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Web Banks, Offering High Interest Rates, Rise in China

SHANGHAI -- Last June, an affiliate of the Chinese e-commerce giant Alibaba made an offer to its hundreds of millions of users: Give us your cash, and we will pay more than Chinese banks will.

Savers swamped the company seeking interest rates that were significantly higher than the low rates fixed by the government. By early February, 81 million people had signed up for the company's money market product called Yu'e Bao, which translates as ''leftover treasure."

The fund, which was established by Alipay, a unit of Alibaba, now has $40 billion in assets under management, making it the country's biggest money market fund.

Other big Chinese Internet companies have followed suit, promising even higher returns than Yu'e Bao. The result is an assault on one of the crucial instruments the Chinese government uses to manage the economy: interest rates.

''This is the beginning of interest rate liberalization,'' says Chang Chun, who teaches at Shanghai Jiao Tong University's Advanced Institute of Finance. ''People want to get a higher yield on their savings deposits, and so this is one way to get around the regulation.''

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Jack Ma, Alibaba's flamboyant and sharp-tongued chairman, insists China's financial regulations are suffocating smaller investors and average consumers. He has vowed to shake up the country's banking and financial services sector. ''The financial industry needs spoilers to make a revolution,'' he said during a speech last June.

The big winners so far are Chinese savers, who now earn up to 7 percent annually on cash deposits. Traditional banks have rarely been so generous. They now pay 3.3 percent.

For years, Chinese policy makers have promised to liberalize interest rates as part of a bold reform effort aimed at letting market forces play a larger role in the economy so that it grows in a more sustainable and healthy way. Perhaps because of strong opposition from banks and other state institutions, the interest rate controls have not yet been lifted.

Analysts say the government's decision to permit Internet companies to offer a wide range of investment and financial services is an effort to create alternatives to state banks and, in effect, loosen interest rate controls.

While the money involved is relatively small -- about $50 billion in a $9 trillion economy -- the phenomenal growth of Internet finance is intensifying competition for deposits and putting pressure on China's dominant state-run banks, which are already struggling to cope with a severe cash squeeze. Internet finance is also emerging at a time when the government is trying to contain the growth of shadow banking, which could be masking huge risks and liabilities that exist outside the purview of regulators.

Not everyone is pleased. In recent weeks, critics have referred to the online products as ''vampires sucking blood out of banks,'' and warned that investors may not be aware of the risks. Chinese regulators said in late February that they are considering new rules to govern the sector.

For their part, the leaders in Internet finance, such as Alibaba, Baidu and Tencent, play down the risks of their new investment products. They say they are operating within the law and putting the cash to work in investments that carry low risk. There are, of course, serious challenges ahead for Internet finance in China, analysts say. For instance, although the online deposits are promoted as if they were savings accounts, they are investment products that carry risk. The principle is not guaranteed, and if consumers begin to suffer losses, analysts say, there could be a flood of redemptions.

For the last decade, the government has aided state-run banks by placing a ceiling on the savings deposit rate and a floor on bank lending rates. The wide spread between the two, known as the net interest spread, has helped banks pocket fat profits that they needed to restructure after massive losses in the 1990s.

Savers, on the other hand, have seen the value of their cash deposits deteriorate, since the rate of inflation has usually been higher than the government-controlled deposit rate. Economists say the policy has acted like a tax on savers.

It has also forced some wealthy Chinese investors to channel their money into hard assets: art, gold and property. In recent years, many investors have also sought higher yields by buying so-called wealth management products through financial leasing companies, trust companies and even local banks. The products, though, can be risky because the money is often used to finance high-interest loans to developers and local government infrastructure companies.

Now, investors are turning to online investment products. The high rates offered by products like Yu'e Bao are exposing weaknesses in China's financial system, where investors have fewer options than in the West, especially with fixed interest rates.

Major Chinese Internet companies are now disrupting those controls by offering enticing yields aimed at ordinary savers with spare cash, people like Gao Yue, a 25-year-old health care consultant in Beijing. Since October, she has put about $15,000 into her new Yu'e Bao account.

''As long as I get a higher return than the regular bank deposit, I'm happy to put my money in there,'' she said in an interview. ''It's better than being beaten by inflation.''

Alibaba is the prime mover in the new business. The company has dominated online shopping for years with its popular websites Taobao and Tmall and even established an arm that lends to small businesses. In 2013, the company's online payment service, Alipay (a kind of Chinese version of PayPal) moved into banking and finance by partnering with Tianhong Asset Management, a small, state-backed firm. (In October, Alipay agreed to pay $200 million to acquire a controlling stake in Tianhong.)

Alipay's 800 million registered users were then encouraged to transfer any money left over in their online shopping account to Yu'e Bao, the new online fund set up by Alipay and Tianhong. The rates promoted by Tianhong were higher than those offered by banks.

Soon after, Yu'e Bao took flight. Analysts say Yu'e Bao's appeal is its simplicity and convenience. Alipay account holders can transfer as little as one renminbi, or about 16 cents, into Yu'e Bao and withdraw the money at any time, without being penalized. They can also get daily earnings updates on their mobile phones.

''What makes Yu'e Bao attractive is the small size. You don't need to invest much,'' says Joe Zhang, a Hong Kong banker. ''Small is the killer app.''

How does Yu'e Bao get such high rates? Company executives say they invest mostly in the interbank market, where banks and other financial institutions extend loans to one another, usually for short periods. Interbank rates have soared in China during the last year because banks, particularly smaller banks, are desperate for cash.

''Banks are definitely short of cash,'' says Charlene Chu, who formerly followed Chinese banks for Fitch Ratings. ''This is why the interbank rate is going up.''

In the United States, PayPal flirted with a similar online money market fund product for years before closing it in 2011. Since then, no major American Internet company has ventured into the banking or investment business.

But Bill Harris, a former chief executive at PayPal, says American Internet companies are missing a big opportunity. ''The reason none of them is doing it is they haven't tried,'' Mr. Harris said. ''If a tech firm did it, they could build systems with no humans. Amazon could do it. PayPal could do it. Apple could do it in spades. I think they're missing the boat.''

Analysts say soaring interbank rates are a sign of stress in the banking system, which means banks or financial institutions could default, leading to losses; or if conditions improve, interbank rates could slide, meaning lower interest rates and lower returns for consumers.

For now, though, Internet finance looks lucrative. With $40 billion in assets under management, Alibaba and its partners are expected to reap $250 million in revenue annually just from management and service fees. Baidu and Tencent have formed partnerships to offer new funds with other fund companies, including the state-run China Asset Management Company.

''Internet finance is here to stay,'' says Johnson Chng, a banking expert at A. T. Kearney, the global advisory firm. ''Internet players are targeting a segment that banks don't look at.''