- We look at the scope and impact of China’s credit crisis
- We believe the possibility of a financial meltdown is low
- We discuss how resolution of the crisis may unfold
News of a trust product on the brink of default has deepened the concerns of increasing instability of China’s financial system. The risk of defaults on trust and wealth management products will likely continue to impact markets. We believe that the shadow banking issue will take an extended period of time to be gradually resolved. Our base case scenario is that probability of a financial system meltdown in China is low, but this is also subject to the steps that will be taken by the government on this fast evolving issue.
What happened and how big is the issue?
The troubled Rmb3 billion (US$496 million) trust product issued by China Credit Trust (CCT) and distributed by ICBC, China’s largest bank was on the brink of default as the funds were invested in a mining company that almost went bankrupt. Under government intervention, investors will receive principal in full with some haircut in interest payment. It is believed that the costs will be shared among CCT (issuer), ICBC (distributor) and the local government involved in this business (implicit guarantor).
In recent years, China’s trust sector has been one of the fastest growing types of non-bank credit, or “shadow banking” credit, to circumvent the government’s bank loan quota system. Currently, overall trust assets are about Rmb 10 trillion (US$1.7 trillion), accounting for 7% of China total banking assets. It is estimated that 50% of trust loans relate to local government financial vehicles (LGFVs) and 20% to the property sector.
To some extent, we are disappointed the government did not allow this trust loan default outright, as in our view, it would have sent a strong signal to the market by breaking the perception of an implicit government guarantee. China’s fast shadow banking growth is hard to slow because of the belief that banks, state-owned enterprises (SOEs) and big investments backed by local governments are too systemically important or too politically connected to fail. This perception needs to be broken in order to continue the financial market liberalization reform. However, it seems like the central government took that safest near-term route by avoiding any contagion risk and significantly reducing potential losses, particularly for public investors. In the absence of a comprehensive framework for the treatment of inevitable further losses in these vehicles, that path seems prudent.
Will there be a financial meltdown in China?
There are some important reasons why the probability of a financial system meltdown is low:
• “China’s shadow banking system includes direct credit extension by nonbank financial institutions (especially trust companies and brokerage firms) and informal securitization through the pooling of proceeds from wealth management products provided by banks. China’s shadow banking system is by no means simple in structure but is not dominated by complex derivatives.” (from April 2013 San Francisco Fed paper “Shadow banking in China: Expanding Scale, Evolving Structure”)
• China’s trusts sector consists of 60 or so trust companies, which are largely owned by agencies of the states. That means the government still has a tight grip of the sector.
• Total trust assets are estimated to be Rmb (US$10 trillion), only about 7% of total banking sector assets. Another shadow banking product is wealth management products issued by banks at Rmb10trn, less than 10% of bank’s total deposit base.
• China has only 10% of gross external debt of gross domestic product (GDP), almost the smallest among all emerging countries. That means debts are largely domestically funded, and by adding in all forms of non-loan and off-balance sheet credit, the resulting banking system loan/deposit ratio is still below 80%.
How to resolve the issue
Widespread media coverage of these events serves as a warning to all market participants and seems likely to slow flows into similar products. Fixing this issue ultimately requires fundamental change in the China financial system. While the government has announced and begun to implement some reforms, there will be no easy or immediate fix. Reform efforts to fundamentally adjust spending responsibility between central and local government (allowing private capital to invest in urban infrastructure construction, allowing bond issuance and setting up local government balance sheets to improve transparency) will help resolve many of the issues surrounding LGFVs. Nevertheless, a sense of urgency regarding reform implementation is growing. The low explicit central government debt level (20%) and the domestically funded nature arguably provide a margin of safety, back-stopping this process, but the size of the issue must begin to be contained.
Potential impact on the real economy
Persistent volatility in the interbank and credit markets due to credit events of this sort has impacted credit costs for about a quarter of the market, mainly in corporate bonds (SOE dominant), LGVF bonds and off-balance sheet credits. However, funding costs for private businesses have not yet registered substantial increases. China’s banking system and implicit guarantee perception have long been causing significant mis-allocation of capital by favoring SOEs and government projects over smaller private operators. A potential medium-term outcome is that market driven capital allocation could help make funding more readily available for the private economy at lower relative costs. Nevertheless, stress on credit availability must be monitored closely.
Even though we think financial meltdown is unlikely, we expect shadow banking issues will continue to create uncertainties and liquidity squeezes. While we anticipate default cases down the road, evidence of a maturing financial system and government oversight that is strong enough to confidently allow contained losses would likely be viewed positively by the markets.