China dodges major shadow banking default

Chinese investors avoided a high-profile trust default on Monday, easing worries that the economy may be about to tip the first domino of shadow banking defaults.

China Credit Trust reached a last-minute deal with investors to repay their investment in the three-billion-yuan (about 500 million U.S. dollars)product, deflating concerns that default would pound investor confidence in shadow banking and trigger credit crunches.

"This offer comes as a compromise given rising concerns over a full default, but it is likely that investors have become more cautious on trust products in general," said Zhang Zhiwei, chief China economist at Nomura.

The trust product, launched in February 2011, attracted some 700 private bank clients of the Industrial and Commercial Bank of China to invest in a private coal miner in north China's Shanxi Province. Shanxi Zhengfu Energy Group went bankrupt last year, unable to repay the loans it secured through the trust product.

Investors retrieved their principal after agreeing to a return of 2.8 percent on the product in the third year, according to documents seen by Xinhua reporters. The annual returns in the first two years were 9.5 percent and 10 percent respectively.

The incident alarmed a market already nervous that China's ongoing financial liberalization will mean millions of people pulling their money out of savings accounts and buying alternative financial products that yield interest more than double that on bank deposits.

While investors have dodged default this time, there may be more bad news from the shadow banking sector.

"Similar incidents will occur more often in 2014," said Ding Shuang, senior China economist at Citibank. "The regulators have become more tolerant of partial defaults as they intend to rein in the shadow banking and raise investors' awareness of risks."

Shadow banking has expanded rapidly in recent years. For instance, trust assets surged to about 10 trillion yuan by the third quarter last year, up 60 percent on the previous year.

Chinese banks are only allowed to offer official rates to depositors, and those rates are flat with inflation, which has left Chinese savers ready to turn to other investments.

Banks are banned from lending money to industries with overcapacity or local government financing vehicles. When borrowers from these categories knock on a bank's door for money, they will be offered a high interest loan from other funding channels. The money is often raised through banks' networks.

As a chunk of non-banking products are due later this year, fear of default is weakening investor confidence in shadow banking system and clogging money pipelines.

As people become less willing to buy shadow banking products, it will likely lead to less liquidity and a credit crunch, said Wang Tao, chief China economist at UBS.

Wang said liquidity would most likely flow back to the banking system, but banks could not automatically expand their balance sheet to offset the shrinkage in shadow banking, as they are constrained by loan quotas, lending restrictions and high reserve requirements.

Some analysts, however, believe borrowing costs in the shadow banking sector may not necessarily rise on default.

"Investors will become more cautious, so they will retrieve their money invested in high-risk areas and purchase more products with lower risks," Ding said. "High-risk projects may see a spike in borrowing costs while low-risk ones can enjoy less costs."

While the high-profile trust incident nerved the market and could lead to tighter regulation on non-banking financing, few expected the authorities to reverse the efforts to liberalize China's financial system.

"Policymakers' ultimate intention is not to halt the trust business, but to ensure clear separation of responsibility between borrower, fund-raising channel and investor, and to prevent risk contagion," wrote Helen Qiao, chief Greater China economist at Morgan Stanley.

If partial defaults can help restore the risk pricing mechanism, financial liberalization will improve efficiency in capital allocation by introducing more competition, and should be encouraged instead of reversed, according to Qiao.