Is the Chinese financial system on the brink of massive systematic defaults occurring?

Bloomberg News Online, Thomson Reuters News, and a whole host of news agencies have been covering this week on what was said to be the largest financial scam involving the trust companies, operating under the shadow banking system, and providing trust products that offer promised guaranteed returns without any financial backups if there were to be a default on the fund distributing the payments to the trust holders.

This latest news comes as Bloomberg News Online reported on January 24, 2014 that the Industrial & Commercial Bank of China, Ltd (ICBC)., which was said to the world’s most profitable bank, has rejected any claims of responsibility to compensate holders of a financing product, known as ‘Credit Equals Gold No. 1 Collective Trust product”, which has a three year tenure, and payment due on January 31, 2014. The underlying for this trust product are the coal deposits belonging to Shanxi Zhenfu Energy Group Ltd., which according to a Thomson Reuters news article dated January 22, 2014, received a key government permit that would enable it to restart production on one of its coal mines. However due to the tight liquidity conditions, combined with the Chinese government crackdown on the USD 4.8 trillion shadow banking system, China Credit Trust Co., the main marketer of the product, faced difficulties in making the required payments by Jan 31, thus risking a default, which if it occurs without any form of government bailout, could potentially set off another wave of global market volatilities. The centre of the dispute regarding who should bear the responsibilities in the event of a default occurring remains uncertain, and several trust holders were seen arguing their cases in a meeting held on Jan 23 at the Shanghai branch of ICBC.

The recent news taking place in China over possible defaults within the Chinese financial system does bear some resemblance of the systematic defaults of many major financial institutions during the 2008-2009 global financial crisis, which nearly brought down the entire US financial system as a result of taking on risky mortgage debts with no tangible forms of underlying collateral. The global financial community is closely monitoring this event, and trying to evaluate whether investment portfolio exposures to the Chinese financial markets should be reduced. In a Thomson Reuters news article on Jan 22, it reported that the Shanxi Provincial authorities, together with ICBC, were looking in depth on how to provide bailout support in order to prevent this massive default that could cause unimaginable consequences to both the domestic and global financial markets. However, at press time, there has not been any visible news on what the plan will look like. The increased jittery over this issue of a massive potential default, combined with the weak preliminary Chinese manufacturing report issued by HSBC bank, set off a wave of global selling yesterday, and sending the Dow Jones, the S&P 500, and the Nasdaq stock indices plunging to new lows on January 23, 2014.

Mr. George Soros, the billionaire hedge fund manager, has cautioned on an Op-Ed article published on the January 02, 2014 Project Syndicate News that “…while there are “eerie resemblances” with financial conditions before the US stock market crash. China’s government controls the banks, and has given precedence to protecting growth over structural reforms recommended by the People’s Bank of China (PBOC).” “The contradiction”, he wrote, in China’s policies is that “restarting the furnaces also reignites exponential debt growth, which can’t be sustained for much longer than a couple of years.”

Regardless of the outcome of whether there will be a default, or a government bailout, the issue over the shadow banking system in China has been brought into centre stage and is now facing its first major test of scrutiny by investors over whether the activities have gone out of hand, and have been operating under the less stringent regulatory controls. The previous rounds of monetary interventions by the People’s Bank of China (PBOC) in the form of tightened liquidity conditions, delayed intervention moves intended to punish the financial firms suspected of engaging in unregulated lending/borrowing activities, have not seemed to damper any moves by banks, and unregulated financial institutions to get their acts together and comply with the regulations. Entities including the likes of household internet names such as Alibaba Group Holdings, and have been offering high yielding deposits for ordinary Chinese people to park their cash, rather than to deposit into a regulated financial entity, such as banks. These non-financial entities have been allowed to offer such high-yielding and risky financial products to ordinary investors, but have not been subjected to any form of tightened financial regulations by the Chinese authorities.

As of press time, there appears to be no solutions coming out from this issue over who bears the responsibility for payments. If there were to be default arising from this ongoing issue, it could set off many alarm bells, evoking massive panic among Chinese depositors, a run on the banks, creating systematic financial meltdown that could set China back to years of low growth, and possibly decades of mistrust among investors on the entire financial and governance system in China. Such an outcome cannot be ruled out, especially given the various episodes of volatilities shown in the financial system which has eroded many investors’ confidence. It could also set a precedent that no countries, including the United States, China are immune to any major risks of systematic defaults. China has a sizeable foreign reserve base, but there are questions over whether a credit event such as a default within the financial system could easily bankrupt a government even if it has the necessary monetary defences being set aside to counter such systematic risks. It nearly took place in the United States following the financial collapse of Lehman Brothers in the fall of 2008, and the financial contagion similar to the size of Lehman has nearly brought down the entire global financial system. If China were to run out of ways to resolve this ongoing shadow banking issue, a similar type of financial meltdown could not be ruled out. Many investors will be watching over the next few days over how the Chinese government deals with the various uncertainties arising from this ongoing dispute over financial responsibilities to the trust account holders.

About Hock Meng Tay - Chief Editor, Asia-Pacific Region

Hock Meng Tay, CAIA has written 181 post in this blog.

Chief Editor, Asia-Pacific Region Hock Meng Tay is a CAIA holder and is currently taking CFA qualification. He has over 10 years of experience working as research associate in several investment companies.He is an expert in financial analysis and has published research reports in his current role. He obtained his Masters of Business Administration in Integrated Management and Masters of Arts in Economics while serving his internship in Starsource Inc