Workers at a coal chemical factory in Anhui province, China, in August 2013. (STR/AFP/Getty Images)
Summary
Once again, China's financial system appears to have averted a potential crisis. China Credit Trust Co. and the Industrial and Commercial Bank of China announced Jan. 27 that they have arranged for a third-party investor to take control of a $496 million wealth management product that was expected to default Jan. 31, thus offering investors in the original product an opportunity to recoup most or all of the principal on their investment. Funds from the product had been channeled to Shanxi-based Zhenfu Energy Group, a coal mining company with a history of financial troubles and that, according to one Chinese source, is already technically bankrupt, with total assets of around $82 million.
Technical defaults on such products have thus far been contained by emergency maneuvers to repay investors, while the impact of bankruptcies in coal and other heavily indebted sectors has remained largely localized. But this has raised questions about when and how such developments might translate into a systemic failure in the nation's financial system.
Analysis
Notably, the identity of the third-party investor remains unknown. Before the Jan. 27 announcement, there was some speculation that Shanxi's provincial government, working in conjunction with China Credit Trust Co. and the Industrial and Commercial Bank, would step in to prevent a default. One reported proposal entailed the Shanxi government covering 50 percent of the product's value while China Credit Trust Co. and the Industrial and Commercial Bank of China each took 25 percent. However, the Industrial and Commercial Bank of China has denied this report, reiterating that it bears no legal responsibility for the product, which it argues it merely marketed, with no explicit guarantee, to wealthy clients.
Alternatively, Xinhua, citing the China Securities Journal, said the China Huarong Asset Management Co., one of the country's four centrally administered "bad banks" established in the late 1990s to assume the debts of China's Big Four state-owned banks, may be involved in restructuring the product. If true, it could be a signal that the central government itself -- rather than local governments or the corporate sector -- is not yet ready to tolerate fully fledged defaults on "shadow" lending products such as the one in question. This would, in turn, fuel uncertainty over the central government's commitment to financial reform, a key component of which will be convincing the corporate sector and private investors alike that the government will not cover losses resulting from informal lending and investment products. The political sensitivity of the matter, and in particular the potential implications of a central government-ordained bailout of an informal lending product for China's broader reform trajectory, in part explains the secrecy so far regarding the third-party investor.
Shadow Lending's Ties to the Coal Sector
Most media coverage of the default and its possible resolution has focused on the implications of a potential default for China's shadow lending markets and financial system more broadly. However, equally notable is the recipient of the loan: a coal mining company in Shanxi province. In recent years, stories of heavily indebted private and locally administered mining companies have become commonplace across China, but nowhere have the degree of indebtedness and potential risks stemming from bankruptcy been greater than in Shanxi, which accounted for 26 percent of China's total coal output in 2013 (second only to Inner Mongolia).
In part this is because Shanxi, more than any other province, has been subject in recent years to intensive efforts by central and provincial authorities to consolidate and streamline the coal sector. Industrial consolidation in the coal sector has taken a variety of forms, including a push to increase the market share of integrated "coal-rail-power" bases such as Shenhua, one of two coal companies administered directly by China's central government. Most often, however, authorities have tried to encourage concentration by mandating minimum annual output requirements -- and in theory, forcing the closure of small-scale mines that fail to meet such targets.
In some cases, these efforts have proved successful. A push by Shanxi provincial authorities in 2009 resulted in the removal of around 60 million metric tons of output from small-scale "township and village" mines. But at the same time, the imposition of minimum output quotas compelled many smaller miners to seek survival through expansion. More often than not, that expansion was fueled by debt.
Between 2008 and early 2011, when Chinese coal demand and prices were high and coal assets therefore more valuable as collateral for loans, much of that credit came through formal channels. But in late 2011, due to a combination of factors, coal prices began to fall. Naturally slowing growth in 2012 and 2013, combined with the central government's move to curb formal credit creation by state-controlled banks, forced all but the largest coal companies to seek funds elsewhere: "shadow" loans, often tied to wealth management products such as the one sold by the Industrial and Commercial Bank of China.
Over the past two years, beset by anemic coal prices -- in 2013, Chinese coal prices fell 16 percent year-on-year -- and increasingly stringent central and local government controls on air pollution, several of Shanxi's largest private coal mining companies have teetered on the edge of bankruptcy, kept afloat by loans such as the $496 million loan received by Zhenfu Energy. According to at least one report, uncertainty over new environmental regulations contributed to a delay in the issuance of a permit that would allow Zhenfu Energy to restart production at one of its coal mines. As of Jan. 22, the permit had been granted, raising the possibility that Zhenfu will seek to sell the mine to help repay its loan.
Zhenfu Energy is not the only Shanxi miner -- or Chinese miner, for that matter -- to have suffered in the face of policy and economic headwinds in China's coal sector in recent years. On Nov. 29, 2013, Liansheng Resources Group, the largest private company in Shanxi, filed for bankruptcy. Liansheng, which had amassed debts of 30 billion yuan (nearly $5 billion) before filing for bankruptcy last year, had similarly been tied to at least one wealth management product, this time managed by China Construction Bank -- the country's second-largest lender -- on which it defaulted. It is still unclear whether or to what extent investors in that product will be reimbursed.
The Threat of Systemic Failure
With regard to the China Credit Trust Co. and Industrial and Commercial Bank of China wealth management product, as with others like it, the key concern for analysts and policymakers remains the potential impact of a default on China's financial system. Emergency maneuvers have minimized technical defaults to this point, but such developments could become a systemic failure in the national financial system.
Whether and when that happens likely depends on sectors such as coal, shipbuilding and steel, all of which suffer from overcapacity issues and face both economic and policy-driven consolidation. Together, these issues can be expected to further jeopardize smaller private and locally administered coal and steel producers' ability to repay loans in the coming years. The coming months will be especially critical for Chinese coal producers as the central government moves to implement a new value-based tax on coal output. Unless combined with effective reduction of locally imposed administrative fees, implementation of the new tax could substantially raise costs for producers, leading to more widespread financial woes -- and perhaps bankruptcies -- among all but the largest and most well-connected conglomerates.
In the long run, the tax is designed to streamline and standardize costs for coal producers by replacing inconsistent fees charged by local governments. But in the next six to 12 months, as kinks are worked out, it could do more harm than good to already struggling small-scale producers. In this context, Shanxi deserves special attention in 2014. With costs rising and prices still muted, the likelihood for further defaults or near-defaults on coal-related shadow lending products will only grow -- and so, in turn, will the likelihood of financial contagion throughout the province's coal sector and beyond.
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