NO 245 – JULY 2013

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BASIC PRODUCT, GREAT EXPECTATION

Chinese economy is undergoing structural changes as it slows down to streamline resource allocation. Misallocation of capital resources is blamed for the recent woes like cash crunch, credit difficulties and wild market fluctuations. Chinese capital markets are now called upon to activate idle funds and provide liquidity to support sound real-economy projects. Instead of sophisticated financial instruments, basic asset-backed securities seem to work just fine to channel funds to viable business projects.

Asset-backed securities (ABS) are a direct means of financing but distinguished from stocks and bonds. The originator, usually a non-banking enterprise, offers for securitization its underlying asset with future cash flow. The financial advisor, usually a securities firm, establishes a special purpose vehicle (SPV) to hold the underlying asset and separate risk from the originator's other assets. The SPV manager then issues ABS certificates to investors and purchase the underlying asset with proceeds raised from issuance of trust units.  In effect, the originator recoups the entire or partial investment up front and investors receives regular payments from the cash flow generated by the underlying asset.

ABS help companies raise funds to develop projects and provides opportunities for fixed-income investment. With ABS, the capital market allocates funds and risk from each according to the risk-bearing capacity to each according to the prospect to generate cash flow. Shenzhen Stock Exchange has responded to the nation's economic challenges by expanding the ABS market. Some success has been recorded in the product to facilitate project financing and diversify fixed-income instruments. This article attempts to introduce some of the exchange's experience with product in the following two case studies.

Small Business Lending Backed by ABS: Case Study of Aliloan

Small and micro-businesses are chronically underserved by banks in China. Traditional banks are ill equipped to evaluate risk involved in small business loans. The cost of risk evaluation simply does not justify small loans in banks' business model. Small and micro-businesses have no choice but to turn to private lending services. According to statistics contained in Report on Financing Behaviours of Banks and Families published by Southwest Finance University, private loans in support of commercial and agricultural activities amount to RMB 3 trillion (USD 485 billion).

There are evident demands for specialized lending services for small businesses. And regulatory hurdles are coming down for private lenders. The Chinese Government has recently issued guidelines allowing establishment of privately-funded banks, financial leasing institutions and consumer finance companies which must bear the risk of operation and be subject to regulation.

Alibaba, China's e-commerce giant, answered the call for small-loan service. Alibaba has demonstrated positive spill-over effects from its e-commerce platform to small business loan service. Alibaba handled USD 1.1 trillion in trade on its portals between and among 370 million registered users in 2012. Aliloan, its small loan arm, leverages on Alibaba's huge trading data to track business customers' trading behaviour. Thus Aliloan has developed techniques to evaluate loan risk and credit worthiness based on proprietary data. Furthermore, reputation in the online marketplace is intangible collateral that no trader would afford to give up.

Aliloan's ABS securitize small loans made to small and micro-business by distributing interest certificates to investors. The proceeds are used to finance further small business loans. The ABS are designed to roll over repaid loans to purchase new small-loan assets. Aliloans with two subsidiaries in Chongqing and Zhejiang, have a combined registered capital of 1.6 billion yuan (USD 250 million). Accord to Caixin, a leading Chinese financial magazine, Aliloan had lent out more than RMB 39.1 billion (USD 6.32 billion) to over 207,600 small and family-owned businesses through company's e-commerce portal by 31 October, 2012. Aliloan was incorporated in 2010. According to a recent report, the majority of the small loans are under USD 60,000. The small loans are often granted to traders on Alibaba's online marketplace as purchasing credit.

Aliloan ABS have completed the review process and are expected to list on Shenzhen Stock Exchange in August 2013. The product is the first ABS based on small business loans, filling a service vacuum for private lending service in China. It is also significant to hundreds of thousands small and micro-businesses hungry for funds to support their business ventures.

ABS product is new to Chinese capital market. How ever the product has demonstrated effectiveness in project financing and resources allo cation.

Improved Capital Structure: Case study of Overseas Chinese Town

Overseas Chinese Town (OCT) is the largest theme park operator in China. In recent years, the company has extended business lines to real estate, taking advantage landscape development and infrastructure for theme parks. The business model, creating synergy across different assets, has incentivized OCT to invest in landscape and infrastructure in different cities. OTC theme parks and tourist facilities also exert positive external effects on the cities where it operates.

OCT started in Shenzhen where it is headquartered. Its theme parks range from miniature global scenic spots to amusement parks. Happy Valley integrates water sports, amusement rides and cultural shows. It is one of the most popular theme parks in China. Classy restaurants, hotels, theaters and high-end residential complexes cluster around the theme park in Shenzhen, creating a tourist, recreational and cultural center for the city. OCT replicates its business model in other cities of Beijing, Shanghai and Chengdu.

However there is always a delicate balance to strike in financial management. Though the housing boom helped real estate business, the theme parks provide relatively slow returns from huge upfront investment. Besides, it requires sophisticated skills and years of operational experience to control operational cost while maintaining sound service standards. Theme parks put a heavy pressure on OCT's cash management. OCT was in bad need of external financing to fund investment and operation of theme parks in 2012.

Despite large overhead and operational cost, OCT's theme parks generate sizeable income. For example, Happy Valley theme parks in Beijing, Shanghai, Shenzhen and Chengdu had received 54 million visitors and recorded RMB 6.2 billion (USD 1 billion) in ticket sales by year-end 2011. Happy Valley Shenzhen started operation in 1998. All other Happy Valley opened in 2009. Gross profits of Happy Valley in different locations range from 14% to 25% in 2011.

OCT was in a good position to raise funds to finance theme-park projects through the capital market in 2012. It was able offload debt-financed theme park assets from its balance sheet and raise funds by issuing ABS certificates on Shenzhen Stock Exchange in 2012. OCT raised RMB 1.85 billion (USD 300 million) through ABS and offered 5.5% return to one-year maturity certificates, 5.8% and 6% to two- and three year maturity. Furthermore OCT improved its cash management, diversified its business risk, improved return to shareholders and provided fixed-income investment opportunities to investors. Now OCT is building new theme parks in Tianjing, Wuhan, Taizhou and Yunan.

ABS for Project Financing

Starting in 2005, SZSE has listed a number of ABS products based on infrastructure projects.

The earliest one was Dongguan-Shenzhen Expressway usufruct ABS project listed in 2005. Later urban sewage system and hydroelectric projects came on line. As many infrastructure projects were funded by local government, ABS has become a useful tool for local governments to unlock idle assets and funds. SZSE has helped project operators raise over RMB 12 billion (USD 1.9 billion) to fund a wide variety of projects.

Risk Management

The lesson from the global financial crisis in 2008 is still fresh in people's memory. The crisis proves that under-regulated financial products, once allowed in self-serving and self-circulating cycle, harm the real economy.

Shenzhen Stock Exchange has taken a few measures to manage systemic risk. First, ABS are defined as an exchange-traded product, requiring high degree of transparency and centralized clearing. Second, ABS are open only to institutional investors, though plans are being evaluated to admit high net worth individuals into the market. It limits risk exposure only to seasoned investors. Third, ABS is a pure cash product. No margin trading or derivatives apply to ABS. Shenzhen Stock Exchange offers early project analysis and advice to help define product plan. As China is in early stage of development in ABS market, intermediary services have not fully developed. Shenzhen Stock Exchange offers free consultation and advice to help originators define projects and identify risk. Shenzhen Stock Exchange also invites external experts for consultation and risk analysis for candidate ABS projects.

ABS product is new to Chinese capital market. However the product has demonstrated effectiveness in project financing and resources allocation. In particular it is helpful for small businesses that do not qualify for IPOs or have limited access to bank loans. It helps reinforce a weak link in the Chinese economy.

Background Information

Asset-based Securities at SZSE

SZSE launched its first corporate asset securitized product in December 2005 and provided trading service for the product through its comprehensive negotiated trading (block trade) platform. The move was aimed at putting into play the role of the capital market in national economic development, expanding corporate financing channels and providing more diversified instruments to the market.

For the issuer, financing by asset-backed securities isolates risk from the underlying assets and the enterprise. And the securitized product helps project originator raise funds for project development.

For investors, the securitized product has a specific maturity and rate of return. Investors can hold to the maturity after subscription. They can also trade the product on the secondary market through SZSE's comprehensive negotiated trading platform.

SZSE conducts research and appraisal of the securitization project and files its opinion to the CSRC. After the listing of the product, SZSE provides liquidity arrangement for the product through the negotiated trading system and facilitate trading.