China trust deal raises thorny questions

January 28, 2014 2:21 am

China trust deal raises thorny questions

By Simon Rabinovitch in Shanghai

A wealthy pensioner in a southern Chinese city deciding to lend money to a troubled coal miner in the country’s north about which she knew next to nothing might seem a dangerous gamble.

But Ms Wang did not see it that way – at least not until a few weeks ago. As a VIP customer at a Shenzhen branch of Industrial and Commercial Bank of China, the country’s largest bank by assets, she was offered a special investment product in 2011. For a minimum commitment of Rmb3m ($500,000), she was promised an annual return of 10 per cent for three years. And, she says, the ICBC client manager assured her that the trust product was safe.

“It was my first time buying a trust product. I had never bought any stocks or mutual funds before. Having seen the Lehman Brothers troubles, I was very careful in reviewing the product, and I only put my money into it as it didn’t look to be risky,” she told the Financial Times. Like many other investors, she wrongly assumed the trust was “backed by the biggest bank in China”.

But like the 700 other investors who took up the offer, Ms Wang sorely underestimated the risks. Last week ICBC warned investors they might not get their money back – and that contrary to a belief held by many, the bank had never guaranteed the trust product.

The trust product she bought – “Credit Equals Gold No. 1” – came within days of a default that would have wiped out almost all of the cash she had invested.

For global markets, the troubled product became emblematic of the risks that have built up in China’s burgeoning shadow banking sector. Non-bank institutions such as trusts now play a crucial role in providing funds to companies deemed too risky by regulators to borrow from the country’s banks. Financing outside the formal banking system accounted for more than a third of the Rmb17tn total new credit issued in 2013.

With roughly Rmb4tn ($661bn) in trusts maturing this year amid tight monetary conditions, many expect more repayment problems. “The market already perceives a higher risk and is in the process of pricing higher risk,” says Wang Tao, an economist with UBS.

In the case of Credit Equals Gold No. 1, ICBC clients invested a total of Rmb3bn in a product sold by China Credit Trust, one of the country’s biggest “shadow banks”. The product – a mere sliver of China’s $1.2tn trust market – was underpinned entirely by loans to and equity in coal miner Shanxi Zhenfu Energy Group. It was a rotten investment: the price of coal plummeted and Zhenfu collapsed under the weight of heavy debts.

Nevertheless, on Monday, four days before the product matured, ICBC told investors a deal had been reached that would allow them to recoup their full principal, although they would miss out on about a quarter of the interest they had expected to earn.

There was little detail about where the money came from, but Chinese media have reported in recent days that a bailout was likely to involve ICBC, China Credit and the local government.

Some investors are vowing to fight for the additional interest. “This is a war of attrition. We have gained the biggest mountain and now we must attack and seize the smaller hills,” says one Shanghai-based investor who declined to give his name.

The last-minute rescue raises a thorny question for the future of the Chinese economy. Has the deal confirmed the widespread belief that the government will do whatever it can to stave off trouble, hence fuelling more risk-taking? Or has the near-default taught investors that high yields come with high risks?

“This is something that policy makers are struggling with. The final solution has probably reinforced people’s perception that trust products bought through banks will be bailed out,” says Shen Jianguang, an analyst with Mizuho Securities. “But this case has also showed many people that it’s not risk-free.”

The optimistic scenario is that the government will now use the extra time bought by the apparent bailout to bring its shadow banking system to heel. Beijing has drafted a series of regulations since late last year to limit off-balance-sheet lending by banks. “This will help regulators push through these rules. It teaches everyone a lesson about the expansion of shadow banking,” Mr Shen says.

The pessimistic take is that it is simply too late – that as money runs short, investors in failed trust products will face far bigger losses than Ms Wang did, creating turmoil for the whole financial system.

“We believe recent trust troubles in China are only the tip of the iceberg,” says Kevin Lai, an analyst with Daiwa Capital Markets.