By Lianting Tu

Yuebao, a fund management platform under Chinese e-commerce group Alibaba, is hurting the bottom line of the country's banks as they scramble to offer competing products, analysts said.

Yuebao has become an attractive alternative to banks because it offers around 6 percent in annualised return. In contrast, banks' demand deposits offer a paltry 0.36 percent. As a result, Yuebao has attracted around RMB500 billion ($81 billion) from more than 81 million users since its creation just nine month ago.

"It is a replacement for demand deposits from many investors' perspective," said Qing Liao, a bank analyst at Standard & Poors in Beijing. Yuebao manages users' cash balance on Alipay, a Paypal-like third-party payment system offered by Alibaba.

Unlike banks, Yuebao passes on to customers most of the yield it earns while investing the money collected from clients into bank term deposits and the interbank market. More than 90 percent of Yuebao funds are invested in so-called negotiable term deposits, meaning the money returns to the financial system, but in higher yielding products than straight deposits, according to a research report from Shenyin Wanguo Securities dated March 5.

When liquidity was tight during the Lunar New Year and interbank loans were paying high yields, Yuebao was offering annualised returns of 6.74 percent. Those yields have since dropped to 5.56 percent as of March 19, but are still considerably higher than bank deposits.

As depositors move into Yuebao funds, banks may be forced to offer more higher yielding money market products, increasing the cost of liquidity in the financial system.

The move is especially worrying as other internet companies move into financial services as well.

In January, another Chinese tech firm Tencent, which has a huge user base on its QQ and Wechat platforms, also rolled out its money market fund called Licaitong. By Feb. 25, the fund had already accumulated assets in excess of RMB50 billion.

Faced with intense competition from Yuebao for retail deposits, banks in China have taken measures to defend themselves. They have established test branches for their own money market products and they have also set daily limits for depositors to transfer funds to Yuebao.

In the past few months, a group of banks - including Ping An Bank, Communications Bank of China, Industrial and Commercial Bank of China, Bank of China, China Minsheng Banking Corp - have also rolled out their own money market products, according to the Shenyin Wanguo research. More banks are expected to follow suit.

Banks are in a better position to sell their own money market products given their huge deposit base.

By end-2013, there were RMB104.4 trillion deposited within Chinese financial institutions, of which individual demand deposits accounted for 17 percent while corporate demand deposits stood around 14 percent. The rest sits in term deposit accounts.

Based on these numbers, if 20 percent of the individual deposits went to money market funds, it would represent RMB3.55 trillion and RMB2.92 trillion for corporates.

While the amounts are daunting and should be an incentive for banks to invest further in their money market business, because of the high yield benchmark being set by Yuebao, increasing the percentage of deposits held in money market instruments will significantly push up the cost of funding for banks.

" have to be careful enough not to hurt their own profits," an onshore credit analyst warned. "It is basically replacing one kind of bank liability with another [costlier one]," said Liao.

Sensitivity analyses show that if 20 percent of banks' deposits shift to negotiable term deposits, the average cost of banks' liabilities will go up to 3.48 percent from 2.5 percent, a 40 percent increase. The cost will shoot to 4.37 percent if the ratio goes to 80 percent, according to the research from Shenyin Wanguo Securities.

Such a large spike in the cost of funding is likely to eat into banks' net interest margins. Liao, from S&P, said that an aggressive estimate suggests that the net interest margin of Chinese banks could be reduced by 0.06 percent to 0.07 percent in 2014. The net interest margins of Chinese banks stand around 2.5 to 3 percent, according to him.

Risky business

As the cost of liquidity rises, banks may try to increase the yields they get on loans, something that could expose them to additional risk, analysts said.

"In order to preserve their profitability, banks may end up lending to riskier borrowers at higher yields, which may lead to higher credit risk facing the banks," said Jonathan Cornish, head of bank ratings, from Fitch.

Counterintuitively, bigger banks are likely take a harder hit in profitability because they do not have the expertise to lend to small and medium enterprises to get higher yields.

On the flip side, the net interest margin of smaller players, such as China Minsheng Banking Corp and Industrial Bank, may even increase as they are able to pass the higher costs on to the borrowers, most of which are smaller companies, the onshore bond analyst noted.

While analysts agree that Yuebao could add fuel to risky lending in China, it could also play a key role in developing Chinese money market funds.

"Average investors in China are getting familiar with money market funds thanks to the publicity that Yuebao has drawn," said Liao of S&P.

Total assets managed by China's money market funds are still quite small, accounting for less than 2 percent of bank deposits, or less than RMB2 trillion, Liao said.

The explosive growth seen by Yuebao and Licaitong may provide a yardstick of how quickly the market could develop.

If history is any guidance, the US money market fund industry grew from one fund set up in 1971 to more than $3.5 trillion in assets by 2008. One factor that prompted such growth was the wide interest rate discrepancy between regulated deposit rates and market rates, the Shenyin Wanguo research noted.

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