Will there be more ‘moral hazard’ type of bailouts after this latest ICBC-China Credit Trust Co. deal?

Bloomberg News reported on January 28, 2014 that China’s state-owned bank, the Industrial and Commercial Banking Corporation (ICBC) was about to step in with an offer of a bailout option for investors in its trust product, known as ‘Credit Equals Gold No. 1 high yield product’ issued by Shanxi Province-based China Credit Trust Co, and marketed through ICBC’s private banking clients. The latest bailout deal allows investors to seek for full principal payment, without incurring any ‘haircuts’ or losses to the principal value. The information was being disclosed to Bloomberg News by an investor, who declined to reveal his identity.

Readers might recall this incident last week when there were rumours swirling around that China was about to witness its first major default of a financial institution. The trust product known as ‘Credit Equals Gold No. 1 high yield product” offers yields ranging from 9.5 percent to 11.0 percent, totalling approximately 3 billion yuan (USD 496.0 million). There was supposed to be a payment due January 31, 2014, and the issuer faced some problems in raising the necessary amount of principal to make the payments to the trust holders. The underlying was being packaged to restructure the debts belonging to a collapsed coal miner; Shanxi Zhenfu Energy Co. which failed in 2012 after its owner, Mr. Wang Pingyan was arrested for illegally collecting deposits.

The latest turnaround of events came as ICBC has earlier said that they are not going to set aside any plans to bailout investors in the trust product, and the purpose was to teach the investors a harsh lesson for not reading the fine print. However, with the next payment due by January 31, 2014, there could be growing pressure by the Chinese government to step in to do something in order to contain the potential contagion risks arising of what were supposedly to be the first ever default by a major trust company. According to the information obtained by Bloomberg News, the amount of total assets managed by China’s 67 trust companies soared to 60.0 percent to USD 1.67 trillion in the 12 months ended September 30, 2013. This is according to the China Trustee Association, even as Chinese policy makers have sought to curb money flows outside its formal banking system, also called the ‘shadow’ banking system and was said to be a USD 60.0 trillion industry. The relative high yield promised for the trust product in question was issued at a time when China’s overall annualised Gross Domestic Product (GDP) growth was averaging 9.0 percent to 10.0 percent. Along with the ongoing China economy slowdown, coupled by the recent tightening curbs on bank lending, property speculation, among others, there could be a severe funding shortage that might have triggered these latest concerns of potential defaults.

If the latest settlement does bear some truth in it, there will bound to be questions over whether who are the backers, which anyone might have accurately guessed will be the Chinese government, as ICBC is a state-owned financial institution. It also brings into question whether this is after all a type of ‘Ponzi’ scheme, where the goal was to attract more new investors in order to fund the existing investors. However, it always ends badly when there is a hiccup or an obstacle in the capital raising activities, especially with the ongoing tightened liquidity situation in the Chinese financial system. There are also questions as to whether the Chinese government is operating with the different set of policies behind the scenes, while its official stance is not to intervene in the financial system, and allow the market forces to dictate the winners and losers. Sadly, it is unlikely to be the last issue that the Chinese government might be resolving soon. There is speculation that there could be other defaults taking place for many trust products, and the size of the ‘shadow’ banking system might start to unwind itself, causing massive defaults to an extent that the Chinese government could not manage the potential contagion risks arising from such a scenario.

Going forward, I believe that banking reforms are necessary, but there has to be step-up efforts made on tightening the level of supervision and regulation. The trust product ‘Credit Equals Gold No. 1 high yield product’ is already a suspect to begin with. One of the first things that comes to many investors’ minds is that how is the entity be able to offer such relative high yields at 9.0 percent to 10.0 percent with its underlying being a failed coal miner, and its owner arrested over taking deposits illegally. There are several tell-tale signs that such financial products are not to be trusted or owned, and investors are now crying foul, and sought for the possible bailout assistance coming from the Chinese government. This is a severe case of ‘moral hazard’ happening in China, and it is quite unfortunate that many investors have seen their portfolios being battered, market confidence being eroded. There seemed to be no end to the various financial issues arising from the past hyper growth seen in China, and it is slowly unravelling itself in this period of slowing economic growth.

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