Chinese shadow banks face major test after ICBC refused to bail out investors in a dud $500m issue. Chinese Stocks Tumble On Contagion Concerns From First Shadow-Banking Default

Last updated: January 16, 2014 6:45 pm

Chinese shadow banks face major test

By Josh Noble in Hong Kong, Jamil Anderlini in Beijing and Sam Fleming in London

China’s vast shadow banking sector is facing its biggest test after ICBC, the world’s biggest bank by assets whose branches sell many of these wealth products, refused to bail out investors in a dud $500m issue.The enormous growth of poorly regulated financing outside the formal banking sector in China and the potential for a panicked run on these shadowy products and institutions poses one of the biggest risks to the global economy this year.

Shadow banking worries extend far beyond China. Paul Tucker, a former Bank of England deputy governor, claimed on Thursday that regulators around the world were struggling to keep up with the pace of change in the “shape-shifting” non-bank sector. He warned of “faltering vigour” in official oversight of global markets.

In China investment trusts and other wealth management products have become a vital source of off-balance sheet funding, and now account for almost a third of total credit in the world’s second-largest economy, up from less than a quarter in 2012.

However many have warned of the systemic risks posed by these products, including China’s state council, or cabinet. Last July, the International Monetary Fund said it was “increasingly urgent” for China to shift away from its credit-intensive growth model, which it said was “not sustainable and is raising vulnerabilities”.

In China the funds are often invested in more troubled sectors of the economy and they have been snapped up by retail investors seeking better returns than those afforded by bank savings.

Most wealth management products are sold with some form of bank guarantee, leading many investors to believe that the products are effectively risk-free, despite the often high promised yield.

But, in an unprecedented move, ICBC has said it will not stand behind the Rmb3bn ($495m) investment product it distributed through its branches in 2010, according to people familiar with the situation. The fund matures at the end of this month.

Zhang Zhiwei, China economist at Nomura, said that a default in the shadow banking sector could trigger a ripple effect across the whole financial system.

“In the past we’ve had several examples of trust companies bailing out investors. I don’t think we’ve had a situation where investors have lost money,” said Mr Zhang. “I think it’s going to change the expectations for some investors for the potential credit risk, and have some risks for the rolling over of a lot of these trust products.”

In a paper published by the US think-tank, Brookings Institution, Mr Tucker said regulators around the world needed to display greater flexibility to cope with “endemic regulatory arbitrage and the shape-shifting dynamic of finance”, pointing to problems in both advanced and emerging market economies.

Globally, shadow banking is worth $71.2tn according to the Financial Stability Board, with its estimate of China’s sector exceeding $2.1tn.

The product which ICBC is refusing to guarantee – optimistically named “2010 China Credit / Credit Equals Gold #1 Collective Trust Product” – was issued by China Credit Trust Company, and the funds raised were used to make loans to a coal company that is now facing bankruptcy.

The trust offered investors a 10 per cent yield, compared to the benchmark deposit rate of just 3 per cent. The first payment is not due until the end of this month.

While the money raised by this product is minuscule compared to the rmb17.3tn in total credit extended last year in China, the government is extremely concerned that failures like this one could cause panic and a run on all trust and wealth management products.

If that were to happen, it could effectively cripple the entire Chinese financial sector and push the credit-dependent Chinese economy into a deep recession.

China Credit Trust Company, the country’s third largest such group by assets, is preparing at least partially to repay investors, sources said, in an effort to shore up its own credibility and that of the wider trust sector.

The growth of shadow banking has helped finance development projects across China, but caused a rapid increase in local government debt, which reached $3tn last year according to official figures. Failure to roll over these debts could prove a significant drag on economic growth due to the resultant delay to investment.

This has raised increasing concern at government level, with the State Council warning earlier this month that shadow banking risks are “complex and hidden, and vulnerabilities can emerge suddenly and spread easily causing systemic problems”.

Analysts warn that the economic effects of a major problem in the Chinese shadow banking sector would not be confined to the People’s Republic.

Danny Gabay, an economist at Fathom Consulting, which has been examining the sector, said a sharp rise in non-performing loans in the shadow banking system would pose a “significant risk” to Chinese banks.

He said: “While the consequences for China were this risk to materialise are very serious, we do not see significant financial contagion risks à la Lehmans to the rest of the world.

“The knock-on effects would be more in the macroeconomy, for example through traditional trade links and demand for commodities and other materials.”

Chinese Stocks Tumble On Contagion Concerns From First Shadow-Banking Default

Submitted by Tyler Durden on 01/16/2014 21:54 -0500

While manufacturing and services PMIs disappointed, the big problem in big China remains that of an out-of-control credit creation process that is blowing up. As we previously noted, instead of crushing credit creation, the PBOC’s liquidity rationing has forced distressed companies into high-interest-cost products in the shadow-banking world. Investors on the other side of “troubled shadow banking products” had assumed that ‘someone’ would bail them out but this evening Reuters reports that ICBC has confirmed that it will not rescue holders of the “Credit Equals Gold #1 Collective Trust Product”, due to mature Jan 31st with $492 million outstanding. The anxiety from contagion concerns of the first shadow-banking default has pushed the Shanghai Composite back near 2,000 for the first time since July – and to its narrowest spread to the S&P 500 in almost 8 years.

The Shanghai Composite is tumbling… to six month lows (and back near 2,000 for the firs time since July)…

and its closest (nominally) to the S&P 500 in almost 8 years…

As we previously noted,

…borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).

Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are. 

Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.

So the PBOC’s efforts are merely exacerbating the situation for the worst companies… for example… Zhenfu Energy…

As Reuters reports,

Industrial and Commercial Bank of China, the world’s largest bank by assets, said on Thursday that it has no plans to use its own money to repay investors in a troubled off-balance-sheet investment product that it helped to market.

ICBC’s shares have fallen this week amid speculation that the bank would be forced to help repay investors in a 3 billion yuan($496.20 million) high-yield investment product issued by China Credit Trust Co Ltd but marketed through ICBC branches. The product is due to mature on Jan. 31.

“Regarding this unsubstantiated rumour, a situation completely does not exist in which ICBC will assume the main responsibility(for the trust product),” an ICBC spokesman told Reuters by phone on Tuesday.

The trust product, called “2010 China Credit / Credit Equals Gold #1 Collective Trust Product”, used the funds it raised from wealthy investors in 2010 to make a loan to unlisted coal company Shanxi Zhenfu Energy Group Ltd.

But in May 2012, Zhenfu Energy’s vice chairman, Wang Ping Yan, was arrested for accepting deposits without a banking licence.

Which Barclays warns:

In our view, despite the trust issuer, distributor bank and local government perhaps trying to bail out the mining company, the regulators and central government could probably allow the trust product default to happen as:

government appears fairly determined to reform the financial system and cut off the implicit guarantee of financial institutions;

the State Council is reportedly streamlining regulation of shadow banking including trust business; and

the default of trust products could have less social impact than the default of WMPs, bonds and other products sold to the general public or have problematic practices, such as asset-pool investments.

In our view, the default of trust products could trigger some short-term negative impacts on China’s financial sector and the reputation of financial institutions. However, we believe it is positive for the healthy development of financial system in the long run because the default could do the following:

Be a step to reduce the implicit guarantee of financial institutions for investment products. Banks could shift their financial liabilities back to the investors.

Increase the risk awareness of both investors and financial institutions, which could correct the pricing of investment products to more risk-oriented.

Its conclusion is dire: If the trust product goes into default, we believe it would be the first default to test the financial system.

Here is the product…

And the growth of such products has been enormous as we have explained in great detail previously: at RMB10.1 trillion as of Q3 should the first domino fall, watch out below.

Finally for those who have forgotten, below is a quick schematic of what a WMP looks like:

As Michael PettisJim ChanosZero Hedge (numerous times), and now George Soros have explained. Simply put –

“There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”

The “eerie resemblances” – as Soros previously noted – to the US in 2008 have profound consequences for China and the world – nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector as explained above.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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