China: another look

2014 is still a newborn and the China story seems to be wailing ever louder. That in turn could mean some serious issues for Asia in general and private debt investors in the region.

In January came news that a shadow banking investment product may default on almost $500 million of obligations at the end of the month. This is a high yield wealth management product (WMP) yielding 10 percent issued by China Credit Trust Co., backed by a loan made by the Trust to the unlisted Shanxi Zhenfu Energy Group coal mining company.

This was a company with apparently some $80 million in assets which had accumulated $980 million in debts. By the end the vice chairman of the company was caught trying to raise unlicensed deposits. The company itself had become another shadow bank.

The WMP was then marketed by ICBC to Chinese investors. ICBC, the world’s largest bank by assets (forget about the quality, just gape in awe at the quantity) said rather cryptically that it would not bear the “main responsibility” for ensuring repayment to investors in the instrument, according to Reuters after a phone interview with the bank.

What is the scale of the shadow banking system in China? The 67 trusts nationally managed $1.67 trillion in assets as of September 2013. They now account for about 50 percent of all new lending. The total level of shadow banking, including illegal loans and all “wealth management products” (“WMPS”) could be $6 trillion. A great deal of these loans have been borrowed by local governments with estimates of their debts being $3.0 trillion, a rise of 70 percent from 2010.

It should be noted that this troubled instrument, the deliciously named “Credit Equals Gold #1 Collective Trust Product”, is not the first WMP to get into trouble. Two instruments risked non-payment in 2013 and were both saved by third-party guarantees.

So now we wait to see if the Chinese authorities will allow this to be the first large scale public default. One stalling ruse may be the Trust pushing out the repayment date to avoid technical default. There is actually another coal mining backed WMP where the mining company in bankrupt. This instrument, marketed by China Construction Bank has not defaulted. Yet.

What is at stake if a default were to occur? Well at the very least it would mean a reduction in capital flows into WMPs which would mean higher rates for the ultimate borrowers – local governments, companies propped up by the local governments and the property developers, all of whom face increasing difficulty accessing normal bank financing.

At worst you could see the borrowers starting to go under which could begin a domino effect of contagion through the system. The resultant crisis might be something even the mighty Chinese state would struggle to stem.

What do I believe will happen? Well for others as long in the tooth as your correspondent, this episode must bring back memories of those other ‘implicit’ guarantees from the Chinese state, the numerous ITIC debts to primarily foreign creditors after the Asian crisis. All those guarantees came to naught.

However I do not think we will see the same result this time round as the consequences would be exponentially more devastating for China, and indeed for all of us. I think the state will ensure, for as long as possible, that implicit guarantees become explicit and any contagion is nipped in the bud.

By the way it is interesting to note that one of four national bad banks, Cinda Asset Management (BBerg 1359 HK), listed in Hong Kong in December 2013. It has since risen 50 percent plus at the time of writing from the issuance price of HK$3.58 – a great return for investors. Depending on how you look at it you are buying a company ideally placed to use its expertise in any distressed situation in China, or you are buying a repository for a great mass of problem assets, many of which are backed by hugely overvalued property positions. Positions which would deteriorate further in any period of distress. I think you can guess my view.