Chris Devonshire-Ellis on China's shadow banking, end of IPO freeze and Yuan prospects

It is definitely a credit issue, and China's state policy on this has been found to be lacking. The Chinese state banks are politically aligned with the state owned enterprises and a lot of these are inefficient and struggling; but they are still funding them. They employ hundreds of thousands of people; although, that money is just being wasted. It is necessary to restructure the state owned enterprises or close down the loss making divisions. The issue that they are facing is that there are a lot of Chinese government officials that have an interest in the state owned enterprises. They do not want them closed as they are just relying on Chinese government handouts and making money from this. China is in between  a rock and a hard place as that money is not going where it should be, which is the entrepreneurial sector. Often small to medium enterprises and also some governments go to the shadow banking area, because it is difficult to raise funds from banks. That is also starting to prove problematic as the government is not supervising the shadow banking sector that carefully. We have seen a lot of money put into trust funds and some of them are likely to default. That could lead to a default equivalent to about a billion U.S. Dollars and the ICBC said that they do not intend to bailout investors in trust. That could be the first time when the trust has defaulted in China; however, it is not the first time as there has been a default in China before. In 1999 the Guangdong provincial government defaulted on the bankruptcy of the Guangdong International Trust and Investment Corp. (GITIC). That was 4.4 billion dollars (about 6.2 billion today) and that included institutional investors, who did invest in Guangdong government and trust fund from overseas. Although, it was a provincial government, the central government declined to bail that trust out, meaning that many investors at that time lost their money and none of the foreign investors recouped any of their losses. There are precedents that China is prepared to allow default on trusts and certainly in the shadow banking area. Therefore, the question is whether it is likely to happen, and precedents suggest that it is. I think the Chinese government will allow certain trusts and perhaps one or two smaller city governments or even smaller provincial banks to go into bankruptcy. The downside of that would be that many wealthy Chinese investors have invested in these funds, but I think that government will just turn around, because they are still communist rather than capitalist. To my mind, the wealthy Chinese that have invested in these trusts may have to take a bit of a haircut. Of course those same people will not be able to protest, because if they do, the government will just send them into a prison. 

In my opinion, Beijing will allow some defaults to happen to send the message to the credit industry as a form of punishment. I think that there will be some blood spilled; however, it will not go up to large provincial government level and it will certainly not affect state level. 

If a company is financially sound there, is no good reason not to invest in it. Currently, Chinese nationals do not have really where to put their money, therefore, investing in China's better quality companies would be a good idea, as it would not be very unwise to invest in the unstable housing market, thus it is probably a good idea that officials ended that freeze. However, investors have to be very aware of whether an offer price is reasonable, whether a company well known, how many clients it has, and is it domestic or international company. There are without any doubt some quality Chinese companies to be listed; although, there are also unstable companies that want to be listed. Generally speaking that it is a good thing that they lifted the IPO freeze allowing people to put their money at least somewhere rather than just deposit in a bank, earning low interest rates.

The U.S. economy has started to strengthen during 2014 and it is starting to look better, thus with the stronger Dollar there might be some reversal in Yuan previous appreciation. I think that the government will keep it on a stable course; therefore, I do not see any shocks to the system. The Yuan might appreciate against the U.S. Dollar; although, with strength in the Dollar China's currency may also depreciate a little bit as well. I would suggest keeping an eye on expanding the U.S. economy and how it impacts the Chinese Yuan.