China’s Trust Bailout Risks Stoking Shadow-Banking Expansion

Jan 28, 2014 3:39 am ET

(Updates with LGFV bond yields in sixth paragraph.)

Jan. 28 (Bloomberg) -- China’s eleventh-hour rescue of wealthy investors in a high-yield trust threatens to drive more money into the nation’s $6 trillion shadow-banking industry, undermining regulators’ efforts to deter excessive risk-taking.

Industrial & Commercial Bank of China Ltd., the nation’s largest lender, yesterday told customers who had invested in the 3 billion-yuan ($496 million) trust product that they can sell their rights to unidentified buyers to recoup the principal. Some clients plan to visit ICBC branches to demand more interest ahead of tomorrow’s 5 p.m. deadline for accepting the offer, according to Du Ronghai, a Guangzhou-based investor.

Averting the nation’s biggest trust default may reinforce investors’ belief in implicit guarantees and the government’s backing of such risky products, stoking their appetite for products in the $1.67 trillion trust market. The bailout underscores the pressure on authorities to maintain financial and social stability even as they aim to prune the government’s role in the world’s second-largest economy and curtail debt.

“The rescue brings short-term relief to the market at the cost of brewing a long-term crisis,” said Zhang Jian, a Beijing-based strategist at BOC International Holdings Ltd. “It aggravates the moral-hazard problem and makes it almost risk- free for investors to pump money into trusts, wealth management products and other shadow-banking sectors.”

Sovereign Risk

ICBC shares halted a three-day decline in Hong Kong trading to close unchanged after climbing as much as 1.3 percent. Credit-default swaps insuring China’s sovereign debt against non-payment dropped nine basis points, the most since September, to 95.97 in New York yesterday, according to CMA prices. The swaps climbed to 104.91 on Jan. 24, the highest since Aug. 30.

The average yield on five-year notes rated AA, the most common grade for so-called local-government financing vehicles, dropped two basis points yesterday, the biggest decline in more than two weeks, to 7.58 percent.

China Credit Trust Co., the Beijing-based firm that raised money through the Credit Equals Gold No. 1 trust in 2011 for a failed coal miner, reached the accord four days before the product matured. In a two-sentence statement, it told the trust’s investors that it had reached a pact for a potential investment and asked them to contact financial advisers at ICBC for more details. It didn’t disclose the source of the funds.

Two calls to Li Jie, a manager of the product at China Credit Trust, weren’t immediately returned today.

Visit Branches

Under the rescue plan, investors in the trust product must authorize China Credit Trust to handle the transaction if they want to recoup their principal, according to one investor who cited the offer presented by ICBC and asked to be identified only by his surname Chen.

Investors plan to visit ICBC branches in Guangzhou, Shanghai and Beijing today to demand more interest, according to Du, who put 3 million yuan into the product. ICBC’s Beijing- based press officer, Wang Zhenning, declined to comment.

“The best outcome is repayment of principal, but not interest,” Dariusz Kowalczyk, a Hong Kong-based economist and strategist at Credit Agricole CIB, wrote in an e-mail. “It would strike a good balance between containing the fallout and beginning a long-term process of reduction of leverage in the economy.”

The Credit Equals Gold high-yield product, distributed by Beijing-based ICBC to its private-banking clients, was structured to raise funds for Shanxi Zhenfu Energy Group. The coal miner collapsed in 2012 after its owner Wang Pingyan was arrested for illegally collecting deposits.

Avoided Default

At least 20 trust products have run into difficulties in making repayments since 2012, according to China Securities Co. All of them have avoided default as issuers or third parties eventually repaid investors in full.

About 5.3 trillion yuan of trust products will be due this year, compared with 3.5 trillion yuan in 2013, Haitong Securities Co. estimated this month. Trust firms are no longer capable of shouldering all the risks tied to offering implicit guarantees as they only have 236 billion yuan of shareholders’ equity, Haitong’s analyst, Jiang Chao, wrote in the Jan. 9 note.

“The latest episode could be a precursor of increased financial stress on China’s trust and shadow-banking sector,” Liu Li-Gang, an economist at Australia & New Zealand Banking Group Ltd. in Hong Kong, wrote in a note today. “2014 will be the year of living dangerously with these products.”

Fund Payments

The Economic Information Daily reported earlier this month that investors in 1 billion yuan of private-equity-fund products hadn’t yet received payment due in December from Beijing Roll-In Investment Management Ltd., an asset manager. Executives at the guarantor, Sino-Mercantile Wealth Credit Guarantee Co., declined to speak with a Bloomberg News reporter who visited its Beijing office on Jan. 22 while about a dozen investors met inside to discuss how to recoup losses.

China Credit Trust made three interest payments since 2011 totaling 670.9 million yuan to investors in Credit Equals Gold, with the last installment in December missing the anticipated rate of return, according to a Jan. 16 statement that was posted on the trust company’s website.

Investors met with ICBC officials at a private-banking branch in Shanghai last week, demanding their money back and threatening to escalate the matter with bank, government and regulators in Beijing if the case wasn’t settled by Jan. 31. They had been given guarantees that it was “100 percent safe,” said Fang Ping, one of 20 investors present at that time.

Kicking Can

With the help of such implicit guarantees, trusts have overtaken insurance to become China’s biggest financial segment after banks. Their assets under management surged fourfold from the beginning of 2010 to more than 10 trillion yuan as of Sept. 30, data from the China Trustee Association showed, even as policy makers sought to curb money flows outside the formal banking system.

“By bailing out investors in the product, China is successfully kicking the can down the road,” Mike Werner, a Hong Kong-based analyst at Sanford C. Bernstein HK Ltd., wrote in a note today. “Investors in these shadow-banking products, despite taking significant risks, appear immune to losses as last-minute solutions, often government-backed, usually emerge.”

--Jun Luo, with assistance from Helen Sun in Shanghai and Zhang Dingmin in Beijing. Editors: Chitra Somayaji, Russell Ward