A default of the “Credit Equals Gold #1” trust product has been avoided. What happens in the coming months will either push China closer towards a financial crisis or help it gradually step back from the edge.
The lack of details that emerged from the trust bailout will undoubtedly draw criticism from foreign investors and analysts alike. Industrial and Commercial Bank of China Ltd. told investors that they could sell the rights in the RMB 3 billion product issued by China Credit Trust Co. to an unidentified buyer at a price equal to the value of the principal. Separately, China Credit Trust announced that it had reached an agreement with a third party to sell the shares it had acquired in Shanxi Zhenfu Energy Group, the coal miner which took out the original loan. According to that statement, investors would not receive interest on the third and final year of the product, equivalent to around RMB 300 million. Neither ICBC nor China Credit Trust acknowledged where the funds came from to repay investors or who the third party was.
In reality, it is possible that we will never know the details of the third party. In 2012, there were two trust defaults, one for a product distributed by Huaxia Bank Ltd. and one sold by CITIC Trust. While we learned that Zhongfa Industrial Group in the end guaranteed the first, the solution to the second was never made public.
As a result of the uncertainty, we will now enter a period of second guessing on reform and concerns that risks in China’s financial sector will only intensify. As argued by Christopher Wood at CLSA:
“If there is a total bailout — or perhaps even worse a bailout through the backdoor as some speculate — it will be a signal that the government’s talk of pursuing reform isn’t perhaps for real. This will increase macro risks, with China’s trust assets now totaling more than 10trn yuan.”
China’ financial system is clearly under more stress than it has ever been given the large sums of money that are now invested in trust and wealth management products (WMPs), which in turn are used to extend loans to different segments of the economy. The degree of risk is unclear, however. China bears will argue that a vast majority of the trust loans cannot be repaid, which will eventually require substantial bailouts and lead to a collapse in the banking system and a larger economic crisis. Even if this is exaggerated and the assets are good, huge liquidity risks exist given the known mismatch between the duration of trust loans and their underlying investments.
This risk of a systemic crisis in the banking system was clearly the primary reason for the bailout. As Christopher Wood put it: “Risk facing authorities is that a default in which holders aren’t bailed out in full might precipitate panic outflows across the trust and related wealth-management product asset class, triggering a liquidity crisis, which would also ricochet into Hong Kong.”
A picture has also begun to emerge on what the scale of the crisis could have been this year. According to market estimates, around RMB 5 trillion of trust products mature this year with a peak of around RMB 1 trillion in May. If the China Credit Trust product was allowed to default, China’s financial system might have been sitting on hundreds of billions, if not trillions of yuan worth of non-performing loans in just a few months time.
While the worst case scenario has been avoided, the current outlook still isn’t great. Even though this default has been avoided, another liquidity squeeze such as the ones that occurred in June and December 2013 will certainly occur in May/June given the trust maturities. If interbank rates continue to spike every few months, it is clear that the People’s Bank of China (PBOC) will never succeed in turning the Shanghai Interbank Offered Rate (SHIBOR) into a pricing tool for credit instruments and that financial reform is essentially dead in the water.
Fortunately, regulators do not appear to be sitting idly by. Last week, in an apparent response to the current trust crisis, the PBOC and National Audit Office announced that they would soon begin an audit of shadow banking. The announcement follows the release of the local government debt audit in December that showed local government had become increasingly reliant on shadow banking to fund their investments, and the State Council 107 Document, also released in December, which called for greater regulation of shadow banking activities, including trusts and WMPs.
It is unclear when the shadow banking audit will finish, but it has the potential to mark a significant turning point in the ongoing trust/WMP saga. Despite the bailout this time, there were many in Beijing calling for a default of the trust product, recognizing the moral hazard that is created when the government bails out the market, allowing investors to continue to take riskier bets in expectation of future bailouts.
As this view is increasingly being held by individuals who can influence decision makers, more aggressive steps to curb shadow banking and risky trust bets are likely. It is possible, for example, that once regulators know the extent of shadow banking activities and how connected the formal banking sector is to the shadow banking sector, a managed default can be undertaken to teach investors a lesson in risk management and begin to adjust trust/WMP investment practices.
Foreign commentators on China always want a quick solution and bold moves, but this is not China’s way. In every segment of the economy, China takes things step-by-step. This approach has underpinned the remarkable growth China has achieved over the last three decades and is the embodiment of the statement by former Paramount Leader Deng Xiaoping that you should “cross the river by feeling the stones.” So we must therefore watch for incremental signs of change and hope that they are enough to prevent a catastrophe.