China's First Default Is Coming: Here's What To Expect
As we first reported one week ago, the first shadow default in Chinese history, the "Credit Equals Gold #1 Collective Trust Product" issued by China Credit Trust Co. Ltd. (CCT) due to mature Jan 31st with $492 million outstanding, appears ready to go down in the record books.
Of course, in a world awash and supported by moral hazard, where tens of trillions in financial asset values are artificial and only exist due to the benevolence of a central banker, it would be all too easy to say that China - fearing an all too likely bank run on comparable shadow products (of where there a many) as a result - would just step in and bail it out. However, at least until today, China has maintained a hard line on the issue, indicating that as part of its deleveraging program it would risk a controlled default detonation, in order to realign China's credit conduits even though such default would symbolically coincide with the first day of the Chinese New Year.
In turn, virtually every sellside desk has issued notes and papers advising what this event would mean ("don't panic, here's a towel", and "all shall be well"), and is holding conference calls with clients to put their mind at ease in the increasingly likely scenario that there is indeed a historic "first" default for a country in which such events have previously been prohibited.
So with under 10 days to go, for anyone who is still confused about the role of trusts in China's financial system, a default's significance, the underlying causes, the implications for the broad economy, and what the possible outcomes of the CCT product default are, here is Goldman's Q&A on a potential Chinese trust default.
From Goldman Sachs: A Matter of Trust
Q. What has happened?
Local and international media (e.g. Caixin, Financial Times) have reported that a RMB 3bn three-year investment trust issued by China Credit Trust Company (CCT) is at risk of not making its principal repayment due investors on January 31 (which also happens to be the first day of the Chinese New Year). The trust assets were used to make a loan to a coal mine company for mine acquisition and related investments, but the company has still not received licenses related to two of five planned mines, and the owner of the company was reportedly arrested in 2012 for illegal deposit taking. It has been reported that ICBC referred the project to CCT, which structured the trust product as a “collective trust” rather than a “single trust” that typically is used by banks to securitize loans. The trust was sold through ICBC to approximately 700 private banking clients, and reports suggest that ICBC will not guarantee investors in the trust against losses. Our China banks team published detailed information on the trust structure, as well as shareholders and financials of the trust company (see “CCT trust product risk; potential scenarios imply slower trust/TSF growth”, January 20, 2014).
Q. What exactly is a Chinese “trust” and how is it structured?
A trust is essentially a private placement of debt. Investors in the trust must meet certain wealth requirements (several million RMB in assets would not be unusual, so the investors are either high net worth individuals or corporates) and investments have a minimum size (e.g. RMB 1mn). The appeal is a much higher yield than can be obtained through conventional bank deposits, in many cases 10% or higher, versus regulated multiyear bank term deposit rates in the low single digits. Trusts invest in a variety of sectors, including various industrial and commercial enterprises, local government infrastructure projects (via LGFVs), and real estate.
As our banks team noted, 29% of trust assets are invested in higher-risk industrial or commercial sectors.
A trust is not to be confused with a “wealth management product” (WMP). WMPs are available to a broader group of individuals, with much smaller minimum investments. They are typically sold through and managed by banks or securities brokers, with or without a guarantee of the payment of interest or principal (WMPs featuring explicit guarantees are booked on banks’ balance sheets; for other non-principal guaranteed products, implicit guarantees may be assumed by some investors). Funds from WMPs may be invested in a range of products including corporate bonds, trust loans, interbank assets, securitized loans, and discounted bills—so WMPs are best thought of as a “money market fund” or pool for other financial products.
Q. How do trusts fit within the “shadow banking” sector in China?
Trust assets total some RMB 10trn as of late 2013. Though small as a share of the total stock of credit in China (Exhibit 1), trust assets have been growing at an annual rate of over 50% in recent years. The net new credit extension from trusts approached RMB 2trn in 2013 based on estimates from our bank analysts, or more than one-tenth of broad credit flow (total social financing) for the year. (Please refer to the “CCT trust product risk” note cited above for further detail on trust asset growth and composition.)
Exhibit 1: Trusts still small as a share of total financing, but growing rapidly
Some clients have asked about comparisons between the Chinese trusts and the SIVs (structured investment vehicles, sometimes known as “conduits”) that were prominent in the US financial crisis. The SIVs were off-balance sheet vehicles generally funded with short-term commercial paper (“asset-backed commercial paper”) with a period of a few days to a few months. Initially, these SIVs invested in relatively low risk, short-term receivables, although over time exposures shifted towards more complex, longer-term structured products such as subprime mortgage-backed securities or collateralized debt obligations. As doubts about asset quality began to arise in 2007, market funding conditions for the SIVs quickly deteriorated, requiring sponsoring banks to provide liquidity support and ultimately consolidate these assets on the balance sheet, which exacerbated funding pressures as well as asset write-downs. Similarities to Chinese trusts include the linkages with banks, the off-balance sheet nature of the trusts (true for many WMPs also), and the maturity transformation aspect (though it should be noted this is less extreme in the case of trusts, where investors are often committed for a period of a year or more, than for most SIVs; even WMPs typically have commitments of 3-12 months). Important differences include the relatively simpler assets of Chinese trusts – often loans, as in the CCT example – and the fact that the Chinese banking system is funded domestically (many SIVs raised funding across borders).
Q. Why is the potential default of a trust important?
With a large volume of trust products scheduled to mature this year, who bears the losses in the event of a default could set an important precedent. In our detailed research on the China credit outlook last year (see “The China credit conundrum: risks, paths, and implications”, July 26, 2013), we explicitly identified “removal of implicit guarantees” as one of four potential ‘risk triggers’ for a broader credit crisis. If the realization of significant losses by investors causes others to pull back from funding various forms of “shadow banking” credit, overall credit conditions could theoretically tighten sharply, with consequent damage to growth.
From the perspective of policymakers, the default of a trust under the current circumstances might be seen as having less risk of contagion than some other “shadow banking” products. First, the trust is explicitly not guaranteed by either the trust company or the distributor. Second, the investor base of a trust is typically a relatively small group of wealthy/sophisticated investors (the minimum investment in the CCT trust mentioned above was RMB 3mn). This contrasts with broadly offered wealth management products, which have many more individual investors with less investment experience and more modest personal finances. Third, the particular circumstances of this trust (lending to an overcapacity sector, failure to obtain key business licenses, arrest of the borrowing company’s owner) might make it easier for authorities to portray as a special case. Put another way, if the authorities felt obliged to provide official support to this product, it is not clear under what circumstances they would be comfortable letting any trust or wealth management product default.
Q. What are the options for policymakers?
The fundamental issue for policymakers is how any losses would be distributed among 1) investors, 2) the trust company and/or distributing bank, 3) the government and government-related entities. Potential options include:
- Allowing the trust to default (investors take losses). As noted above, this would call into question the implicit guarantees perceived by some trust buyers, thereby increasing the risk that new trusts or other non-guaranteed products such as WMPs face more difficulty obtaining funds, leading to tighter overall credit conditions. On the positive side, it would encourage greater focus on the underlying credit quality and better risk pricing going forward.
- Trust company and/or distributing bank provide support (levered institutions take the principal and/or interest losses), making an implicit guarantee explicit. Although legally there are no guarantees of principal from either the trust company or ICBC, to the extent the trust company manager or the distributing bank were obligated by policymakers (or other reputational or legal considerations) to provide support, it could prompt loss recognition, or at the worst a need for capital raising or shrinkage of the balance sheet if losses are substantial. As such, the quality of the underlying assets and due diligence are key to determine whether and how much losses might be taken by these institutions. Investor demand for trusts might rise after such a demonstration of support, but the higher perceived liability on the part of financial institutions would presumably reduce their appetite for issuing such products in the future.
- Government-backed entity provides support (government takes losses). In this case, the short-term market reaction would presumably be relief, as refinancing risks would be reduced and both banks and trusts would be off the hook. However, moral hazard for both issuers and investors would be increased, raising the risk of credit problems further down the road. Policymakers might try to minimize this moral hazard by providing support indirectly (via some government-supported entity or third party, rather than publicly and directly) and/or by providing only partial support. An example of the former occurred last year, when an “unnamed party”, possibly the local government which provided some land collateral and guarantees to the trust loans, intervened to purchase the defaulted loans of a steel plate manufacturer, enabling the investors in a CITIC WMP to be repaid fully (see “Latest China bailout reveals risk of local government’s hidden debts”, Reuters, May 7 2013).
Some mix of these options is of course possible, if the financial institutions or government provides partial support. Most observers seem to expect at least a partial bailout of the investors, reflecting a compromise between concerns about moral hazard and concerns about contagion. Unless there is a total bailout explicitly funded by the government, credit conditions in the trust sector seem likely to tighten at least modestly. Some central government level policymakers could be open to seeing a default, as it would encourage more careful risk assessment and help to contain credit growth going forward. However, other central government and many local government policymakers might be more inclined to contain the problem. Local officials in particular may feel more pressure to support key local enterprises that are major employers and taxpayers; in the current case, officials could in theory take actions such as granting mining licenses to make the trust assets more valuable.
Q. What should investors watch to track the broader market impact?
Besides the immediate news on what approach officials take in the case of the CCT trust, investors can watch other financial metrics for signs of stress. As always, interbank rates are useful as an indicator of the marginal cost of bank funding. Spreads to yields on nonbank products may reflect their perceived risk, although they could also be affected by other factors such as tight overall liquidity conditions. While we do not have high frequency data on trust yields, WMP yields have moved higher of late. Finally, data on credit volumes will be important to watch. To the extent conditions tighten, this should become visible in monthly total social financing flows (the trust portion in particular).
Q. What is the potential impact on economic growth and markets?
The growth impact of a trust default is highly uncertain, as it represents the product of two unknowns. The first unknown is the change in overall credit extension which would result from the default, and the second unknown is the sensitivity of economic growth to new credit. In work last year on the relationship between credit and growth (“The ‘credit impulse’ to Chinese growth”, April 11, 2013), we estimated a RMB 300bn change in the average monthly credit flow would have an impact of 80bp on sequential annualized real GDP growth in the following quarter (with further, gradually fading effects in subsequent quarters if the lower credit flow persisted). This is not far from the average monthly flow of trust loans in 2013 implied by our bank analysts’ estimates. So with our assumption on credit sensitivity, a hypothetical sharp tightening in funding conditions that stifled this flow of new credit (not affecting existing trusts) would imply an 80bp hit to sequential (annualized) growth the following quarter, and roughly a 50bp hit to yoy growth over the following year. Intuitively, the modest estimated impact stems from the small size of the trust sector in the overall financial system. We emphasize the very high degree of uncertainty in these calculations—this is a back-of-the-envelope illustration rather than a forecast. On the side of a smaller effect, officials could take steps to reduce the impact on trust lending or other lending channels could pick up the slack; on the side of a bigger impact, spillovers could occur to non-trust lending or to the real economy via effects on business or consumer confidence.
In the credit markets, more willingness to allow losses should lead to greater differentiation between stronger and weaker credits. This is a theme we have emphasized for some time, including in our in-depth work on the China credit outlook last summer.
A policy/credit tightening bias may put pressure on China equities in the near-term, particularly credit-dependent, investment-heavy cyclical sectors. Investors are unlikely to reward either option 1 or option 2 above, as the default option may trigger contagion and risks to growth (thus earnings as well) and the “bailout by financial institutions” option is structurally unappealing (thus risks valuation). Option 3 is probably the only outcome that would support a slight market rebound near-term, in our view, as immediate contagion is averted and listed financial conditions are protected from bearing losses—though at the cost of longer-term moral hazard.
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