Let market forces work their magic on China's trust industry
When it comes to financial reform on the mainland, watch what the authorities do, not what they say. It has been official policy to rein in China's shadow financial system, and more recently, to give market forces "a decisive role in the economy". But the way the shadowy trust-products sector is being handled tells a different story. Last month, an unidentified white knight appeared to repay wealthy investors their principal in Credit Equals Gold No 1 Trust, a rescue exercise that required 3 billion yuan (HK$3.8 billion). Given the astronomical sum involved, one can only assume the rescue involved one or more large state or state-backed financial institutions. Meanwhile, despite its auspicious name, a high-yield trust product called Songhua River No 77 Shanxi Opulent Blessing Project has gone into a technical default after missing a US$126 million interest payment. Negotiations are now under way with investors, so the outcome is not yet clear.
Trust products are attractive because they offer high interest, well above the maximum 3.3 per cent for one-year deposits at the state banks. And not all trusts are poorly financed. But analysts believe there are more weak ones out there that could face default, especially if the credit environment turns nasty. Investors' confidence has already been shaken because of the slowdown in China's economic growth as well as the plunging capital markets in many developing countries. The 10.9 trillion yuan trust industry in the shadow financial sector is seen as a weak link in the event of a mainland crisis. As a result, some investors and analysts have argued bailouts like the one for Credit Equals Gold, while not ideal, are necessary to avoid a Chinese "Lehman moment".
To be sure, confidence in high-yield trust products can be undermined by defaults, leading to trouble for companies that rely on such bonds because they can not get loans from traditional banks. All these could snowball into a bigger problem for the financial markets. But given China's closed and tightly controlled system, a general credit seizure like the Lehman implosion in the US in 2008 is unlikely.
There will be short-term pain, but more trusts that cannot repay investors must be allowed to default. Investors ought to be taught a lesson by sustaining losses and not expect a bailout. Only then can credit risk be properly priced by letting market forces do their work.