One of China's largest investment trust companies, China Credit Trust, in mid-January announced that it faced defaulting on a CNY3-billion retail investment product it had arranged. The default was averted, but it would have been the first failure of such a product for more than a decade, threatening severe potential impact on investor confidence and systemic financial stability.
IHS Global Insight perspective | |
Significance | The near-default on China Credit Trust's product illustrates the severe inherent risks within China's shadow-banking sector. The expansion of shadow banking poses systemic risks, and will remain a policy priority in the next three to five years. |
Implications | With slower growth expected, distress within the formal and shadow-banking sectors will increase. Inevitably, China will face further default threats in the near to medium term. While recognising some justifications for the bailout of specific to its timing, we view the recent event as a missed opportunity to address wider moral hazards in the financial sector. |
Outlook | New regulations are likely to be introduced in the coming year, aiming to enhance transparency and oversight in the shadow-banking sector. However, over at least the next three to five years, shadow banking will remain a significant component of China's financial system. In the long term, financial reform and liberalisation are required to rein in shadow banking. However, there is a significant risk that multiple vested interests will frustrate systemic financial reforms. |
One of China's largest trust companies, the China Credit Trust (CCT), in mid-January announced that a CNY3-billion (USD495-million) fund it had arranged faced default. The default was averted, but it would have been the first failure of such a product for more than a decade, threatening severe potential impact on investor confidence and systemic financial stability.
One of the most serious current risks in the Chinese economy is the rapid expansion of shadow banking activities over the past five years. In broad terms, shadow banking refers to any credit intermediation involving entities and activities outside the regular banking system. In China, the entities involved include banks, trusts, mutual funds, and even pawn shops on the credit supply side, and local governments, property developers, and small to medium-sized enterprises (SMEs) on the demand side. Supply and demand are bridged by an array of financial products ranging from investment trusts to wealth-management products (WMPs).
The systemic risks associated with shadow banking were highlighted clearly in the United States during the global financial crisis of 2008–09, when excessive lending in the US sub-prime mortgage market and other imprudent risk exposures led to the collapse of several leading financial firms. Investors worldwide are now concerned that the world's second-largest economy may face its own 'Lehman moment' – an event triggering a financial and economic crisis for China – with major global impacts.
Unlike widespread recent media commentary, IHS does not view January's events as directly comparable to the events of 2008. Instead, we interpret the recent incident as a missed opportunity to restrain a prominent moral hazard and to distinguish between conventional and shadow banking (see Banking Risk Service: China: Special report: 10 February 2014: Shadow banking in China and recent near-default case: Missed opportunity or averted disaster?).
Near default and subsequent bailout
CCT's CNY3-billion product, with an interest rate more than triple the standard bank deposit rate, had been sold to private investors by the state-owned Industrial and Commercial Bank of China (ICBC). Initial statements from CCT and ICBC suggested that losses might be borne by investors. In turn, this sparked discussions about a full-blown default and contagion risk to other financial institutions, with potential Lehman-like consequences.
As in previous episodes in China's financial system, there was no established legal framework to address the problem. Multiple parties within the shadow-banking sector wished to maintain the status quo, with every investment perceived to carry an implicit state guarantee. By contrast, pro-market advocates argued that investors should take individual responsibility, pointing to the serious moral hazard arising from the rapid expansion of credit to the riskiest parts of the economy under vaguely defined state guarantee.
Given recently announced government plans to strengthen banking regulations and the pledge, made at the Chinese Communist Party's Third Plenum, to allow market forces to play a "decisive" role, many observers expected that the CCT product would have been allowed to fail. Initial statements by ICBC officials also reinforced these expectations. However, a default was averted on 27 January, four days ahead of the redemption date. CCT announced that a bailout had been arranged with unidentified investors. Subsequently, the media speculated that a unit of the state-owned investment group CITIC "may" be involved.
CCT case in perspective
A CNY3-billion product is tiny in comparison to the total assets of CNY10.1 trillion across some 60 trust companies operating in China: further potential defaults are virtually certain to arise. However, while a single failed fund can be rescued relatively easily, China faces huge potential challenges from the enormous volumes of risk accumulated in its rapidly expanding shadow-banking sector. Trust companies now constitute the second-largest financial sector in China behind formal banking. In 2012–13, CNY3.1 trillion of new trust-related lending was issued, accounting for 10.7% of total credit-type activities in broad terms. Likewise, entrusted loans, in which, in theory, banks are acting only as intermediaries between borrowers and lenders, almost doubled in 2013 and accounted for 14.7% of total financing. Overall, the share of new financing provided via non-banking channels continues to increase, reaching 45% last year, up from 12% a decade earlier. In this environment, it is clearly unsustainable for the government to rescue every instrument that fails.
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IHS Banking Risk Service repeatedly has highlighted the very high risks within China's banking sector that are driven by proliferating shadow banking financing (see Banking Risk Service: China: Special report: 24 April 2013: Shadow banking in China – a ticking bomb). In short, Chinese banking is characterised by extensive financial repression, such as regulatory caps on lending rates and a very tight loan-to-deposit ratio, and by the use of state-owned banks as policy vehicles. These restrictions have encouraged the migration of a significant part of banking activities into the shadow banking system, which official statistics often fail to capture.
Considerations behind bailout
In this specific case, there are several possible reasons why the government opted for a bailout, passing up an opportunity to impose market discipline. Firstly, the incident occurred just prior to the Chinese New Year, a period of high cash demands. A default at that time could have triggered a liquidity crunch. Secondly, shadow-banking reforms are still at a very early stage, with no structural framework yet in place. Thirdly, other complementary financial sector reforms are expected to be announced in the near future, which would make shadow banking reforms more effective. In addition, many shadow-banking products, such as the funds issued by CCT, were created at a time of robust economic recovery around 2010, based on more optimistic economic projections. Growth has slowed considerably since then, making additional difficulties very likely. A single major failure could seriously have dampened confidence and reduced economic growth, causing more funds to fail. Avoiding such a downward spiral is likely to have been a major concern for policy makers.
Politically, although there appears to be broad consensus about the need for financial liberalisation, there are powerful counterbalancing forces. In particular, demand for cheap credit from state-owned enterprises (SOEs) and local governments has blocked interest-rate liberalisation for the past two decades, despite many promises of imminent reforms. The shadow-banking sector developed to circumvent irrationalities within the formal banking system. There is little talk of eliminating shadow-banking altogether. Instead, the discussion is focused on better regulating the sector to harness its benefits, while minimising the risks.
Outlook and implications
Shadow banking in China will be a key political priority in the near to medium term, and the systemic risks stemming from its extraordinary growth are now well recognised. With slower economic growth expected, distress within both the formal and informal banking sectors is set to increase, given inherent interconnectedness between the two. China will inevitably face further default threats. Given this, we view the recent bailout as a missed opportunity to address a prominent moral hazard problem in the financial industry.
We expect several new regulations to be introduced, aiming to bring more transparency and better supervision to the shadow-banking sector. A formal deposit guarantee scheme would represent a key measure separating state-supported bank deposits and riskier shadow-banking investment products. Nonetheless, we forecast shadow banking to remain a significant component of China's financial system. In the longer term, the only lasting and effective solution to the problems of unregulated financing and financial repression lies in broad-based financial liberalisation, so permitting the conventional banking system to rebuild its role.