China prepares for question of trust

The potential default of a trust product - the first of a financial instrument in China - would be a necessary step to providing investors with the proper tools for risk assessment

This year looks set to be an unsettled one for China’s financial markets as the government starts to deal with its debt issues, including the possibility of allowing the default of certain products.

Usually, the government would step in to guarantee any loss incurred in financial markets but Beijing appears determined to continue its reforms and instill proper risk pricing, making a default much more likely.

One reason for the change is that the government has made noises that it would let market principles play the decisive role in pricing and risk-finding, and meddling in the default process contradicts this.

The other reason is that China’s debt size has mushroomed and the government can’t bail out them all.

That is why the possible default of a Rmb3 billion ($490 million) bank-trust product is a moment that will be welcome by the government and the market.

The product, called Chengzhijinkai No. 1, may be the first financial product to default, as the issuer China Credit Trust and distributor ICBC Shan'xi branch refused to be liable for the losses and pay investors back by the end of this month.

The risk of default for this product has been present for a long time, as the project for which money was borrowed was never started, and the money diverted to repaying other debt, according to media report.

A Barclays report also expects a wave of defaults could be coming since trust products have shown substantial growth since 2011 with most products averaging 2-3 years in maturity. The analysts noticed that this year is a peak maturing period and the pace of problem products is accelerating rapidly.

Trust products, sometimes seen as parts of wealth management products, are issued by trust companies with a high yield with the underlying assets usually high-risk such as property projects or mine assets. Commercial banks would like to sell trust products to its clients for intermediate fees.

While investors may suffer from the default, Chinese regulators are more likely to welcome such a trust product default.

“That's [The default is] a necessary evil to clean up the financial system, correct credit misallocation and drive down cost of funding,” said Steven Sun, head of China equity strategy with HSBC.

The authorities have put local government debt as one of the government’s top priorities this year, the State Council rolled out Regulation 107 to control banks’ off-balance sheet activities, and the central bank allowed the Shanghai interbank Offered Rate (Shibor) and bond yields to stay at high levels to curb banks’ off-the-sheet lending.

“Not allowing any default is not fair to the issuers who have conducted due diligence carefully, done research on the details of products and select proper ones, and highlighted the risks to investors,” Zhang Qiong, head of investment products and services with UBS Securities wealth management, earlier told FinanceAsia.

Furthermore, market observers do not take a trust product default as a serious sign of a system collapse because the buyers of trust products are high-net worth investors (usually with Rmb3 million or more in investable assets) who are supposed to understand investments and who are less likely to protest on the streets.

“What will really spill over to financial markets is a debt default from a local government financing vehicle,” said Cui Wei, head of China equity strategy with Bank of America Merrill Lynch.

Cui believes that if one local government announces a debt default, a psychologically very important event, it will trigger a crash of confidence in the so-called “implicit guarantee” by the government.

The proportion of China’s social debt to gross domestic product (GDP) has risen from 129% in 2007 to 199% as of the end of the first half of 2013, according to Cui. The growth of social debts was mainly driven by strong increase of corporate debt (37%) and local government debt (16%).

Among the debts, more than 40% was generated off-the-banking-system, or say, by lightly regulated non-bank system or the shadow banking, compared to 5% in the early 2000s.

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