The story of how a 3 billion-yuan ($496 million) Chinese trust investment wound up on the brink of default shows what billionaire investor George Soros has called the “eerie resemblances” between the 2008 global financial crisis and the nation’s debt market.
Industrial & Commercial Bank of China Ltd., the world’s most profitable bank, is rejecting entreaties to compensate holders of the financing, which was structured by China Credit Trust Co. to raise funds for a coal miner. New York-based Moody’s Investors Service says it is typical of financial products that have kept debt off banks’ balance sheets. The borrower, Shanxi Zhenfu Energy Group, collapsed in 2012 after leading shareholder Wang Pingyan was arrested for illegal deposit-taking. Payment on the three-year, so-called Credit Equals Gold No. 1 product is due Jan. 31.
China’s $4.8 trillion in shadow-banking debt, arranged by trusts and fund managers with less transparency than commercial-bank loans, was equivalent to as much as 55 percent of the nation’s 2012 economic output at the end of that year, according to Moody’s latest estimate. Investors argued their case in a meeting at an ICBC Shanghai branch yesterday, an echo of savers’ appeals to Hong Kong lenders after Lehman Brothers Holdings Inc.’s failure undermined securities called minibonds.
“This case reminds people of Lehman minibonds because complicated credit-linked products were sold to individual investors via bank channels,” said Christine Kuo, senior credit officer at Moody’s in Hong Kong. “It’s not clear whether misselling was involved due to lack of transparency. It’s also not clear who will share the loss. Regardless, both the product packager and distributor have seen their reputation suffer.”
The woes in China’s trust industry underscore concerns that a wave of debt defaults might weigh on the global economy just as the recovery in the U.S. and Europe accelerates. One-third of investors surveyed in a Bloomberg Global Poll this month said China’s economic slowdown is the world’s major risk, up from 26 percent in November.
Soros wrote on Jan. 2 in Project Syndicate that while there are “eerie resemblances” with financial conditions before the U.S. crash, China’s government controls the banks and has given precedence to protecting growth over structural reforms recommended by the central bank. The contradiction in China’s policies is that “restarting the furnaces also reignites exponential debt growth, which can’t be sustained for much longer than a couple of years,” he wrote.
Goldman Sachs Group Inc. Chief Economist Andrew Tilton wrote in a Jan. 22 report that trusts are similar to structured investment vehicles prominent in the 2008 crisis in their “linkages with banks, the off-balance-sheet nature of the trusts” and the long-term projects funded by short-dated funds.
Goldman estimates the 2 trillion yuan in lending by trusts last year accounted for 10 percent of financing in the economy and a removal of credit flows from trusts would knock 0.8 of a percentage point off the nation’s growth rate. Gross domestic product will expand 7.45 percent this year, the slowest since 1990, a Bloomberg survey of economists signals.
The Shanghai Composite Index of stocks has slumped 11 percent in the past year as concern there could be trust failures pushed up money-market costs. The benchmark seven-day repurchase rate rose to a record 10.77 percent on June 20 and averaged 4.09 percent last year, from 3.50 percent in 2012.
Borrowing costs also increased as a government audit estimated local-authority liabilities climbed 67 percent from the end of 2010 to 17.9 trillion yuan as of June 30, with shadow banking accounting for as much as 33 percent. The yield spread on five-year AA securities over the sovereign widened to 3.31 percentage points yesterday, the most since February 2012.
The first default of a trust product in at least a decade would shake investors’ faith in their implicit guarantees and spur outflows that may trigger a “credit crunch,” according to David Cui, China strategist at Bank of America Merrill Lynch in Hong Kong. The government and state banks may bail out a significant portion of bad debt “to prevent a financial crisis,” he said. Guangdong International Trust & Investment Corp. failed to pay Yankee notes in 1998, the nation’s first default since the People’s Republic of China’s founding in 1949.
China Credit Trust designed Credit Equals Gold with an indicated annual rate of return of 9.5 percent to 11 percent for different investment amounts, according to a sales document. The central bank allows lenders to offer savings rates as much as 1.1 times the 3 percent benchmark deposit rate, making such returns attractive.
The money raised for this investment in February 2011 was used to fund four coal-mine acquisitions in Shanxi province, equipment upgrades and processing factories, the documents show. Only two of the four were in production, according to a 2011 report to investors. Wang Pingyan initially owned 90 percent of Zhenfu, according to the documents, while his father Wang Yusuo held 10 percent. They sold 49 percent to Credit Equals Gold as part of the financing, the documents show.
Bank of America Merrill Lynch wrote in a Jan. 20 report that while the new projects would have more than doubled the miners’ capacity, getting licenses to start production was bound to be “complex.” Four people died in violent clashes between miners and villagers in Shanxi in 2009 over exploration rights, according to a Xinhua news agency report that year.
Newcastle Thermal Coal prices have dropped 40 percent from their high in May 2011 as the economy slowed. China Coal Energy Co., the nation’s second-largest producer, forecast today its full-year profit will drop as much as 65 percent.
China Credit Trust Board Secretary Wei Qing didn’t answer two calls to his Beijing office. ICBC press official Wang Zhenning declined to comment. An ICBC executive, who asked not to be identified, said on Jan. 17 that the bank won’t assume primary responsibility because it was only distributing the product. Su Zhenguo, the contact person for Zhenfu’s website, said he no longer worked at the company and hung up.
China Credit Trust issued a notice to investors in June 2012, after learning that Zhenfu’s Wang Pingyan was under investigation for taking deposits to help fund investments without a banking license, saying the private financing by Zhenfu and related companies wasn’t listed on its balance sheet. Wang Pinyan was arrested in May 2012, the China Business Journal reported. No other information is publicly available.
ICBC and China Credit Trust may each take responsibility for 25 percent of the product’s payments, while the Shanxi government may assume the rest, Guangzhou-based Time-Weekly reported yesterday. Shanxi government denied it would take a 50 percent responsibility in a report on its website yesterday. Shares of People’s Insurance Company (Group) of China Ltd.,the largest shareholder in CCT, fell 1.7 percent in Hong Kong to the weakest level since August.
ICBC Chairman Jiang Jianqing told CNBC in Davos, Switzerland, that the lender won’t “rigidly” pay out on the trust and the incident will be a lesson on risk for investors and a chance to educate trust companies and his own bank.
The potential failure of the trust could expose the vulnerability of China’s banking industry, Standard & Poor’s wrote in a report today. While ICBC probably won’t bail out the investors, S&P said, such an action could raise questions over its liabilities and lead to a debt-rating review.
Chang Feng, 33, a finance-industry worker from Shanghai, who teamed up with his uncle to invest a combined 3 million yuan in Credit Equals Gold in 2011, said he was offered “implicit guarantees” of repayment by a product manager at ICBC.
“Originally, I didn’t plan to invest in a trust-related product,” said Chang, a spokesman for the protest group. “But ICBC’s product manager told us the project will be guaranteed by the bank. There’s no way to prove it now. We didn’t record it. We trusted ICBC.”
In Hong Kong after the global financial crisis, banks selling investment products were required to question investors on their risk appetite and tape marketing conversations. China, which has a minimum investment in a trust product of 1 million yuan, needs to modernize its regulations before “things get disastrous,” said Xu Bei, emerging Asia economist at Paris-based investment bank Natixis. Rules aren’t clear enough to ensure financial intermediaries do due diligence, she said.
“It’s a problem with sales and marketing of these products,” Liu Mingkang, former head of the China Banking Regulatory Commission, said in a Jan. 22 interview in Davos. “They should have made clear the return rate is not guaranteed and what kind of risks are involved. There shouldn’t be an ironclad guarantee at all.”
In January 2013, investors of an unauthorized wealth-management product sold by a Huaxia Bank Co. employee had their principal repaid in full, after a guarantee company bought the asset, the Securities Times reported.
This year, it hasn’t been so easy to settle. The Economic Information Daily reported earlier this month that investors in 1 billion yuan of private-equity-fund products hadn’t yet received payment due last month from Beijing Roll-In Investment Management Ltd., an asset manager. Executives at the guarantor, Sino-Mercantile Wealth Credit Guarantee Co., declined to speak with a Bloomberg reporter who visited its Beijing office with about a dozen investors meeting to discuss how to recoup losses.
Increasing credit evokes comparisons to Japan’s debt surge before its lost decade and to that in Thailand ahead of the 1997 Asian financial crisis. China’s credit-to-GDP ratio rose to 187 percent in 2012 from 105 percent in 2000, compared with Japan’s increase to 176 percent in 1990 from 127 percent in 1980, JPMorgan Chase & Co. said in a July report.
Joe Zhang, a former UBS AG banker who now consults for small finance companies in China on corporate-governance issues, said that the scale of the nation’s shadow banking is “nothing” compared with the U.S. subprime crisis and it is easy to sort out the “certain percentage of bad apples” because few involve complex derivatives.
“China is moving in the direction of the U.S. subprime crisis,” Zhang said. “But the system is at least a few years away from eruption. China can deal with this credit explosion cleverly if it wants to by raising interest rates steadily to defuse the bomb.”
While the cost to insure China’s debt from default climbed to an almost five-month high at 99.5 basis points on Jan. 23, that is down from 147 basis points in June at the height of the cash crunch. The yuan rose 2.7 percent against the dollar over the past year as investors took confidence in China’s $3.8 trillion of foreign reserves.
The CBRC ordered regional offices to increase scrutiny of credit risks in industries with overcapacity such as mining, two people with knowledge of the matter said today. They were also told to boost supervision of trusts, the people said. The regulator said earlier this month that banks should publish more information on wealth-management products and imposed tougher disclosure requirements on trusts.
“A couple of years ago this type of product was all in vogue,” said Adam McCabe, deputy head of Asian fixed income at Aberdeen Asset Management in Singapore, which manages $324 billion globally. “Guess what? That stuff comes due this year. So if you’ve got a period of tightened liquidity conditions that’s obviously going to put some of these products at risk.”
Just as in 2007 in the U.S. and Europe, fund-management companies that “want to survive” will seek to minimize losses to their investors, McCabe said.
“The most likely scenario is that all related parties, including the trust company and the bank, will work together to prevent a default,” said Li Qing, a bond analyst at Guotai Junan Securities Co. in Shanghai. “Otherwise they will have difficulty selling products in the future. The market will panic if there is a default because it hasn’t priced in such an expectation.”
Raised voices were heard from inside ICBC’s private-banking branch in Shanghai as investors met with executives yesterday. The final version of a bailout plan may only be known next week, according to Time-Weekly.
“ICBC is taking advantage of their private-banking customers,” said Alex Ke, 45, before joining other investors in Credit Equals Gold at the meeting. “This is a shocking scam.”
— With assistance by Fion Li, and Sarah Chen