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Get ready for more China shadow-banking defaults

Leslie Shaffer | Writer for CNBC.com
Monday, 17 Feb 2014 | 7:21 PM ET
Wang Zhao | AFP | Getty Images

China has just settled a high-profile failure of one shadow-banking product and already another has emerged, with analysts expecting a wave of potential defaults ahead.

"We definitely expect to see more trust-related products souring through 2014 and maybe next year as well," with the difficulties likely coming from stressed industries, such as coal, as the economy slows, said Ruta Cereskeviciute, senior economist at consultancy IHS.

(Read more: Why China isn't ready to let trust investments fail)

In January, a trust marketed by ICBC with the moniker "2010 China Credit / Credit Equals Gold #1 Collective Trust Product" said it likely wouldn't be able to pay investors back as the 3 billion yuan, or around $496 million, trust used its funds to make a loan to unlisted coal company Shanxi Zhenfu Energy Group, which has since collapsed.

Local media have since reported the trust firm reached an agreement allowing investors to recover their invested principal, but that they would sacrifice their final interest payment. Some reports have said that the Shanxi government may have contributed funds to the bailout.

But concerns over the shadow banking sector didn't get much of a break, with products worth around $126 million issued by Jilin Province Trust failing to repay investors in recent weeks; the trust also made loans to a coal company, Shanxi Liansheng Energy. Six other trusts also lent more than 5 billion yuan to this same delinquent coal company, Reuters reported, citing state media.

"The most important question now in this latest case is whether investors will be bailed out. It's already in default," Cereskeviciute said. She noted that up until now, investors have been repaid even when underlying assets soured, creating a moral hazard.

(Read more: China trust sector reports slower growth; default risks in focus)

Others also expect continuing to bail out trust investors will weigh on China's financial stability.

"We have not seen a significant default in China's shadow banking market in over a decade," Bernstein Research said in a note last week. "The lack of investor losses has ensured that credit continued to be channeled to unproductive and risky entities," it said.

"Good money is going after bad money," it said. "Banks and investors are, in order to prevent defaults, investing money in unprofitable companies that would, in other situations, be deemed insolvent."

(Read more: Why people fear a shadow banking crisis in China)

Bernstein expects further defaults ahead with more than 40 percent of the 10 trillion yuan of outstanding trust products used to finance shadow banking credit due to mature in 2014.

Around 80 percent of trust product principal will need to be repaid to investors in the next two years, Bernstein said.

"If borrowers of trust loans are unable to refinance their outstanding debt via another trust loan or via some other shadow banking product, the company may default on its trust loan, leading to a potential default in the underlying trust product," Bernstein said, noting that often there is a duration mismatch between the loans and the underlying projects receiving financing.

When will the Chinese get a hard lesson in capitalism?
Miranda Carr, head of China research at NSBO, discusses China's shadow banking system and how investors are protected against risks in certain products in the world's second-largest economy.

(Read more: Do China's banks face a new headwind?)

"Borrowing companies need to be able to rollover their loans until the projects they are funding generate substantial cash flows to service the underlying loan. Such a mismatch renders the project/borrower vulnerable to a liquidity event," it said. "The central bank is tightening the interbank markets, making it more difficult for shadow banking borrowers to roll over debts."

To be sure, Bernstein views the likely upcoming defaults as both a long-term positive and a necessity to reform the financial system and improve capital allocation.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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