to fraudulent transactions that, after all, contribute to the bank’s deposit growth.

Say an arbitrageur starts out with 100 million RMB and through his network becomes acquainted with a banker struggling to meet a 1 billion RMB deposit target. He deposits 100 million RMB in the bank as a securitized, structured deposit at an annualized rate of about 4.6 percent and receives 100 million RMB in banker’s acceptances. Even better, the bank prepays the interest, driving the effective rate even higher. After our arbitrageur receives his drafts, he discounts them at a rate of roughly 4 percent, leaving a 0.6 percent spread. In one day, he makes a profit of 600,000 RMB on capital of 100 million RMB. In the Tianjin shadow banker’s words, “People are pooling together money to get enough money to buy structured deposits and profit from the spread. It has absolutely no risk to anyone. It just has a cost to the bank.”

Moreover, because this transaction ties up the 100 million RMB in capital for less than a day, this arbitrage can be done iteratively. With the cash gained from discounting the banker’s acceptances and receiving the prepaid interest, the arbitrageur buys another structured deposit, rinses and repeats, and continues to make a risk-free about 200 percent annualized return—not bad work, if you can get it. This process can go on indefinitely and in practice continues until bankers no longer need more deposits to fill their quota, or until the discount rate and the structured deposit rate converge to the point that arbitrage is no longer worth the risk of getting caught.

From an accounting perspective, the transactions look good for the bank as well. They show up in the bank’s liabilities as an increase in deposits and may even increase the bank’s cash balances. Economically, the impact is less benign. The bank pays 4.6 percent on deposits that will melt away as soon as the spread between the discount market and structured deposits closes, but that is a worry for another day and, perhaps, a different colleague.

One point of contention is the fact that undiscounted bills rose along with discounted bills. An undiscounted bill is a banker’s acceptance that is held to maturity—and their numbers are rising, indicating, according to some analysts, that the bills market is healthy.

Unfortunately, there are a few problems with this rosy interpretation. The most telling metric is not the absolute number but the ratio of discounted bills to undiscounted bills. This ratio grew sharply until January and then fell off in February. That is, the ratio rose precisely during the period in which arbitrage was most profitable.

Second, not all discounted bills appear in the data. In addition to the formal discount market, China is home to a sub rosa gray market in banker’s acceptances. Most gray-market buyers consist of regional state-owned enterprise managers or large private companies looking for a way to earn a little extra income on idle cash. To find these buyers requires a deep network of connections. Again, this explains why so many gray-market financiers have experience in the state bank sector: Our arbitrageur knows other local state-owned enterprises that trust him enough to purchase his banker’s acceptances at a lower discount rate than he could get by selling to a bank. As the Tianjin arbitrageur explained, this kind of underground trade depends on contacts—and on the payoff being worth the risk. “No one would sell drugs if they cost the same as cabbage. It’s only because there’s so much money to be made that people take the risk of arbitraging BADs,” he said. (More realistically, while some forms of financial fraud in China nominally come with the death penalty, banker’s acceptance abuse appears to be punished with corporate fines.)

In February, as arbitrage opportunities went away, these banker’s acceptance transactions began to unwind. According to my contact in Tianjin, the spread narrowed between deposits and cost of capital. “The market was getting saturated, so the spread was narrowing. In the last four months the spread was between 0.4 and 0.5,” he said. “After January, people will have to put up more money to settle the transactions they entered into prior to that. In February, the spread settles down again. Every year this happens.” But this downplays the extent of this year’s spike. While banker’s acceptance drafts generally rise in December and January, the bump is usually on the order of about 5 percent. This year, total bills in the system grew by an astonishing 15 percent. The unprecedented spurt of bills financing was driven by unusually rich arbitrage opportunities.

Ultimately, the annual patterns of banker’s acceptance arbitrage is emblematic of a contradiction at the heart of China’s reform process: the desire to transition to a market economy as long as it yields desired price outcomes. To say that the market may function so long as deposit rates do not appreciate too much, nor defaults rise excessively, nor property prices fall too precipitously is as useful—and as coherent—as asking for an X-ray only if the doctor promises there will be no sign of cancer. If the government wants to banish arbitrage, it must allow the banks to do legally what arbitrageurs do under the table: offer market-rate returns on capital to Chinese savers.

Matthew Lowenstein worked as a financial analyst in Beijing and New York; he is now a student of Chinese history at the University of Chicago.

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