On the eve of the Lunar New Year, news that a default on a 3 billion yuan (HK$3.8 billion) trust product had been averted brought relief to some in China. This was the trust industry's most serious crisis to date. The danger may have passed for now, but the last-minute bailout has shone a light on the growing risks lurking in the country's shadow banking sector.
In 2011, China Credit Trust, one of China's largest "shadow banks", issued an investment product seeking 3.03 billion yuan. Credit Equals Gold No 1 offered investors an annual 10 per cent return for three years - no doubt with a hefty cut going to the issuing company - to be paid back in full by January 31.
Whether these terms could be met depended on coal prices remaining high. But not only have prices fallen in a cyclical downturn in recent months, the fund's borrower, Shanxi Zhenfu Energy Group, collapsed under a mountain of debt in 2012 after its major shareholder, Wang Pingyan, was arrested for illegal deposit-taking.
Investors had one other reason to think their investment was sound. The Zhenfu group had let it be known it was close to buying a coal mine in Luliang that was known to produce high-quality coke. But until the end of last year, such a deal was wishful thinking on Zhenfu's part, as the local government had not approved it.
The fallout from Zhenfu's collapse should have been left to take its course. In a free market, the issuer, distributor and investors should all bear the costs of an investment blunder. But instead, unnamed third parties came to the rescue to allow investors to recoup their full principal and most of their interest earned.
China Credit and the distributor, the Industrial and Commercial Bank of China, probably found a state-owned asset management company to restructure the fund. If so, the rescue would be similar - in nature if not in scale - to that of the dozen or so failed trust products since last year, all of which were based on a long-standing belief that the government would not allow any default for fear of knock-on effects on the whole banking system.
In recent years, financial regulators have repeatedly stressed that, in a free market, both buyers and sellers must bear full responsibility for their investment risks. Hence, when news emerged that the China Credit product was facing default, some industry players speculated that it might be the first allowed to go sour. But at the moment of truth, the authorities chickened out and chose to take the "safer" route of a rescue.
It's clear all parties involved - ICBC, China Credit and the local government - have no wish to bear responsibility for the investment failure. With the bailout, the true scale of the risks in the financial industry remains hidden, and the problem of moral hazard will only rise.
"Too big to fail" isn't China's only problem; so apparently is "too small to fail". This is worrying. The authorities must learn their lesson. They need to find out where the fault lay in the near-default. Both China Credit and ICBC are industry giants, and no doubt earned a sizeable commission for their part, but did they fully perform their duty of care? Was there due process in prior checks, risk assessment, product management and information disclosure?
China Credit cannot shirk its responsibilities as the issuer and, as the distributing bank, ICBC played an even greater role, as is usual in mainland practices.
The costs of ensuring "stability" are high indeed. It is said that it was the local government's promise to approve the sale of the Luliang coal mine that convinced third parties to stump up the money. It's well known that, owing to the patchy implementation of the rule of law and the murky nature of deal-making in China, local governments wield considerable influence in economic decisions.
If regulators are serious about addressing the issue of moral hazard, they must stop local governments intervening in improper ways, so that the markets may learn to accurately price risks.
Shadow banks that issue wealth management and trust products have proliferated in recent years, so much so that some international agencies estimate the sector is worth 40 trillion yuan. As the economy slows, we can expect to see some defaults in the coming year. The regulators' urgent task must be to find a way to moderate the systemic risks of such defaults.
Just how high are the bad debts in the shadow banking system? And how will one default affect the health of the whole? We need careful, systematic study to find the answers to these critical questions. Unless they can be found, the central government will continue to be held hostage to the problem of "too big and too small to fail".
The State Council has published guidelines to strengthen regulation of off-the-balance-sheet lending, but it needs to spell out how risks can be moderated. In light of the China Credit near-default, this is not only urgent but critical to the success of longer-term financial reform.
This article is provided by Caixin Media, and the Chinese version of it was first published in Century Weekly magazine. www.caing.com