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Alicia Dou recalls how the customer service officer at China Construction Bank repeatedly tried to sell her an investment product whenever she visited her local branch. After being pitched the idea more than ten times, the Beijing-based headhunter finally decided in July 2012 to buy the so-called wealth management product.

Dou invested 100,000 yuan ($16,500) in a “premium trust certificate” that yielded 12 percent annually, nearly four times the rate the bank pays on one-year term deposits. The certificate, which had a one-year maturity that could be rolled over, was issued through a trust by a group of mining companies from Shanxi, a province southwest of Beijing. Issuance of such trust certificates has soared in recent years, making this one of the fastest-growing areas of China’s so-called shadow banking system, which extends credit outside bank lending channels.

“I took a chance and gained handsomely,” says Dou. Despite the high return, she decided to cash out after one year. “I remember reading the fine print on the certificate: ‘The bank doesn’t guarantee the safety of this investment,’” Dou says. “I asked the teller about it, and she said, ‘Just ignore that: It’s standard contract language. I can tell you our bank will guarantee your money back plus the interest stated on the certificate.’ Though I enjoyed a 12 percent gain, I decided one-year [of] risk was all I was willing to take.”

Dou had reason to be cautious. China’s banks have sold trillions of yuan worth of similar wealth management products in recent years, and those investments are looking increasingly shaky. In January more than 700 investors — both wealthy individuals and institutions such as People’s Insurance Co. (Group) of China, the state-owned company that is the country’s largest property/casualty life insurer — were forced to take an effective write-down on a 3 trillion-yuan certificate, the Credit Equals Gold No. 1 product, after the issuer, mining operator Shanxi Zhengfu Energy Group, ran into financial trouble. Shanxi Zhengfu Energy began defaulting on bank loans and local-investor-backed credit lines last year. To prevent the company from defaulting on the trust certificate — which was issued by China Credit Trust Co., a leading trust company, and sold by Industrial and Commercial Bank of China, the country’s largest bank by assets — the authorities intervened and arranged a deal in which Shanxi Zhengfu Energy paid 2.8 percent interest for the third and final year rather than the product’s supposedly guaranteed 10 percent rate. It was not the first such write-down on a trust product, but it was the most prominent given that the investment had been sold by giant ICBC.

Although the arrangement spared investors larger losses, the opaque nature of the deal failed to reassure some observers. “No one at China Credit Trust, ICBC or the government has announced who ended up paying the bill” on the certificate, says Qian Yanmin, associate professor of finance at Zhejiang University’s College of Economics and a leading expert on China’s shadow banking system. “But there is no question that the government was involved. The mining company, which is going through a debt restructuring, certainly couldn’t afford to pay back the investors. In the end, the government, the trust and perhaps ICBC all played a part in the bailout.”

ICBC declined to comment on the deal to Institutional Investor. Asked about the issue at the  World Economic Forum in Davos, Switzerland, in January, the bank’s chairman, Jiang Jianqing, said ICBC wouldn’t bear responsibility for bailing out investors in wealth products. The incident would serve as a lesson to investors about the risks associated with such investments, he added.

Since 2012 more than 20 trust products totaling 23.8 billion yuan have run into payment difficulties, according to Wang Tao, Hong Kong–based China economist at UBS. About half of those cases are in litigation; the remainder were settled with full or partial payments by the trust companies or their guarantors.

The China Banking Regulatory Commission (CBRC) has begun to strictly monitor the trust industry and will work with individual firms to handle each problem as it occurs, deputy chairman Yang Jiacai said in a recent statement posted on the agency’s website. “Trusts ultimately must take responsibility for any losses incurred,” Yang said, adding that the agency will watch carefully to see that trusts do not use leverage and sell only products backed by capital reserves.

Analysts say the comments by Jiang and Yang suggest that the authorities are worried about the moral hazard of bailouts and do not want to give the market an impression that wealth products have an implicit government guarantee, but that they are also determined to do whatever is needed to safeguard China’s banking system, even if that means selectively bailing out trust products that could pose systemic risks. Some analysts worry that the intervention by the authorities in the case of Credit Equals Gold No. 1 has sent a dangerous signal.

“This is a de facto bailout in our view, and it averted a potentially devastating default risk,” Michael Luk, a Hong Kong–based China economist with Mizuho Securities Co., says of the China Credit Trust incident. “However, it could be negative over the medium term, as investor perceptions of ‘guaranteed principal with 10 percent return’ have been reinforced. Thus it is introducing an even larger moral hazard problem, as it encourages risk-taking behavior.”

Andy Xie, an independent analyst and former chief economist for Morgan Stanley in Asia, has a similar concern. “Investors should be taught a lesson,” he says. “Otherwise China risks systemic crisis further down the road.”

As China’s regulators have clamped down to slow the pace of bank lending in recent years, the country’s shadow banking sector has filled the gap with its own explosive growth. These financial channels have provided a lifeline to private and state-owned companies deprived of credit by the country’s big state-owned banks. They also have given banks high-yielding wealth management products to sell to their customers and allowed banks to sidestep tight controls over deposit rates. Now many analysts worry that the bill for this lending frenzy is coming due.

The shadow banking sector had extended more than 30 trillion yuan in credit — that’s $4.9 trillion, or roughly 60 percent of the country’s gross domestic product — as of June 30, 2013, according to various analysts. Trust companies, about a third of the shadow credit market, had sold more than 10 trillion yuan worth of investment products, up from just 2 trillion in 2010; the sector expanded by 40 percent in 2013 alone. The other two thirds of the shadow sector consists of commercial bills, unregulated corporate bonds not underwritten by banks or securities houses, and informal lending channels, including loans made by individuals and companies that borrow from banks or private investment pools and then relend the funds to third parties at higher interest rates. Most of the shadow credit has been extended to private companies and businesses owned by local governments that do not have access to the corporate bond market.

Given the rapid rise in lending, much of it short-term in nature, analysts are growing increasingly concerned about the risk of defaults. Olivier Blanchard, chief economist at the International Monetary Fund, said in January that Chinese authorities need to contain the mounting risks in the financial sector without excessively slowing economic growth. “This is always a very delicate balancing act,” he warned in a conference call with the news media.

The People’s Bank of China has encouraged higher interest rates and even rate volatility over the past year in a bid to slow the growth of shadow banking and encourage greater discipline among lenders — banks and nonbanks alike. Tightening measures were most visible in June, when Chinese interbank lending rates spiked to as high as 28 percent. By September the central bank had drained almost 100 billion yuan from the money markets. Officials allowed a slightly faster appreciation of the renminbi, which rose 3.2 percent against the dollar in the 52 weeks ended February 17.

The measures have had an impact, with growth of the broad money supply, M2, slowing to 13.6 percent year-on-year in December from 14.7 percent in August and growth in total social financing — a broad credit aggregate covering everything from bank lending and shadow credit to bond and equity offerings — easing to 18 percent in December from 20 percent in June. But in its fourth-quarter report, released in mid-January, the central bank continued to express concerns about an “increasing reliance of growth on investment and debt,” citing “massive borrowing and construction led by local governments” and saying that “significant amount of resources went to the property sector, crowding out SME [small and medium-size enterprise] financing.”

The government has the financial resources to contain defaults if they spike. China’s total government debt stood at a manageable 45 percent of GDP at the end of 2012, according to a paper released in January by IMF analysts Sophia Zhang Yuanyan and Steven Barnett. The government owns stakes in state-owned enterprises worth nearly 190 percent of GDP, the analysts note, citing estimates by the Chinese Academy of Social Sciences, and the authorities control the world’s largest pool of foreign currency reserves: $3.82 trillion at the end of December.

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