Why China isn’t ready to let trust investments fail

Leslie Shaffer | Writer for
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China's decision to prevent a default by one of the country's high-yield trust investment products may have spurred concerns about its commitment to reforming its shadow banking system, but some analysts believe the moment simply wasn't right.

"In theory, these products should be allowed to fail to send a warning," Erwin Sanft, a managing director at Standard Chartered, told CNBC. "That's unlikely at the moment."

(Read more: China shadow bank says reached pact to avoid default)

He noted that China faces an economic slowdown and restrictions on public sector financing as well as the need to deregulate interest rates and put a deposit insurance system in place.

"It's just not a good time to allow products to fail in the middle of this transition," he said. "It's better to do it when the growth rate has stabilized and there's clear messaging that small depositors are protected, but large depositors aren't."

Relax, China's credit squeeze isn't new: S&P

News that the trust, which has the unwieldy moniker "2010 China Credit / Credit Equals Gold #1 Collective Trust Product," likely wouldn't be able to pay investors back at the end of January had spurred concerns both over the stability of the financial system and that it might spark a panic over other similar products.

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.

(Read more: China's shadow banking woes are 'exaggerated')

Despite the trust products offering interest rates well above deposit rates, investors widely perceive them as having a guarantee from state-owned banks.

Local media reported the trust firm had 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.

(Read more: China's shadow banking reform faces its first test)

"Given China does not have a deposit insurance system, all deposits are therefore implicitly state guaranteed. The state ownership of the financial system also suggests that the state is behind all financial transactions," ANZ said in a note. "The moral hazard argument does not yet apply to the Chinese financial system until it has a more diversified ownership structure."

ANZ also does not believe the government should move aggressively to impose losses on investors in the trusts.

Chinese trust fund hiccups are nothing new: Citi

"The regulators, local governments, and financial institutions alike will need to tread carefully and rewind their financial liabilities patiently," it said, noting many of the trust-related liabilities were built up as part of stimulus measures during the global financial crisis.

"It will be foolish to use the name of moral hazard to blaze the trail. If they did, the house of China's financial system could also be burnt down," it said.

To be sure, not everyone believes bailing out the trust's investors will benefit the financial system in the long run.

(Read more: Is China really running out of cash?)

"Implicit guarantees in shadow banking foster excessive investment, as expected returns are higher for the investor (which has no downside) than society (which pays for downside via government or bank bailouts)," JPMorgan said in a note.

Concerns over government debt levels have risen recently. China's state auditor said in a report last month that local governments owe almost $3 trillion in outstanding debt, much of it raised via trusts. The debt pile is viewed as one of the biggest threats facing the country's economy, with concerns that much of it cannot be repaid as it was used to fund non-profitable projects.

"Credit is still locked up in these projects," Patrick Chovanec, chief strategist at Silvercrest Asset Management told CNBC. "Even though there's plenty of money being dumped into the Chinese economy, there doesn't seem to be enough money to go around to actually fund growth."

He is concerned about the decision to bail out the Credit Equals Gold trust.

"This bad debt did not suddenly become good. Some entity which is yet to be named was directed by the government to provide the money and take on the loss," he said. "Brushing this kind of bad debt under the rug doesn't really solve anything."

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