The 700 investors in China's "Credit Equals Gold No1 Trust" are hoping that Industrial and Commercial Bank of China will bail them out. Unfortunately, what would be good for individual investors would be very bad for China's financial system as a whole. It's harsh, but the troubled 3 billion yuan (HK$3.85 billion) investment scheme should be allowed to fail. Come the end of the month, the Credit Equals Gold1 product was supposed to mature, returning investors their capital plus a 10 per cent yield. That's not now going to happen. China Credit Trust, which structured the product, has warned it will have difficulty making its payout. Meanwhile, the coal miner whose loans underpinned the scheme has ceased production after its vice-chairman was arrested for taking deposits without a banking licence. Not surprisingly, the investors are angry. They say they were promised a 10 per cent annual return on their capital by the ICBC staff that sold them the product as a high-yield, low-risk alternative to their savings deposits. Now they are demanding that the bank make good their losses. That puts ICBC - and the Chinese regulators - in a tricky position. The lender isn't obliged to bail out the products' buyers, and the bank's bosses insist they have no intention of doing so. Yet they may well reason that the bank's reputation would suffer too much damage if they allow the product to fail. Similarly, China's authorities may decide a default could risk precipitating a crisis of confidence in the country's financial system. A bailout could be the lesser evil. However, Beijing's financial reform agenda relies for its success on instilling more accurate perceptions of risk. Until now, savers have always regarded wealth management products like the Credit Equals Gold No1 as carrying the implicit guarantee of the banks that sell them. In other words, savers typically see an investment in trust company loans as the equivalent of a zero-risk deposit in a state-owned bank, only with a higher return. At the same time, neither borrowers nor lenders have much experience of correctly assessing and pricing credit risk. Many borrowers expect to be able to roll loans over indefinitely at rock bottom rates of interest. For their part, lenders regard businesses and investment companies linked to local governments as benefiting from official guarantees, so they are seen as posing low or no risk as borrowers. These distorted perceptions of risk have encouraged the explosive growth of credit in China over recent years, much of it through the shadow market in the form of wealth management products backed by trust company loans. Last year, China's trust companies made a record 1.8 trillion yuan in new loans, an increase of more than 40 per cent over 2012 (see chart). If the authorities do now let the 3 billion Credit Equals Gold No1 product fail, there is the danger of a knock-on chain reaction, with plunging public confidence triggering a series of similar defaults. On the other hand, a broad rerating of credit risks is badly needed. The whole point of the leadership's financial liberalisation programme is to let the market price risk, allowing China to allocate capital more efficiently in future. And that will entail letting wealth management notes like Credit Equals Gold No1 default on their investors when the ultimate borrowers behind the products cannot service their debts. It's tough on the investors, of course, especially as it's likely many buyers were misled about the real level of risks involved in trust products by bank sales staff. But bailing them out will simply magnify the moral hazard that beset China's financial system, and set back the cause of reform. tom.holland@scmp.com