China trust’s default avoidance fuels moral hazard risks

Source: Shanghai Daily | February 10, 2014, Monday |

Print Edition

The move to avoid default by a trust product managed by China Credit Trust comes as a relief to local investors and market participants, but it also represents a potentially missed opportunity to limit moral hazard.

The size of the exposure - around US$500 million - is not the main issue. Rather, its significance is in understanding the credit implications of why the authorities may have encouraged the outcome - to protect investors at this point - and the moral hazards created by it. This episode has highlighted risks to which we have been drawing the markets attention for some time.

First is the management of systemic liquidity risk. The authorities have intentionally tightened liquidity in an effort to hold credit growth under control, while they are also trying to strike a delicate balance of ensuring the economy continues to grow while it rebalances. Overall systemic liquidity is much tighter than the numbers suggest, because bank cash flows are being affected by a growing level of loan non-performance that is not showing up in published numbers.

Related to liquidity risk is the close linkage between the banks and their “wealth management product” (WMP) activities. In effect, these constitute a second balance sheet which the banks create as part of their funding and liquidity plans, but can also create asset/liability mismatches. The concern is that a WMP credit event could trigger a broader loss of investor confidence akin to a deposit run.

However, by bailing out investors in this particular instance, the authorities are perpetuating moral hazard within the Chinese financial system - and this risk may in fact have become a whole lot bigger. There was an important difference with this product: it appears to have been sold through bank branches of Industrial and Commercial bank of China, but it was not a bank managed product. So in this case it was one step further removed - issued by a trust company, China Credit Trust, which counts The People’s Insurance Company of China and other state-owned enterprises as its largest shareholders.

We think the authorities have missed a chance of putting a clear marker in the sand that non-bank products would certainly not be supported. But what they may have also created is the impression that investments in bank-managed products would most certainly be made whole - at least for the time being. Moreover, this event will increase systemic risks down the road - given the very high (and still rapidly growing) levels of credit in the system.

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