Interesting details have emerged regarding the Chinese trust fund that was on the verge of default a few days ago. In fitting irony, the name of the fund is Credit Equals Gold No.1.
On January 15, Reuters reported China's ICBC says won't compensate investors in troubled shadow bank product.
"Industrial and Commercial Bank of China, the world's largest bank by assets, said on Thursday that it has no plans to use its own money to repay investors in a troubled off-balance-sheet investment product that it helped to market."
Investors should have taken a hit. Certainly the promised 10% yield was too good to be true. Heck, the name of the product itself was a likely indication of trouble.
Yesterday morning, the South China Morning Post commented It's tough, but China must let trust company products fail.
The 700 investors in China's "Credit Equals Gold No1 Trust" are hoping that Industrial and Commercial Bank of China will bail them out.
Unfortunately, what would be good for individual investors would be very bad for China's financial system as a whole. It's harsh, but the troubled 3 billion yuan (HK$3.85 billion) investment scheme should be allowed to fail.
Come the end of the month, the Credit Equals Gold1 product was supposed to mature, returning investors their capital plus a 10 per cent yield.
That's not now going to happen. China Credit Trust, which structured the product, has warned it will have difficulty making its payout.
Meanwhile, the coal miner whose loans underpinned the scheme has ceased production after its vice-chairman was arrested for taking deposits without a banking license.
Did you catch the error in the headline "China must let trust products fail"?
It's not a question of "letting the trust fail". The trust did fail. The assets backing the trust failed. The question at hand is not failure of the trust, but whether or not losses would be recognized.
Without a bailout investors would have taken huge losses, and most likely totally wiped out.
Moral Hazard Bailout in Progress
Later yesterday a decision to do the wrong thing was made. Where the money came from is uncertain, but the bottom line isn't ICBC Offers Clients Option to Recoup Funds From Trust.
Industrial & Commercial Bank of China Ltd. said investors in a troubled high-yield trust can recoup their funds, averting a threatened default that underscored concern over the shadow-banking system and helped spur a selloff in emerging-market currencies and stocks.
Rights in the 3 billion-yuan ($496 million) product issued by China Credit Trust Co. can be sold to unidentified buyers at a price equal to the value of the principal invested, according to one investor who cited an offer presented by ICBC and asked to be identified only by his surname Chen. China Credit Trust earlier said it reached an agreement for a potential investment and asked clients of ICBC, China's biggest bank, to contact their financial advisers.
Getting it Wrong
"A default was bound to lead to systemic risks that China is unable to cope with, so in that sense a bailout is a positive step to stabilize the market," said Xu Gao, the Beijing-based chief economist at Everbright Securities Co. Still, implicit guarantees distort the market and "delaying the first default means risks are snowballing," he said.
Bailouts and guarantees (implicit or explicit), coupled with loose money and manipulated interest rates are what causes these credit bubbles in the first place.
Bailouts do nothing but encourage more of the same moral hazard investment behavior, all but ensuring still bigger bailouts down the road.
There is an enormous credit bubble in China, guaranteed to come crashing down.
The Financial Times reports China trust deal raises thorny questions.
For global markets, the troubled product became emblematic of the risks that have built up in China's growing shadow banking sector. Non-bank institutions such as trusts now play a crucial role in providing funds to companies deemed too risky by regulators to borrow from the country's banks. Financing outside the formal banking system accounted for more than a third of the Rmb17tn total new credit issued in 2013.
With roughly Rmb4tn ($661bn) in trusts maturing this year amid tight monetary conditions, many expect more repayment problems. "The market already perceives a higher risk and is in the process of pricing higher risk," says Wang Tao, an economist with UBS.
In the case of Credit Equals Gold No. 1, ICBC clients invested a total of Rmb3bn in a product sold by China Credit Trust, one of the country's biggest "shadow banks". The product, a mere sliver of China's $1.2tn trust market, was underpinned entirely by loans to and equity in coal miner Shanxi Zhenfu Energy Group. It was a rotten investment: the price of coal plummeted and Zhenfu collapsed under the weight of heavy debts.
Nevertheless, on Monday, four days before the product matured, ICBC told investors a deal had been reached that would allow them to recoup their full principal, although they would miss out on about a quarter of the interest they had expected to earn.
There was little detail about where the money came from, but Chinese media have reported in recent days that a bailout was likely to involve ICBC, China Credit and the local government.
The last-minute rescue raises a thorny question for the future of the Chinese economy. Has the deal confirmed the widespread belief that the government will do whatever it can to stave off trouble, hence fuelling more risk-taking? Or has the near-default taught investors that high yields come with high risks?
Bubblicious Refresher Course
Shen Jianguang, an analyst with Mizuho Securities commented "This will help regulators push through these rules. It teaches everyone a lesson about the expansion of shadow banking."
Shen is completely wrong.
It's not the lack of regulations that caused this mess. It is central bank manipulation of money and interest rates that fostered shadow banking schemes.
Indeed there is little difference between the credit bubble in China, and the housing and credit bubbles in the US that blew sky high in 2008 and 2009.
Shen Jianguang seriously needs a Bubblicious Refresher Course: What Causes Economic Bubbles? When Do Bubbles Burst? Can the Fed Prevent Bubbles?
Credit is Never Gold
The Financial Times noted that investors were not happy to get their money back. "This is a war of attrition. We have gained the biggest mountain and now we must attack and seize the smaller hills," says one Shanghai-based investor who declined to give his name.
Investors in a coal mine that does not even exist (and won't due to plunging price of coal) ought to lose everything.
Credit implies risk. There is no such thing as a 10% risk-free investment. The higher the promise, the greater the risk.
Don't Want Credit Risk?
Looking for something with no credit risk? Then buy physical gold and hold it.
There is a risk of decline in the purchasing power of gold as the plunge from over $1900 an ounce to under $1200 an ounce shows, but there is no risk of default.
Start of a Global Currency Crisis?
With every passing day, odds of global currency crisis increase. Emerging markets, Latin America, Japan, Europe, and China are all in the mix.
For further discussion, please see Start of a Global Currency Crisis?
Looking for something that's not in the mix? Buy gold.