Controlling local government debt became one of the top tasks set forth during the economic work conference, for the first time.
And several senior local government officials now think the central government won't backstop their debts.
Rising local government debt has had many concerned about an impending financial crisis in China. The latest audit of Chinese government debt, showed that local government debt is up to 17.9 trillion renminbi (about $2.8 trillion).
And shadow banking, including the use of wealth management products (WMPs) — a pool of securities like trust products, bonds, stock funds that offer higher yields than bank deposits and are sold as low-risk investments — has been one of the main sources of credit for local governments.
A Wave of Trust Defaults
Bank of America
We've seen WMPs rise 47.4% in Q3 2013, from a year ago. Trust products are up 60.3% in the same period and LGFV bonds are up 59.7% on the year.
In the past five weeks, we've seen sales and yields of WMPs spike. Eighty-three percent of WMPs sold in the last five weeks have seen an expected return of 5-8%, an all-time high, Cui points out.
Yesterday, an official with the Industrial & Commercial Bank of China (ICBC) told Reuters that the bank would not repay a 3 billion yuan ($495 million) trust product that is expected to mature on Jan. 31.
ICBC, China's largest state-owned bank, distributed "2010 China Credit/Credit Equals Gold #1 Collective Trust Product" to raise funds for coal-miner Shanxi Zhenfu Energy Group. As China's economy slows and commodity prices fall, many miners are taking a hit.
Bank of America's David Cui writes that there might be a "wave of trust defaults" coming, and that the pace of these defaults "appears to be accelerating rapidly." From Cui:
- Liansheng Resources, a Shanxi coal miner, may default on its 384 million yuan product issued in Nov 2012.
- Xin Bei Fang, also a Shanxi coal miner, said it can't pay the expected yield of its 1.3 billion yuan trust product.
- Another 100 billion yuan in products, in other mining related trusts, are expected to mature this year.
"If a local government finance vehicle (LGFV) trust defaults, a psychologically very important event, we suspect that the trust market may tip over," writes Cui.
Moreover, the risk of bond defaults is rising too. "An unidentified enterprise bond might have defaulted in Dec 2013 (Dec 30, Golden Securities), and a Shanghai-based tech company recently announced a default on its SME collective note," writes Cui.
"At this stage, we think it's unclear whether the various parties involved will cover up these losses. Nevertheless, our impression is that default pressure is building and it's a matter of time before some corporate bonds will default. 1Q this year is another peak maturing period."
What does this mean?
All of this is worrisome for a few key reasons. With wealth management products and trust products we often see a duration mismatch. The products themselves tend to have shorter maturities (about three to six months) than longer-dated assets (like long-term construction projects) they're invested in. And often many of these projects don't pay off.
For instance, "61.8% of WMPs sold over the past five weeks have a 1-3 months duration; 4.7%, less than one month," wrote Cui in a note to clients. "So in total, around 66.5% of WMPs sold last five weeks have a duration of less than 3 months, moderately edging up from previous period."
Of course this isn't new. We've seen a stream of trust defaults for two years now. But the size and the pace of these defaults are picking up as the sector has grown. And this is part of the reason banks are under pressure to cash out.
"This is one of the reasons for the cash crunch. The banks, if they have a product, a wealth management product that they've sold or trust products, that if they don't want to see that fail, they have to step up to the plate and cash it out," Patrick Chovanec of Silvercrest Asset Management told Business Insider.
These are basically cash obligations that are not on their balance sheets and are growing larger every year. But not doing so raises concerns of a systemic risk that would lead to a broader credit crunch.
"Everything is too big too fail," Chovanec said. "Even the smallest trust or company is too big to fail because the consequences of any kind of default tend to have a domino effect." Moreover, it'll make it harder to sell the next trust or WMP because people will realize they're assuming a lot more risk and that would make it much harder to roll over bad debt.
When we take these waves of trust defaults, WMP defaults, the credit crunch we saw in December and back in June, and the surge in local government debt at a time when China's economy is slowing, the picture gets a little scary.
"People have said for some time that China's shadow banking sector, including trust sector, are an accident waiting to happen and now it's happening," Chovanec said.
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