China trust default is least painful option

January 17, 2014

By John Foley

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Much about China’s financial system is fuzzy, particularly when it comes to so-called trust companies. But when push comes to shove the case for letting an investment product fail is pretty clear.

Take “Credit Equals Gold”. The curiously named product was sold to investors by ICBC <601398.SS>, China’s biggest bank by assets, with the promise of a yield between 9.5 to 11 percent. The trustee, China Credit Trust, channeled the cash to a mining company, Zhenfu Energy, which subsequently went bust, according to Chinese media. The product is due for repayment of its 3 billion yuan principal on Jan. 31. ICBC says it has no plans to compensate customers.

The question is whether a failure to repay would create a confidence crisis. Trust products are seen by many buyers as being safer than they actually are, because blow-ups are rare. If that changed, investors might shun the sector, depriving some miners, property companies and local government investment vehicles of their credit lifeblood. How many is unknown: there are around 4 trillion yuan of trust loans in issue, according to Bernstein Research, but that doesn’t capture loans like Zhenfu’s, which was structured as an equity-like investment.

In practice, a trust default shouldn’t cause a crisis. Buyers tend to be high-net-worth individuals, who can afford to take the hit. The risk, and borrower’s identity, is also clear from the outset. It’s a far cry from less transparent, lower-yielding “wealth management products”, which banks sell to regular savers as a substitute for deposits.

If Credit doesn’t Equal Gold, what next? Some rich investors will lose their cash. A few borrowers might face higher rates, but then the cost of borrowing from trusts has been rising anyway for many borrowers since concerns about Zhenfu first surfaced well over a year ago. By contrast, a visible bailout would send a message that institutions stand behind everything they sell, even when the documentation says otherwise.

Still, don’t rule out an eleventh-hour reprieve. ICBC did much of the work in structuring the “Credit Equals Gold” product, according to a person familiar with the investment. Both the bank and China Credit Trust have every reason to help Zhenfu repay at least part of its dues, even if they do so behind the scenes. That would be a huge wasted opportunity.

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