Worry over China's shadow banking mess
Timing of trust's possible default could lead to a 'Lehman Moment'
THE countdown to the Chinese New Year has never been so stressful for Chinese housewife Tina Zhu - and it is not the spring cleaning that is keeping her up at night.
Rather, it is China's informal lending sector mess, which could see its biggest default of an investment product to date on Friday.
The 3 billion yuan (S$634 million) trust, based on loans to an embattled coal company, matures on that day, but is unlikely to be able to repay investors. Its distributor, state-owned giant Industrial & Commercial Bank of China (ICBC), has refused to bail it out.
ICBC chairman Jiang Jianqing told US network CNBC last Friday the bank will not take "rigid responsibility" for the losses, to teach investors a lesson about the risks of such investments and about moral hazard.
It is unclear whether the authorities, who are reluctant to perpetuate lending shenanigans in the non-bank sector through repeated bailouts, would step in to do damage control this time.
But analysts warn that the fate of this trust, if not handled properly, could potentially trigger the failure of other shadowy products - perhaps including the three funds that Ms Zhu sank "80 per cent of her family's savings" into.
She is considering yanking out her money from the trusts - the details of which she knows little other than the promise in 2012 that they are "capital guaranteed" - one year before they mature, in case they are bad eggs too.
"If such a big state bank like ICBC is not willing to compensate customers, then what more the other smaller distributors?" asked Ms Zhu, 34. "If I don't try to recover part of my money now, I might lose everything later."
Such fears among retail investors are what could turn a potential Jan 31 default of the ironically named "Credit Equals Gold No.1" trust into China's equivalent of the "Lehman Moment". This refers to the collapse of a relatively small bank - Lehman Brothers - in 2008, which unexpectedly sparked a chain effect leading to the United States sub-prime crisis and global economic turmoil.
"The risk of a 'Lehman Moment' is real in this case," said UOB China economist Suan Teck Kin. "If the authorities go in with the thinking of 'let it default and teach everyone a lesson'... then it could be disastrous for everyone. It could even set off a recession for China, and have wide impact on the rest of the world."
At first glance, the default of "Credit Equals Gold No.1" may seem a piffle - and hardly worth the global headlines it has drawn.
After all, it represents a minuscule 0.03 per cent of the US$1.67 trillion (S$2.14 trillion) of assets managed by China's 67 trusts. And the coal company, Zhenfu Energy, that it raised funds from well-off retail customers to make loans to, is hardly well-known.
Even in May 2012, when Zhenfu's vice-chairman Wang Pingyan was arrested for illegally accepting deposits and the debt-ridden company faced bankruptcy, its downfall was not remarkable.
It would hardly be the first trust in trouble, pointed out Nomura analyst Zhang Zhiwei. "Default has been avoided as trust companies found ways to pay investors, sometimes with their own capital," he added.
China Credit Trust Co, which set up the fund, has indicated that it will attempt to partly compensate customers.
But what makes its possible default seem like a "Lehman Moment" is the timing. It comes amid a slowdown in China's economy and an expected liberalisation of interest rates. This could squeeze borrowers' ability to repay and raise their loan costs, escalating the risks of defaults.
It also comes after two cash crunches in June and December last year, that drove up interbank interest rates to record highs before the central bank bailed out the banks by injecting liquidity.
The cash squeezes have already highlighted the risks of the shadow banking sector, which has grown so fast, vast and complex that any default risks destabilising the entire system.
Shadow banking refers to the poorly regulated money flows outside the formal banking system, that include trusts, funds sold outside of banks' balance sheets and local governments' financing vehicles (LGFVs). JP Morgan economist Zhu Haibin reckons that it is worth about 36 trillion yuan.
And it is estimated to make up almost a third of total credit in China, surging from less than 25 per cent two years ago.
Shadow banking products also tend to be interlinked - for instance, trusts may raise funds through wealth management products, in order to lend to the LGFVs. Local governments use these vehicles to skirt a ban on them borrowing directly from banks, by tapping the shadow banking sector for loans that often end up in less viable projects.
The collapse of one part, even a tiny one, could have a magnified impact on the whole.
"Failure of some wealth management products does have cascading effects because they are financial packages that are tied to one another," said University of Toronto professor Lynette Ong.
She believes a default of some trusts or wealth management products may take place this year or next year. But "it is difficult to say for sure the ICBC trust will be among them", she said. "Other things being equal, if this happens to a smaller bank, the likelihood of default is higher."
Indeed, the probability of a complete default of "Credit Equals Gold No.1", where investors get no compensation, is low, said Mr Suan. "The government is aware of the systemic risk that could spread and most importantly, a loss in confidence that could spread through the financial system," he explained.
But the authorities "will be approaching this case very cautiously, as it would serve as a benchmark case for other wealth management products", he added.
Another 100 billion yuan of trust products are due to mature this year, with some already in financial difficulties, reported the Shanghai Securities News.
So even if "Credit Equals Gold No.1" is saved from a blow-out, it does not mean the risk of China's "Lehman Moment" is past.
The real tipping point could come if a LGFV trust defaults - "a psychologically very important event", wrote Bank of America Merrill Lynch economists.
It could spark a debt crisis if the market believed that the top leadership had allowed local governments to fail - or was unable to prevent it. But it would also inject much-needed discipline into the unruly and amorphous shadow banking sector, say analysts.
China Securities Co analyst Huang Wentao described a major default with a Chinese proverb "zhuang shi duan wan", where a warrior bitten by a snake chops off his arm to stop the poison from spreading across his body. "This is necessary for the long-term health of the market," he noted.
The risk of a 'Lehman Moment' is real in this case. If the authorities go in with the thinking of 'let it default and teach everyone a lesson'... then it could be disastrous for everyone. It could even set off a recession for China, and have wide impact on the rest of the world.
- UOB China economist Suan Teck Kin