China: Orderly default of trust product kicks the can ahead

China Credit Trust today announced that it has reached an agreement on restructuring its trust product ‘credit equals gold #1’ (CEG1). The CNY3bn trust product, based on the promised repurchase of capital injection by a now bankrupt mining company, was due to expire on 31 January. According to press reports, the investors in the trust product will receive the principal on their initial investment, but will not get the promised interest payment (more than 10%). Hence, the restructuring of the trust product implies a haircut for the investors in CEG1 and technically it is also a default, although the loss for investors is relatively modest. Press reports also suggest that the trust product will be purchased from China Credit Trust by an asset management company, which implies that the asset management company will take control of the coal mining company, as equity has been used as collateral in the trust product.

The orderly default of CEQ1 probably means that the risk of a major negative credit event later this week has been avoided. The size of CEG1 is modest (about 0.1% of the overall trust market). Hence, the size of the default in itself could hardly be regarded as a systemic risk. The main risk was that a default on the trust product could decrease investors’ confidence in the overall market for trust products and possibly also for wealth management products issued by commercial banks. However, the money market in China and money market rates have not been trading at stress levels in recent days. CDS premiums for Chinese banks have been increased recently but, in a historical perspective, are not trading at stressed levels either.

Government bond yields and swap interest rates with longer maturities have started to decline in recent days, underscoring that the People’s Bank of China (PBoC) probably started to ease slightly on the back of the recent signs of slower growth and lower inflation. For the market, it will be extremely important what the PBoC does in connection with its ordinary monetary operations tomorrow. If tomorrow it injects liquidity in connection with its ordinary reverse repo operations, it will be a clear sign that it has now started to ease after monetary policy de facto has been tightened since mid- 2013.

Looking ahead, we expect data to continue to show signs of slower growth in coming months. The slowdown is to a large extent a lagged response to the PBoC’s monetary tightening. Hence, Chinese data will probably continue to be challenging for emerging markets in coming months. On a positive note, some of the indicators that have warned about renewed weakness in growth in H1 14, such as real money supply growth, are also starting to suggest a stabilisation. This picture would be reinforced by possible monetary easing from the PBoC.

A risk of negative credit events still remains. Loans made by trust companies such as China Credit Trust could be regarded as sub-prime or junk debt. For that reason, it will also be among the trust loans that we expect to see the first signs of an increase in bad loans and there is a high likelihood that similar cases to CEG1 could emerge in coming months. Arguably, a more severe default on CEG1 could have been healthy for the longterm development of China’s financial sector, as it could have contributed to a larger acknowledgement by investors of the true underlying risks in, for example, trust products. In the long run, this might prove to be the only way to curb strong growth in the trust sector. In that sense, the partial bail-out announced today has just kicked the can ahead.