Talking Point

Searching for redemption

This year’s big debate: will Beijing allow a trust product to default?

Jilin w

Another week, another bailout: this time a potential default by Jilin Trust was averted by Beijing policymakers

One of the odder encounters for Edward Heath in China was with a biology student. The former British prime minister was at a cocktail party in Beijing in 1983 when the student approached him and asked in halting English: “Do you talk old rubbish?”

The bizarre exchange came about thanks to David Tang, the Hong Kong entrepreneur. In the early 1980s Tang gave English classes to the first batch of Ph.D students at Peking University that were being groomed to study abroad. To improve their language skills, Tang would take them to drinks receptions and encourage them to talk to foreign attendees in English. ‘What about?” they would ask. “Oh, any old rubbish,” Tang had replied.

The biology student took Tang’s advice literally and – insofar as Heath was concerned – may have hit a raw nerve. His successor Margaret Thatcher regularly derided Heath’s outdated solutions to Britain’s economic problems and those in her circle would dismiss his critiques of her bolder reforms (WiC can imagine them remarking ‘That’s just Ted talking rubbish again’). A one-term prime minister, Heath ended his parliamentary career in a permanent huff, feuding with Thatcher from the backbenches. Proud and prickly, the student’s linguistic faux pas must, at best, have produced a grimacing chuckle from Heath.

But what link is there between an 1980s Beijing cocktail party and the gatherings attended by today’s Chinese financial elite? Ironically, a lot of the conversations are also about rubbish – or more specifically the country’s wealth management products (WMP) and the threat that their toxic contents pose to the banking system.

Issued by investment trust firms and distributed by the banks, these WMPs have multiplied in recent years in large part because they have offered returns far in excess of bank deposits. The problem? A number of them seem to have done little more than make questionable loans to shaky borrowers. Last month just such a product (sold to ICBC clients) almost defaulted, saved only by a last-minute rescue (see WiC223).

Many now fear that other WMP defaults are inevitable and that they will soon start to erode confidence in the financial sector. This would be no small issue given the estimates of WMP volume. Ratings agency Fitch thinks Rmb13 trillion ($2.1 trillion) have been issued with at least 40% of the notes set to come due this year. Disaster scenarios include a liquidity crunch and a tidal wave of bad debt with the banks hit hard as the contagion spreads.

Industry spokespersons like the China Trustee Association, which promotes the use of wealth management products, has tried to strike a more confident tone, telling reporters last month that asset quality is “quite sound and systemic risks are impossible”.

But privately China’s regulators won’t be quite as confident – knowing the shadow lending sector represents what Dick Cheney might once have termed as a ‘known unknown’. That is to say, the financial authorities are acutely aware of the problem but struggle to assess its full magnitude. It is this sense of uncertainty that has contributed to decisions to prevent defaults from occurring. The preferred tactic has been to cobble together a bailout.

Of course, a credit market without defaults isn’t normal. The current system depends on what might be termed ‘the Beijing Put’ – a belief that the government won’t let any of the WMPs fail. Ergo investors feel safer buying the instruments, regardless of the credit risk of the borrower. Like the better-known ‘Bernanke Put’ – the Fed’s commitment to easy money propping up the stock market – the assumption is that the financial authorities will do whatever is necessary to keep the markets and the economy from going down. In China the put has basically allowed investors to buy products that yield far more than bank deposits, but seem to have the same kind of state guarantee.

The question in China is whether the Beijing Put could be under threat…

Bailouts galore…

The latest evidence is that the government’s commitment to avoiding defaults still holds. That’s because another trust product has been bailed out this week. This time it was the Songhua River #77 Shanxi Opulent Blessing Project that was rescued. It had loaned cash to the Liansheng Group, a troubled coal producer from Shanxi province. In a note to investors last month, the product’s backer, Jilin Trust warned that few opulent blessings were forthcoming. Instead the product was going to default on Rmb100 million ($16.43 million) of notes on February 19 because Liansheng was struggling to repay Rmb30 billion in other debts.

All of this would have been distressing to clients at China Construction Bank, which had sold the product through its branches.

(Alert readers will recall we’ve mentioned Liansheng before, but in a somewhat different context. Its boss Xing Libin grabbed nationwide headlines in 2012 when his daughter got married. As we described in WiC144, the elaborate wedding included a ‘dowry’ of six Ferraris for the new son-in-law and a ceremony reputed to cost Rmb70 million.)

However, investors were once again saved from disaster. Liansheng’s main creditor is the state goliath China Development Bank (for more on which see WiC189). And according to Xinhua, it organised a restructuring to stave off default. The 21CN Business Herald has also reported that three (unidentified) local companies would be investing Rmb3 billion in Liansheng and CDB would advance Rmb2 billion of additional capital in exchange for a 50% stake in the miner.

The Financial Times noted it was “the second time in less than a month that Chinese financial institutions have rescued shadow bank products”.

What’s next?

It looks like a case of two down, but several trillion more redemptions to go. “The good news,” the Wall Street Journal points out, “is that investors are getting reacquainted with risk”. For example, one metric now being more closely monitored is CDB’s own cost of funding. The New York Times says this is a number worth “watching carefully” as investors are evidently growing more worried about the bank’s credit profile. Yields on its long-term yuan-denominated bonds have spiked “about 50% in the past year, from about 4% to almost 6%”, the newspaper warns.

According to Japan’s Nikkei, signs of unease are showing up in the wider bond market too. “Concerns over potential defaults on high-yield financial products are making Chinese companies put some debt issues on hold due to wary investors. Since January, nine companies have postponed or cancelled issuance plans for a total of Rmb5.75 billion in bonds and commercial paper.”

How about broader concerns for the banking sector? Caijing magazine says that official data from the regulator signals that the non-performing loan ratio has risen to 1% in aggregate. Ambrose Evans-Pritchard, a bearish commentator in the UK’s Telegraph newspaper, thinks there could be a lot more bad news to come. “Total credit has jumped from $9 trillion to $23 trillion in four years, an increase equal to the entire US banking system,” he warns, adding that George Soros fears that there could be a “run” on China’s state banking system akin to the Lehman bust.

Other views?

One longtime WiC reader – formerly an investment banking chief in Hong Kong – sent us a long email on the topic from London. He said that he’s met a variety of Chinese businesspeople and officials in the British capital recently and they all talked at length on the subject of whether a default would be allowed to occur.

“It occurred to me,” he wrote, “that the question we all ought to be asking is: can China’s economy survive in its current form without the ‘government put’? In other words, is China’s economy today so dependent on the implied government guarantee of all government, quasi-government and SOE debt that it is impossible for the ‘government put’ to fail?”

“If the answer is ‘yes’, then the talk of default is misplaced as it cannot be allowed to happen.  If the answer is ‘no’ then default is inevitable. I suspect the answer is ‘yes’. China’s economy is too dependent on the ‘government put’ at this point in its development and so, for now at least, the market is massively mispricing the risk of default.

“That is not to say there is not a huge problem in the system, but rather that unwinding this problem is not going to be the rapid process which many offshore analysts seem to think. These analysts forget that a closed capital account, an absence of aggressive hedge funds, a complete lack of derivatives which would enable shorting and a system where government banks are owed money by government SOEs gives China a remarkable ability to delay the pain.

“So if that is the plan (and the fact they blinked and bailed out China Credit Trust might give one pause to think that it could well be the case) then how could they be planning to solve the issue?

“I had always thought the obsession with 7% growth was about preventing unemployment and achieving the target of doubling the size of the economy this decade.  But it occurs to me that there may be a third reason for the obsession – that they need to maintain relatively high growth to enable them to grow their debts away (however slowly).  If the interest rate is 5-6%, you need growth greater than 5-6% to shrink the debt over time.”

Of course, this muddle-through strategy would require further action in hoovering up the financial detritus of the past five year’s lending binge. As we pointed out in WiC223, one institution that could help with this is Cinda, the ‘bad bank’ that listed in Hong Kong in December.

But some senior figures from China have been making contrary noises about the muddle-through approach, suggesting it might be better if the Beijing Put is allowed to expire. Xia Bin, a counsellor of the State Council, said recently that individual financial institutions should be allowed to default as long as they do not pose a threat to overall financial stability, reports Caijing.

At the World Economic Forum, Li Daokui, also told Bloomberg: “A controlled default is much better than no default.” The Tsinghua professors, a former central bank adviser, said that controlled losses will “let future investors know that the trust products are not risk free”.

The same theory is shared by Fang Gang, a professor at the Peking University HSBC Business School and also a former member of the central bank’s Monetary Policy Committee. At a Hong Kong conference for global investors the prominent economist said he believed the government was seeking out a “good default case”. He then elaborated: “They want to pick one that can teach the market a lesson but where the blame should not go to the local government. A Ponzi scheme type of case would be good. They also want the case to be containable (in terms of its contagion).”

When was the last time the Beijing Put was tested?

In fact, high-profile defaults have been permitted previously, not least in 1999 when banks and international investors were badly burned by the Guangdong Investment Trust (better known as GITIC: notably, it was also a trust firm). Investors had bought GITIC’s debt products thinking they were implicitly guaranteed by the central government in Beijing and were shocked when it defaulted. China’s current anti-corruption tsar Wang Qishan was sent to Guangzhou to fix the mess (see WiC176). But on that occasion China’s economy was much smaller and the immediate impact of the default was of less concern to the wider world. That would be less true today.

The opportunities for a default meanwhile are legion. Ping An Securities reckons “coal mines’ trust products are the weakest link”, and so periodic default scares may continue to emanate from that sector. According to consultancy Cnbenefit, there are 19 coal-related WMPs due to redeem this year.

Any moves to fix the problem?

China’s banks surprised analysts with their January lending numbers: making Rmb1.32 trillion of new loans, or nearly three times December’s level (and a four-year high for January data).

That seemed at odds with statements from the People’s Bank of China late last year that the economy is facing a longer-term period of deleveraging. But the PBoC also reported that lending by trust companies had fallen to Rmb104 billion, half as much as a year earlier.

One interpretation is that the central bank is loosening credit to limit the chances of an abrupt slowdown as it tries to bring the shadow banking sector under greater control.

There was also speculation that the spike in bank lending indicates that the banks are moving off-balance sheet lending via WMPs back onto their books after attempts to crack down on the practice.

In mid-February the PBoC also released new policy guidance banning banks from issuing WMPs and using the proceeds for proprietary trading.

As the Wall Street Journal comments: “The central bank’s move – which follows other regulatory actions aimed at cutting risks in China’s financial system – represents further evidence that authorities are taking seriously the country’s debt load, especially funds raised outside banking channels.” For now, at least, the Beijing Put lives on.


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