Distrust of China’s Trusts; Growth of a shadow banking system creates moral hazard

Distrust of China’s Trusts

Growth of a shadow banking system creates moral hazard.

Updated Jan. 29, 2014 3:54 p.m. ET

The lunar new year holiday on Friday will usher in the year of the wood horse in the Chinese zodiac. And yes, Chinese are well aware of what they call the “wooden horse strategem.” But if there’s a nasty surprise in 2014, it’s likely to come from within China’s own financial system.

The new year is of particular interest because it’s the deadline for the Credit Equals Gold No. 1 trust product to return $3 billion yuan ($495 million) to investors. That’s been a worry for several weeks since its main investment, a coal mining company in Shanxi, was closed down and its CEO arrested. A default was averted on Monday when a mysterious investor took over the mining loan. While no details are public, it seems the government stepped in with a bailout, as it has for several other struggling trusts in recent years.

So investors will get back their principal, but not the promised 10% annual interest. They were clamoring for the bank that sold them the trust product, Industrial and Commercial Bank of China, to make them whole, but ICBC insisted it wasn’t liable for losses. Investors were supposed to accept the risk of default in return for the high yield.

For political and economic reasons, however, Beijing could not afford to let that happen. Investors protesting outside ICBC would be bad enough. But most damaging would be the knock-on effects of a loss of confidence in the implicit government guaranty investors have learned to rely on. Suddenly many companies and local governments would have to pay more for credit or might not be able to borrow at all.

Beijing’s inability to let a single trust product go bust exposes the weakness of the shadow banking system that has sprung up since 2009. As Anne Stevenson-Yang writes nearby, regulators have created a massive moral hazard, as investors ignore the risks of losing their money and shady operators are able to borrow freely.

So why did shadow banking take off so quickly, with trust products growing by seven times from 2007-2012? After the start of the global financial panic, Beijing encouraged banks to lend without restriction, which created a massive expansion in investment. But as regulators tried to bring the banks back under control, companies continued to demand more credit. Meanwhile, savers were looking for higher yields, which are capped in ordinary bank accounts.

Trusts were the only available way to bring the two sides together off bank balance sheets. In more developed markets, this role is largely played by junk bonds, which are publicly traded and so give continuous feedback on the risk of default. Trusts as vehicles for private debt placements are best suited to institutional investors, not individuals.

It’s ironic that in spite of Beijing’s distrust of tools that have sometimes caused problems elsewhere, such as junk bonds, derivatives and hedge funds, it still ended up creating systemic risks. But such unintended consequences are commonplace in finance, as money finds ways to flow where it is most wanted.

It would be a mistake for Beijing to overreact now by simply clamping down on trusts, which perform some useful functions. The best prudential regulation is not about blanket bans on particular products, but rather looking for signs of dysfunction and getting ahead of the problem. The explosion of trust products suggests that the Chinese financial system needs new conduits for capital outside the banks. The challenge is to make sure that they are transparent, well regulated and free of any expectation of government bailouts.