China Needs to Tread Carefully on Reforms


China’s trust lending sector – part of the country’s shadow sprawling shadow banking system – has been in the news quite a lot recently. Pacific Money recently outlined the salient details of the case that was the focus of much of the recent attention – a scare involving a trust product called Credit Equals Gold No. 1.

Some have argued that the failure to allow a default of this product was a kind of U-turn in the process of financial reform in China. The argument is that in order for a more market based system for capital allocation to develop, investors and borrowers have to be given some harsh medicine. A default would have been warning shot to all investors that they should be aware of the risk associated with high promised.

However, it is almost certainly too early for a dose of this kind of bitter medicine in China’s shadow banking system. A default of this trust product would probably have had very negative consequences not only for the trust industry, but for the wider economy as a whole.

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A key factor explaining this phenomenon is a so-called maturity mismatch in the China’s wealth management product (WMP) business. Funds sourced from investors at short maturities (often three, six or nine months) are actually used to lend to companies and projects for durations of years. Investors who have bought these short-term products receive their cash back at the end of the investment term, but this leaves a “cash hole” on the side of the issuer, as the final borrower still has no obligation to repay the funds.

The solution is to issue another WMP to fill the hole  (an effective roll-over). This may take a couple of days – during which many issuers are forced to turn to China’s money markets to borrow the funds.

Had a default occurred and Credit Equals Gold No. 1 investors lost their funds, investors in all of China’s multitudinous WMPs would have received a very rude awakening. They would discover (many for the first time) that the products they were investing in could fail, and that the government would not be there to bail them out.

Some would continue to invest, but many would not. The ability of issuers to issue new WMPs to fill the holes would be destroyed. WMP issuers would thus be left with a big funding gap, forcing them and their end-borrowers into distress and an increasingly vicious spiral. The liability side (investors) of their balance sheets would be in crisis, and this would not take long to affect the asset side (the borrowers).

The economic fallout as various coal, real estate, and local government borrowers (to name a few key examples) lost this source of funding would be large. There is roughly USD$1.6 trillion invested in China’s trust industry, and this is not even the entire WMP picture. Many borrowers in this sector are forced to borrow here precisely because they are not able to secure cheaper financing from other lenders. Many would fail without these channels.

Equally, the formal banking system relies on WMP to earn fee income and move assets off the balance sheet. The fallout from a WMP rout would not be easily contained. The ensuing crisis would set reforms back as the government would have to move into full fire-fighting mode.

This hypothetical example serves as a reminder of why China’s reforms must come slowly. Any negative consequences that may result from each reform must be carefully anticipated and pre-empted. The authoritarian government in Beijing cannot afford a Lehman moment.

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