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China Needs Trust Default as Lesson, Ex-Adviser Says

China needs to let investors in a troubled trust-investment product suffer losses to demonstrate the true risks and let interest rates reflect market forces, a former central bank adviser said.

“A controlled default is much better than no default,” economist Li Daokui said in an interview yesterday at the World Economic Forum in Davos, Switzerland, when asked if a product distributed by Industrial & Commercial Bank of China Ltd. should default. Putting a structure in place to let some of the investors take losses, “is also much better than uncontrolled default,” he said.

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 Bank of America Corp. ICBC Chairman Jiang Jianqing told CNBC the lender won’t compensate investors for losses tied to a 3 billion-yuan ($496 million) product distributed by the bank, and that the incident will be a lesson for investors on risks.

Controlled losses will let “future investors know that the trust products are not risk free,” said Li, a professor at Tsinghua University in Beijing who served as an academic member of the People’s Bank of China monetary policy committee from 2010 to 2012.

Trust defaults “will teach the future investors a very important lesson,” Li said. Even a small loss would be “still better than no loss,” he said.

Shadow Finance

Products like the ICBC-distributed Credit Equals Gold No. 1, which has a tenure of three years and boasted a 10 percent annual return for investors, have mushroomed in China as part of a surge in shadow finance outside the traditional banking system. Payment on Credit Equals Gold No. 1 is due Jan. 31.

Assets managed by China’s 67 trusts soared 60 percent to $1.67 trillion in the 12 months ended September, according to the China Trustee Association, even as policy makers sought to curb money flows outside the formal banking system.

Li said China this year will probably allow one or two, or even as many as five, trust-product defaults to serve as warnings to domestic investors.

“Without defaults, the interest-rate setting is not complete, not market-based,” Li said. “Only with defaults the market can teach investors the lesson.”

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