China Should Allow Investments To Fail, Major Shadow Banking Bailout Raises Risk Of Moral Hazard

China’s financial market just narrowly dodged a bullet, but the $1.7 trillion trust industry (the fastest-growing segment of the shadow-banking system) will continue to experience disruptions in the year ahead. More importantly, the last-minute bailout of the soured 3-billion-yuan ($500 million) high-yield investment trust goes against the government’s commitment to let markets play a “decisive” role.

The condition for default in China is ripe: slowing credit growth, elevated costs of funding, waning economic momentum and tighter financial regulations.

“China has been in a similar place before, for example in late 2011 when underground banks fell like dominos,” Yao Wei, a Hong Kong-based China economist at Societe Generale SA, wrote in a note. “Actually, this time, the situation is actually grimmer than ever.”

Big state-owned banks are no longer liquidity-rich and local governments are overly burdened by debt. But for defaults to happen, one more factor is needed -- the willingness of the central government.

“Whether financial products in China can default or not is, at the end of the day, a political decision,” Yao said, adding that this has previously been the case. Four corporate bonds in 2012 and nearly two dozens of trust products in 2013 managed to find money from various pockets of the state, which came to their rescue just hours before the deadline.

“However, we think defaults and probably stock-market delisting of state-owned enterprises will still happen,” Yao said. “Having financial market defaults is actually in the exact spirit of reform.”

The key guideline of the Third Plenum decision is that the market will play a more-decisive role in determining factor prices. If the invisible hand of the market doesn't have the freedom to destroy failed investment, there will be no base for “decisive” roles.

Yao added: “On one hand, we are strong believers that the new leadership will go ahead with painful short-term adjustments for the long-term good. On the other hand, we are well aware that it would never be Beijing’s intention to push the economy into a hard landing. Hence, defaults, if they occur, are likely to be a controlled process, at least at the very beginning.”

A Trust That Is Too Big To Fail

The “2010 China Credit / Credit Equals Gold #1 Collective Trust Product” that avoided the fate of defaulting on Chinese New Year’s day, used the funds it raised from wealthy investors in 2010 to make a loan to unlisted coal company Shanxi Zhenfu Energy Group Ltd.

The trust offered investors a 10 percent yield, compared with the benchmark deposit rate of just 3 percent. It was issued by China Credit Trust Co. Ltd., one of the country’s biggest “shadow bank” institutions, and marketed through Industrial Bank Co. Ltd. (SHA:601166) branches.

According to the Chinese-language 21st Century Business Herald, Zhenfu Energy has already been declared bankrupt amid surging costs and shrinking profits as the country puts greater emphasis on economic restructuring and transforming the growth pattern.

In May 2012, Zhenfu Energy's vice chairman, Wang Pingyan, was arrested for accepting deposits without a banking license.

Following an investigation, China Credit Trust Company told investors that Zhenfu Energy had taken out high-interest underground loans totaling 2.9 billion yuan, bringing its total liabilities to 5.9 billion yuan. Meanwhile, total assets have been valued at less than 500 million yuan.

ICBC, the world’s largest bank by assets, told Reuters that it has no plans to use its own money to repay investors. “Regarding this unsubstantiated rumor, a situation completely does not exist in which ICBC will assume the main responsibility [for the trust product],” an ICBC spokesman said.

Most wealth-management products are sold through state-owned banks, leading many investors seeking better returns than what bank savings offer to believe that the products are effectively risk-free, despite the often high promised yield. But banks aren't legally required to shield investors from losses when products they help create and sell go bad.

Under increasing pressure, China Credit announced on Monday that it had reached an agreement with an unnamed third-party to sell the shares it held in Shanxi Zhenfu Energy Group. China Credit had taken control of Zhenfu’s shares as collateral when it failed to repay the loan.

According to that statement, investors wouldn't receive interest on the third and final year of the product, equivalent to around 300 million. Those who don't accept the deal will be given shares in Zhenfu, an unappealing prospect given the miner’s struggles.

Bloomberg reported on Wednesday that most clients in Shanghai, Guangzhou and Beijing signed an agreement the previous day with China Credit to transfer their rights in trust to unidentified buyers in exchange for an amount equal to the product’s face value.