One company's distress provides a good test case on the problems of shadow banking

Last month it became clear that one of the trust products that China Credit Trust Company sells faces default. The product, backed by assets from a once highly successful mining business, not only lacks the cash flow to repay its investment dividends, but also the necessary assets to cover the product's principal, which were both due on Jan 31.

Shanxi Zhenfu Energy Group, the coal company that has taken out 3 billion yuan ($500 million; 361 million euro) from China Credit Trust Company and through Industrial and Commercial Bank of China, faced a problem in coming up with the cash to pay its interest and meet its principal repayment obligations. Zhenfu Energy originally took out the 3 billion yuan loan to expand its production, hoping that coal prices would rise. However, with the tapering off of the quantitative easing by the US Federal Reserve and plunging coal prices, it had to stop production, resulting in its financial distress.

An interesting point about the financial product is that China Credit Trust Company has said it is only a distributor and that the product's real holder and guarantor is the Shanxi branch of ICBC, China's largest bank and one of the world's largest banks by assets and revenue.

But ICBC has said it accepts no responsibility for repaying the principal or the interest on the products. The case has attracted widespread attention partly because such symbiosis between banks and trust companies, or the formal and shadow banking systems of China, had worked well until recently, and nobody is sure what will happen if that relationship breaks down.

Leaving aside the details about the relative responsibilities of each party involved in the product, the stance from both sides presents a very good test case on shadow banking in China. Shadow banking, including many high-yield-paying trust products and wealth management products that have mushroomed in the past few years (China Credit Trust and ICBC promised their wealthy clients returns ranging from 9.5 percent to 11.5 percent a year in selling the products related to Zhenfu coal mine), have shouldered a large fraction of financing for not only small and medium-sized enterprises in China, but also investments in many industries with severe over-capacity, many local government debts and local government financing vehicles.

Such products have become tremendously popular not only because they provide highly attractive returns, sometimes ranging from 12 to 18 percent a year, but also because many people believed that they were very safe. Many investors in such products understand that even though product prospectuses clearly state that the security of the principal is not guaranteed, the trust companies and related commercial banks will guarantee the safety of their investment, because of regulatory and reputational concerns.

Such a layer of implicit guarantee is further strengthened if the products are used to finance local government debt or financing vehicles. Even though local governments do not promise to take any responsibility for the financial distress of local government financing vehicles, most investors believe that they would, in the case of default. In fact, as many local governments take out increasing amounts of debt and run into difficulties, investors turn to the central government, believing that it will not let local governments fail and will bail out local governments debts if it has to.

Such expectations of implicit credit guarantees by local and central governments lie at the center of the increasing problems with shadow banking. Reining in shadow banking or at least making it more transparent has been the subject of recent meetings of the Chinese Banking Regulatory Committee, and there has even been talk of a weighty official document on the matter having been drawn up.

With increasing disclosure of related financial and fiduciary responsibilities shouldered by different involved parties, investors can learn more about the viability and sustainability of many trust products and wealth management products used in shadow banking.

Probably more important though, is that governments and regulators alike would get a clearer picture of how serious the shadow banking and local government debt problem is. According to recent auditing by the China Audit Authority, local government's liabilities rose 70 percent over the past three years to the alarming level of 20 trillion yuan. That figure is largely in line with some earlier estimates, but the pace at which local government debt has increased and the diminishing sources of local government fiscal revenue has many people worried about the soundness of local governments finances.

Indeed, one key source of financing for such an alarmingly high level of local government debts is shadow banking through trust companies and wealth management products. The matter has grown in importance partly because of some fundamentally unsound investments sold to the public under the guise of how safe they are. In some ways, many of the trust company products bear many similarities to collateralized debt obligation products in the West before the 2007-08 global financial crises.

To make things a lot worse, such a phenomenon of implicit guarantee has permeated many other aspects of the Chinese economy. Overcapacity and resulting pressure on producer prices, an economic problem that has started haunting the economy, is largely the result of reckless investment poured into industries such as cement, steel and iron, and solar panels. Such investments were made possible not only by easy financing through products like the one distributed by China Credit and ICBC, but also by investors' belief that local governments would bail them out if things went sour.

Shanxi province's permission for Zhenfu coal mine to restart production, and an earlier bailout by Jiangxi province of the solar panel producer Jiangxi Saiwei, all added to investor confidence that the government would step in to save the day.

Likewise, investors in Chinese real estate and in the country's A-share stock market have come to believe that the government values social stability so much that it will not allow real estate prices or A-share prices to fall because if it did there would be protests and unrest.

So if increasing risks in trust company and wealth management products, and the Chinese financial system generally, are to be diffused, it is crucial that product disclosure be improved so all parties know exactly what is at stake and who is responsible for what.

There will always be those with unrealistic expectations about investment returns, and they need to realize that economics follows certain principles. If risks and productivity costs are distorted over any length of time, the bubble must eventually burst, leading to recession.

There is, unfortunately, no better way of setting expectations right than by allowing some non-performing products to default. Only through people losing money will investors learn firsthand about risk and adjust their expectations accordingly. Only when investors' expectations are realistic will the market system be able to properly set the price for risks. Only under a proper pricing system will government and business invest and finance reasonably and responsibly.

Steve Jobs may well have been right when he said that "death is very likely the single best invention of life". Likewise, failure may be the only cure for China's shadow banking problems.

The author is a faculty fellow at the International Center for Finance, Yale University; and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 02/28/2014 page10)