China Considers “Teaching Investors A Lesson” In Moral Hazard With Trust Default

China Considers “Teaching Investors A Lesson” In Moral Hazard With Trust Default

China faces a very significant test of its reform policy pursuit rhetoric. With China’s Bank regulator set to issue an alert on coal-industry loans – “as a result of outout cuts, they don’t have much cash flow and thus they can’t repay loans and debt,” the massive growth in wealth products such as the CEG#1 (which offered a 10% yield for a 3 year term) based on these loans leaves the Chinese with a moral hazard dilemma – bailout or no bailout. ICBC has made it clear it wil not bailout investors since reputational damage would be “well manageable,” and former-PBOC adviser Li Daokui adds that “a controlled default is much better than no default,” noting critically that trust defaults “will teach future investors a very important lesson.” Belief that contagion can be “contained” brings back memories of 2008 in the US but a total (or even partial) bailout will merely increase the leverage and risk-taking problem and signal government talk of policy reform is not real.

Chinese regulators are preparing to issue alerts on Coal-industry loans (which obviously applies to all over-capacity industry loans that back the trillions in shadow banking system loans and wealth management prodsucts)…

China’s banking regulator ordered its regional offices to increase scrutiny of credit risks in the coal-mining industry, said two people with knowledge of the matter, signaling government concern about possible defaults.

The China Banking Regulatory Commission also told its local branches to closely monitor risks from trust and wealth-management products, said the people, who asked not to be identified as the matter isn’t public. The commission issues such alerts for matters that it judges may pose significant risks to banks, the people said.

Coal prices fell 16 percent last year, according to data tracked by Bloomberg. Prices fell below the break-even point for most small and medium-sized producers, forcing them to reduce output, Helen Lau, an analyst at UOB Kay Hian Ltd. in Hong Kong who covers the coal industry, said by phone.

As a result of output cuts, they don’t have much cash flow and thus they can’t repay loans and debt,” Lau said. “The fact that the government is giving warnings and not bailing out defaults will be good for industry consolidation, indicating it is letting the market shoulder the burden of its own risks.”

Larger companies have also suffered. … The market is “quite worried” about the coal industry, Rainy Yuan, an analyst at Masterlink Securities Corp. in Shanghai, said by phone today. “Coal is a pillar industry in the economy and banks’ exposure to the sector should be quite substantial.” China is the world’s largest producer and consumer of coal.

ICBC said it will not bailout the Trust product investors:

ICBC Chairman Jiang Jianqing told CNBC the lender won’t compensate investors for losses tied to a 3 billion-yuan ($496 million) product distributed by the bank, and the that the incident will be a lesson for investors on risks.

But Trust products like this have exploded in recent years:

Products like the ICBC-distributed Credit Equals Gold No.1, which has a tenure of three years and boasted a 10 percent annual return for investors, have mushroomed in China as part of a surge in shadow finance outside the traditional banking system. Payment on Credit Equals Gold No. 1 is due Jan. 31. Assets managed by China’s 67 trusts soared 60 percent to $1.67 trillion in the 12 months ended September, according to the China Trustee Association, even as policy makers sought to curb money flows outside the formal banking system.

As Bloomberg notes,

China needs to let investors in a troubled trust-investment product suffer losses to demonstrate the true risks and let interest rates reflect market forces, a former central bank adviser said.

A controlled default is much better than no default,” economist Li Daokui said in an interview yesterday at the World Economic Forum in Davos, Switzerland, when asked if a product distributed by Industrial & Commercial Bank of China Ltd. should default. Putting a structure in place to let some of the investors take losses, “is also much better than uncontrolled default,” he said.

The first default of a trust product in at least a decade would shake investors’ faith in their implicit guarantees and spur outflows that may trigger a credit crunch, according to Bank of America Corp.

As CLSA warns:

Risk facing authorities is that a default in which holders aren’t bailed out in full might precipitate panic outflows across the trust and related wealth-management product asset class, triggering a liquidity crisis, which would also ricochet into Hong Kong

If there is a total bailout — or perhaps even worse bailout through the backdoor as some speculate — it will be a signal that the government’s talk of pursuing reform isn’t perhaps for real

This will increase macro risks, with China’s trust assets now totalling more than 10t yuan; cites another estimated 11t yuan of wealth-management products issued by banks, citing China Reality Research

Mesanwhile Nomura is a little more concerned at the macro picture:

Maintains view of one-in-three likelihood of a hard economic landing commencing before end-2015

The bottom line seems to be that – as former PBOC adviser Li adds:

Controlled losses will let “future investors know that the  trust products are not risk free,”

Trust defaults “will teach the future investors a very important lesson,”

Even a small loss would be “still better than no loss,”

It would appear – as we noted last night – that investors are starting to brace for just this to occur – but a belief in containment once again remains a pipe-dream should a default occur.

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