By avoiding a small crisis now China risks a big one in future
With the trust product bailout, Beijing gives the green light to expansion of the shadow financial system instead of acting to let market price risk
Yesterday the 700 investors in China's "Credit Equals Gold No 1 Trust" were able to breathe a collective sigh of relief after their stricken shadow market investment scheme got bailed out.
The rest of us should be very nervous indeed.
No one quite knows who has stumped up the three billion yuan (HK$3.8 billion) needed to repay investors their principal and avoid a default. Market participants point the finger at various suspects: ICBC, which sold the Credit Equals Gold notes to its customers; Huarong Asset Management, the traditional store house for ICBC's bad assets; state insurance giant PICC, which owns a third of the trust company that structured the product; and the provincial government of Shanxi, the original backer of the failed coal company that borrowed the money in the first place.
It could be none, any, or all of them. But whichever it is, no one can doubt that China's authorities have decided to cobble together a rescue rather than risk a default. It is questionable whether the bailout really helped China to avert a "Lehman moment", as some analysts are claiming.
Sure, if the Credit Equals Gold trust had been allowed to default it would have badly damaged investor confidence in other trust products. Savers would have stampeded back into low-yielding banks deposits, which would have made it difficult for China's trust companies to sell enough new products to pay out the investors in their maturing short-term notes.
In turn, that could have triggered a nasty shake-out in China's shadow financial system. There would have been a major re-pricing of credit risk. Other trust products would have defaulted, and some weak borrowers would have gone to the wall.
Ultimately the state banks would have stepped in to provide funding to stronger borrowers, effectively taking the exposure back on to their balance sheets.
The process would have been painful. But in a closed off, state-controlled financial system like China's where the government can call the shots, the chance that credit markets would have suffered a general seizure, as international markets did following the implosion of Lehman Brothers in October 2008, would have been minimal.
In short, the risk of a default would have been containable. In contrast, the risks created by this week's bailout may turn out to be entirely uncontrollable.
By approving the rescue of investors in Credit Equals Gold, the authorities are broadcasting an unequivocal message. The buyers of high-yield trust products don't need to think about the dangers involved in lending to dodgy borrowers. If things go wrong, they will always get their money back.
Similarly, the trusts that structure the notes and the bankers that sell them can forget about credit and reputation risks. Everyone gets a free put option. In effect, the authorities have given the green light to the continued expansion of China's opaque and poorly regulated shadow financial system.
Charles Dumas, chairman of independent economic consultancy Lombard Street Research, neatly summarises the threat. At the end of 2012 China's total debt equalled 213 per cent of gross domestic product, high for a developing economy but "just within reasonable bounds".
"China's authorities have an ugly choice to make," he warned last week. "Either they pursue controversial financial reforms, and endure a major but manageable debt crisis soon; or they do not, and have a massive national debt crisis in a few years time."
Unfortunately the authorities have made the wrong choice. In throwing a lifeline to the Credit Equals Gold trust, they have fatally undermined their own planned reforms aimed at allowing the market to price risk. And without a market price on risk, China will find it impossible to avoid a giant debt meltdown at some point in the future.