A Shock for China Investors?

02/05/2014 12:01 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

The recent news that investors in a Chinese investment trust may now get their principal back is encouraging, but MoneyShow's Jim Jubak still has several questions.

China didn't solve its big financial problem, but it took a step toward reducing some of the big worry. On January 28, one of China's biggest banks, in fact, China's biggest lender, the Industrial Commercial Bank, said, “Hey, you know that product out there, this investment trust that we were telling you we weren't really connected with, we were selling it, but we weren't running it,—and, you know how they're going to not be able to pay back principal when it came due on January 31—well, we've lined up some buyers, so we're going to create rights that will enable you to get your principal back.”

Don't know who the buyers are, in fact, not going to tell you; but don't worry about it. It's all going to be fixed. It's one of those typical, let's sweep it under the rug, fix it somehow solutions. But it's an important one, because, basically, you've got two things happening. One, is that the bank, which is claiming that it doesn't have any connection to investment trusts—which represent about $2 trillion to $3 trillion in the Chinese financial system—have been a hugely popular thing, growing at about 60% over the last three or four years.

Banks are going to be able to say, “Well, we still don't have any connection with that since we're not putting up our money. It's these buyers over here.” The buyers are probably the bank, and another bank, and the central government, and whoever else they could line up to do this. The bank will be able to remain steadfast in its saying that, “Hey, these are not our loans. They're off our balance sheet.”

Second, is that you'll have the markets going, “Well, you know these things that we thought were guaranteed, well, they really are guaranteed. We know that they're not supposed to be safe, but, hey, they are safe, so we'll continue to buy them.” Maybe not at the same rate, but you're talking about an implicit guarantee that now looks like it really is exactly what people were thinking it was, a guarantee that you're not going to lose principal.

The people that invested in this trust, which then turned around and took their money and invested in bonds issued by what is now a defunct Shanxi coal company—which is why there is no principal to pay back on the 31st, they're getting about 10% on their money, in theory. It turns out, they're going to collect most of that interest but, at least, they'll get their money back. This is important because the real, sort of, fallout from this was that in the last week, or two, you've seen a huge increase in credit default swaps. These are a derivative used to protect against default. We had about a 15% increase in the cost of this kind of insurance over the last week. That's a huge move in such a short period of time. Once that starts to happen, what you then get is the sense that, well, money is getting more expensive; and more importantly, some borrowers, some companies that need money, some local governments that need money, won't be able to borrow at all.

The fear, of course, is you get that kind of cascade. One of the entities that's really on the hook are local governments which, again, are not allowed to issue debt themselves, but can set up companies that issue debt, and they're sort of affiliated with them.

The wink, wink, wink, is that, hey, they're backed by the local government. There is roughly, oh, it's up to about—it was ten trillion Yuan at the end of 2012—and it's now up to about $17 trillion to $18 trillion Yuan, so you can see big growth rate in loans put out by these government-affiliated (wink, wink) entities. If those start to go bad, if corporate loans start to go bad, you are looking at a big financial crisis. This has been averted. It's not clear how much the markets are going to care because the problem itself hasn't gone away. You can do this once, twice, three times, but there is a lot of debt out there that comes due this year, that, really, there is no way to cover.

The question is, is the government going to pay for all this? Is everybody's principal going to be made good, or is this a one-off, because it really is just an important bank. That's what really no one knows, and that's why, while credit default swaps went back down a little bit in price, they didn't fall back to where they were, and interest rates didn't fall all that much. We still have a crisis in China, but we averted the very near-term catastrophe that was going to happen on the 31st if this trust didn't manage to pay back its principal.

This is Jim Jubak for moneyshow.com video network.

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