* Credit guarantee company that sold protection steps in
* Boost of confidence for shadow banking investments
* Weakens investor assumption of implicit guarantee
* Experiment in interest-rate liberalization trundles on
By Gabriel Wildau and Samuel Shen
SHANGHAI, Jan 22 (Reuters) - Chinese investors who bought a high-yield investment product that later defaulted have recovered principal, but not interest, after a credit guarantor agreed to cover losses, in a move that could bolster confidence in China's lightly-regulated shadow banking sector.
The repayment appears to mark the end of a saga that began when investors in the product, which was distributed through a Shanghai branch of Hua Xia Bank Ltd, protested in front of the branch in early December after learning that their investment wouldn't pay off as planned.
Sales of lightly-regulated wealth management products (WMPs) have boomed in recent years as retail investors hunt for higher-yielding alternatives to traditional bank deposits, whose interest rates are still subject to administrative caps.
The Hua Xia incident was widely viewed as a test case for how authorities would handle defaults by WMPs. Investors widely view such products as carrying an implicit guarantee from distributing banks and the government, even though legally binding guarantees don't exist for many products.
On Tuesday, two investors in the product confirmed to Reuters that Zhongfa Investment Guarantee Co. Ltd., which sold insurance on the product, had stepped in to repay principal, but not interest.
Zhongfa had previously said it would refuse to cover losses if it turned out the fraud had resulted from criminal activity.
Zhongfa couldn't be reached for comment on Tuesday afternoon, while Hua Xia declined to comment.
Having tacitly encouraged the rise of WMPs as a useful experiment with interest-rate liberalization, regulators have recently begun to fret about systemic risk posed by these products. Analysts have warned of a bank liquidity crisis if investors were to suddenly loose confidence in them.
WMPs are an attractive substitute for bank deposits due to their short maturity - usually a year or less. But the underlying assets for the higher-yielding varieties are often longer-dated, illiquid assets such as corporate bonds and high-interest loans.
This maturity mismatch means that banks rely on customers rolling over maturing WMPs in order to maintain sufficient liquidity to avoid a run on a bank.
The resolution of the case, without Hua Xia yielding to extra-legal pressure to compensate investors for their losses, established a positive precedent for many similar cases reported in the media recently, Luo Jing, banking analyst at China International Capital Corporation, wrote in a note to clients.
"We believe a market-ized solution will break investors 'limitless guarantee' expectation. From a long-term perspective, that will help to awaken society's awareness of credit risk," he said.
A former central bank official said last week that if Hua Xia was forced to cover losses, it would mark a huge step backward for China's fledgling wealth-management industry.
Hua Xia has said that the product, which was issued by Zhongding Wealth Investment Center, was sold without permission by a rogue employee at the bank's branch in Jiading, a light manufacturing region on Shanghai's outskirts. But the husband of the sacked employee has said the bank is using his wife as a scapegoat.
The bank's employee sold four Zhongding-issued instruments in 2011, Hua Xia said previously. Money raised through the products was invested in a pawn shop and an Audi sales agent in the poor but populous inland province of Henan, the bank said.
According to its prospectus, Zhongding planned to raise up to 200 million yuan ($32.15 million) through the four instruments and was offering interest rates of 11 to 13 percent.
More typical wealth management products at other banks are currently offered at 3-5 percent, with high-yield products at 8-10 percent. ($1 = 6.2213 Chinese yuan) (Reporting by Gabriel Wildau; Editing by Simon Cameron-Moore)