China Economic Comment – March 2014

In early March, China recorded its first domestic corporate bond default when the Shanghai Chaori Solar Energy Science & Technology Company failed to make a RMB 89.8 million interest payment, having narrowly avoided a similar outcome in January 2013.

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China needs to manage the short term risk of shadow banking during financial reform

In early March, China recorded its first domestic corporate bond default when the Shanghai Chaori Solar Energy Science & Technology Company failed to make a RMB 89.8 million interest payment, having narrowly avoided a similar outcome in January 2013. It is significant that neither the central nor local governments chose to bailout the company – despite the relatively modest size of the interest payment (equivalent to around US$14.7 million) – and instead allowed the default to remind investors in the country’s $1.4 trillion corporate bond market of the inherent risk of these products.

The default followed a last minute bailout of a Chinese trust in late January, when the Credit Equals Gold No.1 trust product, sold by the China Credit Trust and backed by the Industrial and Commercial Bank of China (ICBC) – China’s largest bank by assets – came within days of a default that some commentators argued could have triggered a major financial crisis. Funds from the product were used to finance a loan to a coal company that failed. Instead, a deal was struck four days before maturity between ICBC, China Credit Trust, the Shanxi provincial government and a reported but unidentified buyer, which guaranteed investors the return of their principal but not all of the scheduled interest.

These two events, along with a range of similar products approaching maturity in coming months (according to Bernstein Research, more than 43% of the RMB 10.9 trillion ($1.8 trillion) worth of outstanding trust products come due in 2014), have once again highlighted the broader concerns around the country’s shadow banking sector. Bank of America-Merrill Lynch have described the bond default as China’s ‘Bear Stearns moment’ – a precursor to a broader financial crisis. In such a scenario, wary investors and bankers become more risk averse, and attempt to liquidate suddenly undesirable assets. This would also trigger a major credit crunch, which could cause further bankruptcies.

For the moment such concerns are a worse case scenario. For one thing, the scale of the Chaori default is far smaller than the Bear Stearns. Secondly, in the cases of both Bear Stearns and later Lehman Brothers, these firms were major financial intermediaries, with countless financial counterparties worldwide, which contributed to the rapid spread of contagion. Thirdly, there is misplaced belief that there is no history of default within the shadow banking sector, when in fact there have been several cases of credit trust defaults, including cases which resulted in investors losing money (albeit none for around a decade). Finally, concerns around risk in China’s financial sector could increase the pace of reform, potentially a beneficial process for the economy.

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