By Sara Hsu, an Assistant Professor of Economics at the State University of New York at New Paltz. Her research interests include the Chinese economy, financial flows, and the international economy. Originally posted at Triple Crisis.
Two days ago, we learned that the Chinese government was behind the bailout earlier this year of a trust product—a type of financial product that the central government has heretofore emphatically distanced itself from. Huarong Asset Management, using a 3 billion RMB loan from the Industrial and Commercial Bank of China (ICBC), the trust product seller, was the mystery lender behind the January bailout of the Credit Equals Gold trust product, the Financial Times reported on August 31. ICBC and Huarong Asset Management are both state-owned entities.
This is a notable event that changes the way that analysts look at shadow banking financial products. Up until this point, there appeared to be a firewall between the traditional banking system and the shadow banking sector. The China Banking Regulatory Commission (CBRC) has sternly warned the financial sector that it would not bail out non-traditional loans or other assets. In keeping with this approach, many flagging financial products were indeed not bailed out by the central government, including trust products like those sold by Jilin Trust and CITIC Trust and, more recently, mutual fund products including those sold by Shanghai Goldstate Brilliance Asset Management and Mirae Asset Huachen Fund Management Co. The central government aimed to limit its implicit backing of the financial sector.
Now, however, as a result of the Huarong fund injection, we know that the implicit guarantee in practice runs deep, especially when financial products are sold via state-owned banks.
In this case, ICBC was pressured by investors and the government to guarantee the product’s payment. ICBC is the world’s largest lender by assets and market capitalization and is listed on the Hong Kong and Shanghai Stock Exchanges.
ICBC previously experienced a trust product default. A prior potential wealth management product default in July 2013 was realized. The default was greeted with a protest from investors dressed in white sheets. Investors were furious that the product defaulted, as they were led to believe that ICBC guaranteed the product. In the cases of other trust products, defaults were often avoided as local governments stepped in to repay investors.
Until this point, the central government has not been on the hook for shadow banking liabilities. Although some analysts have viewed local government bailouts as potential central government liabilities, this has not been clear. Certainly, we have seen local governments increase their liabilities via local government financing vehicles (LGFVs), entities closely tied to local governments. The liabilities have mounted, and the leadership has announced that local governments will be able to issue municipal bonds to roll over some of this debt. This is already starting to happen. Nothing has been as explicit, however, as a bailout via a central government asset-management firm.
A central-government guarantee of the shadow banking system would extend its financial responsibility from 71.90 trillion RMB in bank loans (outstanding loans at year-end 2013) to 110 trillion RMB (outstanding shadow banking assets under management plus loans at year end 2013) in bank loans and shadow banking loans, an increase of over 50%. The central government has been loath to extend guarantees to the shadow banking sector, which inherently carries far greater risks.
Can the central government support this new scale of debt? Not comfortably. The central government has worked hard to keep non-performing loans in its state-owned banks to a very low ratio. Government revenues are not overwhelming, and local governments already face a revenue shortage in the redistribution of funds from the local governments to the central government, and back again. Assets can be sold, or foreign reserves used, at great expense to the domestic economy.
Does this increase moral hazard among non-state financial entities? You bet. Knowing that the central government has set the precedent of contradicting its own terms and bailed out a failing financial product will increase the likelihood that shadow lenders will take risks. As a result, the CBRC and other financial regulatory bodies had better increase regulations for the shadow-banking sector before moral hazard takes root on a grand scale.
Additional regulations are expected to be implemented soon. Draft regulations are under way, as the CBRC prepares regulations on banks’ off-balance sheet lending. Regulations to increase control over internet lending and other components of shadow banking are also being considered. Somehow the shadow-banking system needs to be made less of a liability. The leadership is well aware of this issue, but addressing it is difficult and complex. The Huarong bailout may have made the process of reducing risk in the financial system even harder.