Why A Default (Or Two) May Actually Be Good For Investors

The author is Michael Werner, senior research analyst covering the Chinese and Hong Kong banks at Sanford Bernstein & Co.

At the end of January, investors in an RMB3 billion trust product were bailed out in the 11th-hour by an undisclosed entity as the product narrowly escaped default. Even though investors lost a year’s worth of interest payments (RMB300 million), they will recover their full principle, a huge win for them.

The only silver lining from this incident is that from the start, ICBC, the main distributor of this specific trust product in 2010, was adamant that it would not compensate investors for any losses on this risky product.

Assuming they did not participate in the 11th-hour rescue, this is a positive for shareholders in the Chinese banks as it sets a strong precedent for other banks in the future, reducing the likelihood that banks will be expected to protect investors in similar scenarios.

Backstopping investors losses create severe moral hazard problems. While the 11th-hour rescue was a godsend for the trust product’s investors, we believe it is a negative for China’s financial markets.

This move further entrenches the idea among investors that risky financial products enjoy an implicit guarantee against losses (even those products that are issued in the shadow banking market).

For other trust products that have defaulted in the past, either the auctioning of collateral and/or the generosity of a local government had ensured that the investors’ full principle was returned.

We expect more shadow banking defaults (or near-defaults) as we progress through 2014 driven by three factors:

1) repayment schedule accelerates as more than 40% of the RMB10 trillion of outstanding trust products (to finance shadow banking credit) matures in 2014;

2) the central bank is tightening the interbank markets, making it more difficult for shadow banking borrowers to roll over debt;

3) credit cycle is emerging in eastern China.

This is not a "Lehman Brothers-like" event. Despite reports to the contrary, we do not think a default (or even several defaults) in the trust product market will have a substantial impact on China’s financial system.

While it is true that investors in trust products have not experienced losses in the past, the average duration on these products is usually 2-3 years which means the market is not prone to a sudden collapse of liquidity due to the long lockup periods.

We view any trust product defaults as a long-term fundamental positive for China’s economy. Trust products largely fund unproductive areas of the market (such as the failing coal miner that was financed by a nearly defaulted trust product last month).

This has led to the decline in the efficacy of credit formation in recent years as GDP formation for every RMB of credit issuance has fallen from 0.80 over 2003-08 to less than 0.40 over 2009-current.

While we could expect some minor dislocations in China’s financial markets, these defaults are a necessary process to reform China’s financial system and improve its capital allocation.

In our viewpoint, a systemic crisis that essentially derails China’s economic growth is unlikely. First, there is little risk of a liquidity crisis as massive withdrawals of funds from wealth management products and trust products, the two most important funding sources for shadow banking credit, are highly unlikely.

Second, the upcoming credit cycle will be softened by the government as they are the owners of the major borrowers and lenders in China, ensuring the banks have the opportunity to earn their way out of rising credit costs.

Despite the potential secondary and tertiary effects of the upcoming trust defaults, we do not expect them to have an overly negative impact on economic growth. While it could slow from the current 7% -8% to 5%-6%, the improvement in the productivity of capital allocation as shadow banking growth decelerates should mitigate the downside risk.

Long-term investors in the Chinese banks will probably benefit from sitting on the sidelines as the volatility plays out in 2014. We do not expect any meaningful or sustainable appreciation in the share prices of the banks until we begin to see real reforms or market discipline be implemented in China.

In the near-term, we expect defaults (or near-defaults) in the trust product market to generate significant share price volatility and provide short-term trading opportunities for investors in the Chinese banks.

(The article has been edited for clarity)

Caishen.Co - Primary Data for China Secondary Investment and Stock Markets
Caishen.Co - Primary Data for China Secondary Investment and Stock Markets