Correction - Fitch: China Trust's Default Avoidance Fuels Moral Hazard Risks

Thu Jan 30, 2014 12:40am EST

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(The following statement was released by the rating agency) SINGAPORE, January 30 (Fitch) This is a correction of a release issued earlier today. China Credit Trust’s largest shareholders, as cited in the sixth paragraph of this commentary, are The People’s Insurance Company of China (PICC) and other SOEs, not China Life and other SOEs as stated in the earlier release. The correct version is as follows: The move this week to avoid default by a trust product managed by China Credit Trust comes as a relief to local investors and market participants, but it also represents a potentially missed opportunity to limit moral hazard, says Fitch Ratings. The size of the exposure – around USD500m – is not the main issue. Rather, the significance of this event is in understanding the credit implications of why the authorities may have encouraged the outcome – to protect investors at this point – and the moral hazards created by it. This episode has in our view highlighted risks to which Fitch has been drawing the markets attention for some time. First is the management of systemic liquidity risk. The authorities have intentionally tightened liquidity in an effort to hold credit growth under control, while they are also trying to strike a delicate balance of ensuring the economy continues to grow while it rebalances. China’s economic growth remains heavily reliant on new credit. Overall systemic liquidity is much tighter than the numbers suggest, because – among other things – bank cash flows are being affected by a growing level of loan non-performance that is not showing up in published numbers. Moreover, interbank assets are not as liquid as one would normally expect. The bouts of strained market liquidity that occurred during 2013 are symptomatic of these issues. Related to liquidity risk is the close linkage between the banks and their “wealth management product� (WMP) activities. In effect, these constitute a second balance sheet which the banks create as part of their funding and liquidity plans, but can also create asset/liability mismatches. The concern is that a WMP credit event could trigger a broader loss of investor confidence akin to a deposit run. However, by bailing out investors in this particular instance, the authorities are perpetuating moral hazard within the Chinese financial system – and this risk may in fact have become a whole lot bigger. There was an important difference with this product: it appears to have been sold through bank branches of ICBC, but it was not a bank managed product. So in this case it was one step further removed – issued by a trust company, China Credit Trust, which is independent of any bank, has historical links with the authorities, and counts The People’s Insurance Company of China (PICC) and other SOEs as its largest shareholders. As a result, we think the authorities have missed a chance of putting a clear marker in the sand that non-bank products would certainly not be supported. But what they may have also created here is the impression that investments in bank-managed products would most certainly be made whole – at least for the time being. Moreover, this event will increase systemic risks down the road – given the very high (and still rapidly growing) levels of credit in the system. As a result, we believe these repayment difficulties are likely to become more frequent. It is these issues that have been driving negative rating action in China over the past 12 to 18 months. The banks with the largest exposure to WMP relative to their balance sheet are the mid-tier to smaller sized banks. These are also the banks with weakening funding profiles – contributed in part by their more limited franchises than larger state banks – and this means they will become increasingly exposed to the risks highlighted above. WMP activities have become an important source of profitability as well. The large state banks are, however, better positioned to absorb these risks thanks to their traditional funding franchise strength. But the China Trust case does reveal that they are not immune to the risk, as the product was reportedly sold through ICBC’s branch network. Jonathan Cornish Managing Director, Financial Institutions Tel: +852 2263 9901 Aninda Mitra Senior Director, Fitch Wire Tel: +65 6796 7232 Media Relations: Leslie Tan, Singapore, Tel: +65 67 96 7234, Email: leslie.tan@fitchratings.com; Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: wailun.wan@fitchratings.com. The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings. Applicable Criteria and Related Research: 2014 Outlook: Asia-Pacific Banks here Chinese Banks: Mid-Tier Most Under Pressure here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

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