Will China’s shadow banking craze slow down?

A financial crisis occurs when people think something - Greek government bonds, U.S. mortgage-backed securities, Cypriot bank deposits, you get the idea - is safe and are wrong. This means there are two ways governments can try to prevent crises: They can guarantee the nominal value of every asset believed to be “safe,” or they can try to set investors straight.

The Chinese government has traditionally preferred option one, going to tremendous lengths to prevent companies and lenders from failing, even if that means expropriating resources from beleaguered households. Now it may be experimenting with option two.

Bloomberg News reports that the Industrial and Commercial Bank of China may not protect investors from losses on “Credit Equals Gold No. 1,” a “trust product” it sold them that ended up financing an insolvent coal mining company. This would be the first default on this type of high-yield asset. How would the Chinese financial system handle the experience?

Until recently, the only way for Chinese households to protect their savings from confiscation by negative interest rates was to buy property (hence all the empty apartment buildings) or involve themselves with quasi-legal lenders that occupy a space somewhere between loan sharks and pawnbrokers. But as the Financial Times’s Cardiff Garcia has written, financial innovation eventually finds a way around the rules imposed by regulators if those rules are at odds with the economic interests of enough people.

In the United States, punitively low interest-rate ceilings on deposits during the great inflation of the 1970s were circumvented by the new money-market mutual funds, which offered many of the benefits of traditional bank accounts but were allowed to pay fair market yields. Now Chinese financiers have invented a variety of “Wealth Management Products,” the core of China’s $6 trillion shadow-banking system. These instruments are often marketed and distributed to savers by the big state-owned banks as alternatives to savings accounts.

It’s unclear what is supposed to happen if the borrowers financed by WMPs can’t repay the original investors. Many people who buy these instruments are under the impression that the government stands behind them. Past defaults on WMPs have led to protests by angry savers.

The government seems to be taking a tougher line now. Interest rates on new WMPs have been increasing since the summer, which has presumably discouraged borrowers from taking on more debt. Bloomberg News reports that the China Securities Regulatory Commission is increasing the “disclosure requirements for trusts and wealth management products.” ICBC executives probably wouldn’t be telling newspapers they’re unwilling to bail out investors unless they had the backing of senior government officials, considering the megabank is a state-owned enterprise. This doesn’t necessarily mean that investors in “Credit Equals Gold No. 1” are going to lose all their money. China Credit Trust, the private company that actually created the product, may have to cover some of the losses incurred by investors out of its own capital. Either way, risk-takers would still get burned.

How would holders of other trust products (a subset of WMPs) react to these losses? The industry funds about $1.67 trillion of credit and has grown by 60 percent just in the 12 months ended September. A threat of losses might well reduce investor demand, which would make it harder for dodgy companies to fund speculative projects. In the medium term, that would probably help the Chinese economy rebalance away from excessive investment and toward greater domestic consumption. The transition could be bumpy, though.

* Matthew C. Klein Writer for Bloomberg View