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Monday, January 20, 2014

China Faces Financial Crises

From Forbes:
On Friday, Chinese state media reported that China Credit Trust Co. warned investors that they may not be repaid when one of its wealth management products matures on January 31, the first day of the Year of the Horse.

The Industrial and Commercial Bank of China sold the China Credit Trust product to its customers in inland Shanxi province. This bank, the world’s largest by assets, on Thursday suggested it will not compensate investors, stating in a phone interview with Reuters that “a situation completely does not exist in which ICBC will assume the main responsibility.”

There should be no mystery why this investment, known as “2010 China Credit-Credit Equals Gold #1 Collective Trust Product,” is on the verge of default. China Credit Trust loaned the proceeds from sales of the 3.03 billion-yuan ($496.2 million) product to unlisted Shanxi Zhenfu Energy Group, a coal miner. The coal company probably is paying something like 12% for the money because Credit Equals Gold promised a 10% annual return to investors—more than three times current bank deposit rates—and China Credit Trust undoubtedly took a hefty cut of the interest.

Zhenfu was undoubtedly desperate for money. One of its vice chairmen was arrested in May 2012 for taking deposits without a banking license, undoubtedly trying to raise funds through unconventional channels. In any event, the company was permitted to borrow long after it should have been stopped—reports indicate that it had accumulated 5.9 billion yuan in obligations. Zhenfu, according to one Chinese newspaper account, has already been declared bankrupt with assets of less than 500 million yuan.

... A WMP 
[Wealth Management Product] default, whether relating to Liansheng or Zhenfu, could devastate the Chinese banking system and the larger economy as well. In short, China’s growth since the end of 2008 has been dependent on ultra-loose credit first channeled through state banks, like ICBC and Construction Bank, and then through the WMPs, which permitted the state banks to avoid credit risk. Any disruption in the flow of cash from investors to dodgy borrowers through WMPs would rock China with sky-high interest rates or a precipitous plunge in credit, probably both. The result? The best outcome would be decades of misery, what we saw in Japan after its bubble burst in the early 1990s.
The author dismisses arguments that a default won't happen because there is no "market," per se, since the Chinese government controls the market. He explains:
Because Chinese leaders have the power to prevent corrections, they do so. Because they do so, the underlying imbalances become larger. Because the underlying imbalances become larger, the inevitable corrections are severe. ...
Why will China’s next correction be historic in its severity? Because Chinese leaders will prevent adjustments until they no longer have the ability to do so. When they no longer have that ability, their system will simply fail. Then, there will be nothing they can do to prevent the freefall.

We are almost at that critical point, as events last June and December demonstrate. The PBOC did not try to tighten credit as analysts said in June and December; it simply did not add liquidity. The failure to add liquidity caused interbank rates to soar and banks to default on their interbank obligations. In the face of the resulting crises, the central bank backed down both times, injecting more money into state banks and the economy. So Chinese leaders showed us twice last year that they now have no ability—or no will—to deal with the most important issue they face, the out-of-control creation of debt.
 The author notes that even if Chinese authorities are able to kick the can down the road, it only delays the inevitable--there were nearly 11 trillion yuan in outstanding WMPs by the end of last year.

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