12 December 2018

The wonderful world of high-return, no-risk China trusts

It wasn’t the first and already it’s very clear it won’t be the last. A high-yield product from China Credit Trust teetered on the brink of default last month, briefly rattling financial markets before a last-minute bailout allowed investors in the 3 billion yuan (US$492 million) fund to heave a sigh of relief. 

Now, a similar product has failed to meet its redemption deadline. It can’t be long before investors in the 5 billion yuan Jilin Province Trust fund tied to coal mine projects press for repayment, either from the ultimate borrower, the trust company or from the bank acting as the sales agent.

It’s a problem afflicting the fastest-growing financial sector in recent years — faster even than insurance, banking and stocks. The size of trust assets has ballooned to 10.9 trillion yuan, according to the China Trustee Association, meaning that for every 10 yuan deposited with banks, mainlanders put 1 yuan into these highly flexible investment products.

The trust industry in China is a lot different from its Western equivalent. In China, trusts pretty much include anything outside the traditional banking, securities and insurance businesses, covering almost everything from asset management to private equity and with highly “versatile” products and practices, Zhu Pingman wrote in the Hong Kong Economic Journal Monthly.

The sector has taken off as slow deposit growth and stricter reserve requirements have made it harder for banks to lend. Lenders also typically prefer to loan to state-owned companies over private firms, leaving a big part of the economy starved of funds, a void trust firms happily rushed in to fill.

Based on September 2012 figures, mining and infrastructure-related projects were the investment focuses, Zhu said. And this was the direction in which the Jilin trust lay. But since then the entire coal sector has been afflicted with weak prices and falling demand and the trust has ended up taking a massive hit.

Investors in these kinds of trusts are lured by the prospect of double-digit returns, sometimes as high as 20 percent per annum. Common sense dictates that with high potential returns comes high potential risk. There is nothing wrong with that, so long as investors take the hit if things go wrong. It’s standard market practice.

But so far the authorities have not been willing to take the chance of letting problematic trusts fail, for fear of the impact on economic stability. Trust firms and banks also have a lot at stake, given the hefty fee and sales agent income they collect. 

Since 2012, about 20 trust products threatened to default, but they were all redeemed in the end, according to the China Securities Journal. Bailouts like the China Credit Trust case only add to the confidence of those mainland investors who chase yield with the assumption that someone will pick up the tab no matter how rotten the underlying companies or projects are.

This is apparently how the salespeople pitch the investments to clients. It must be safe if there are implicit principal guarantees, local government guarantees, a trust overseeing the whole thing and banks selling it to them. When the proverbial hits the fan, officials will of course blame wayward individual agents for talking up the products in this way.

Many are calling the trust sector a time bomb. The industry has grown rapidly in recent years while the overall economy has slowed. With these dynamics, more trusts will end up in trouble as the backing projects fail.

With a usual maturity of two years, 2014 is lining up to be a peak repayment period. In 2012, average quarterly trust issuance exceeded 1.1 trillion yuan, 40 percent higher than the previous year, the Journal noted.

The average size of each trust is also getting bigger and the debt structure more complex. If a trust were to default, it would be an extremely cumbersome process to try to auction off the underlying assets.

The bailouts can’t keep going. At some point, the financial sector and the government will have to bite the bullet and selectively let some trusts fail to send the right message to investors, to borrowers and to the financial intermediaries.

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EJ Insight writer

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