Executive Comment:

The Growing Pressure For China To Shine More Light On Financial Risks
Head of Greater China: Ping Chew, Managing Director, Hong Kong (852) 2533-3530; ping.chew@standardandpoors.com

Table Of Contents
Innovation Is Crucial But Takes Time Shadow Banking Problems Are Indicative Of Disclosure Risks Defaults Are Signs of A Healthy Debt Market Greater Investment Efficiency Is Key Related Research

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Executive Comment:

The Growing Pressure For China To Shine More Light On Financial Risks
China is at a turning point. The country is entering its next stage of development at the same time that it undertakes economic and financial reform. We expect its economic growth to slow to 6%-7% annually over the next 10 years after averaging 9.8% for two decades. These conditions will likely reveal inefficiencies that high growth and strong liquidity have previously masked. China has impressively lifted millions out of poverty and reached US$7,000 in GDP per capita from US$500 in 1993. But recent growth has relied on cheap labor and low factor prices. The result has been mispricing of resources, excessive credit creation, and overinvestment--particularly in the past decade. One indication: overall debt in China rose to 213% of GDP in 2013 from about 140% in 2007. China's new leadership outlined its reform blueprint following the third plenum of the Communist Party late last year. The central government's commitment to restructure the economy included financial liberalization and internationalization of the Chinese currency. These initiatives should open up China's financial system, which has been repressed by a closed capital account, where capital may not move freely in and out of the country, and state domination of the banking system. In the past, these characteristics provided a much-needed liquidity cushion as the economy developed. They also spurred high investment that is tapering off, especially in the public sector. It is commonly held that China now needs more efficient investment in the public sector, higher investment from the private sector, and greater domestic consumption to sustain its high economic growth.

Innovation Is Crucial But Takes Time

Throughout history, liberalization of financial markets and deregulation have been synonymous with innovation. Particular benefits of financial innovation include more efficiency and liquidity in capital markets, improved funds intermediation between users and sources, and more appropriate transfer of risk. However, financial innovation must be coupled with sound risk management and sensible regulation. And one of the major tenets of good risk management is to have better information. Financial innovation also requires a period of trial and error to test out new products. This process involves due diligence, price discovery, and time for products to season. Even after a trial period, timely information and transparency are needed to ensure the longevity and stability of innovation. It's during this trial-and-error period that a robust risk management framework has to be developed to prevent or limit behavior that could impede financial innovation. Even with such a framework, financial innovation inevitably brings about new and hidden risks. Incentives surrounding financial innovation often encourage indulgence and leverage, and financial regulations usually follow with a lag. Financial innovation therefore requires a complementary and greater effort among market players to understand and

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Executive Comment: The Growing Pressure For China To Shine More Light On Financial Risks

manage the associated risks. Without such knowledge for planning and hedging, there would be no ready remedies if risks materialize that would damage entities and even the larger financial landscape. Eventually, regulators should facilitate market integrity and provide the infrastructure for efficient trading. For innovation to work, each party to a transaction must have the greatest possible understanding regarding the risks to which they are exposing themselves. Otherwise, the efficiency gains cannot be realized. A lack of transparency would result in sub-optimal outcomes and rising risks. Information needs to be timely, clear, accurate, and complete. Standardization and quality are just as important as the quantity of information. In many developing markets, these basic tenets of financial markets are still evolving. Measures that don't support these principles and only focus on sheltering and increasing the size of the market are likely to engender moral hazard among financial institutions and investors, with expectations of eventual government bail-outs rather than a focus on self-discipline.

Shadow Banking Problems Are Indicative Of Disclosure Risks

China's "shadow banking" system has highlighted the risks arising from the opaqueness of the financial sector. Market concerns have been growing over the size and quality of various wealth management products, which are off the balance sheets of banks. Shadow banking credits outside the regular banking system grew to about Chinese renminbi (RMB) 30 trillion (US$4.9 trillion) by the end of 2013 from RMB22.9 billion (US$3.8 trillion) a year earlier (see "Why Shadow Banking Is Yet To Destabilize China's Financial System," published on RatingsDirect on March 27, 2013.) Rapid growth in shadow banking is a by-product of China's financial liberalization. Capital may be better channeled to the underserved private economy, and at the same time help investors who are seeking diversified assets and higher returns from their savings. The recent failure of a high-profile wealth management product in China highlights the current dysfunction. Investors in a RMB3 billion (about US$500 million) collective trust program from China Credit Trust Co. (CCTC) have allegedly incurred losses amounting to RMB200 million. CCTC has reportedly reached an agreement with an unnamed new buyer that will enable the trust to repay all the principal but not the remaining interest in the final year. While a crisis may have been averted for now, several unanswered questions point to continued risks in the financial sector, including moral hazard. For a start, it's not clear why there is a reluctance to officially recognize the CCTC program as a failure even though investors have lost money from their original purchase terms. Further concerns lie in the lack of information over the identity of the buyer, the terms of the resolution, and the role of the Industrial and Commercial Bank of China, which distributed the products. It's not clear whether this event will continue to condition investors in other such vehicles to expect bailouts and therefore relinquish the need to conduct their own due diligence. The central government has stated that it would like to eliminate moral hazard, limit implicit government guarantees, and provide a platform for the healthy development of the non-bank sector. One of the main aims that the central government announced following the third plenum is to let the market play a decisive role. If a government-related

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Executive Comment: The Growing Pressure For China To Shine More Light On Financial Risks

entity or the local government bailed out the distressed collective trust program, we believe a golden opportunity has been missed to address moral hazard. In any case, China's State Council recently issued a directive to better supervise the shadow banking sector, recognizing that is needed to continue to support economic growth. The issue for regulators is the timing and conditions under which these wealth management products are brought to market, including the way in which the products will perform in more trying market conditions. We believe that the risks and costs associated with these investments must be communicated clearly and effectively, too, particularly if products are in the hands of retail investors.

Defaults Are Signs of A Healthy Debt Market

A failure or default is a good way to smooth out the kinks in banking and non-banking systems. Defaults are part and parcel of any debt market. According to Standard & Poor's latest default study, global corporate default rates (including both investment- and speculative-grades) have ranged from 0.51%-4.09% from 1981-2012. The speculative-grade corporate default rate was highest at 11.01% in 1991. But in China's huge bond market, which is the fourth-largest in the world, there has been no default. This is not because all issuers or assets have been able to repay their debt in full and on time, but because local governments or trust companies have bailed them out--or because banks have extended new loans rather than register the original loans as bad assets. We believe that China's bond market can absorb defaults from weaker issuers. In our view, a bond market functions to shift risk toward those investors willing and able to undertake such risks. This reduces the potential impact of defaults. It also diversifies risk that otherwise would be concentrated in the banking sector. A default would also start shifting responsibility to investors from the government. But to let that shift take place, investors need to be armed with the necessary information to conduct due diligence. Better information would help investors to more appropriately price any project or investment according to a trade-off between risks and returns. Uneconomical and inefficient investments or projects would be priced out, or require a higher return for investors to take on such risks. Without such information and abilities to price projects, investors won't obtain the appropriate returns for their capital on a micro level, while credit will be wasted on less-efficient investments on a macro level. China has high long-term liabilities, including social security and pensions. Indeed, it's often said that "China is growing older before it gets richer." Protecting these investment obligations with suitable rewards should be a key policy orientation, in our view.

Greater Investment Efficiency Is Key

China needs to lower its excessively high investment level mainly because each investment dollar is returning less and less benefit. However, a lower investment rate can still support high economic activity. This will require greater investment efficiency, which means better discipline and allocation of capital to stronger projects. The benefits of transparency cut across all parts of China. For example, in the latest audit report on Chinese local

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Executive Comment: The Growing Pressure For China To Shine More Light On Financial Risks

governments, fiscal transparency has alleviated some of the concerns over public finances. We believe such disclosure will drive fiscal reform and economic efficiency (see "Enhanced Fiscal Transparency Could Support Chinese Fiscal Reform And Economic Efficiency If Furthered, Says S&P," published Dec. 30, 2013). More clarity over the health of the banking system and efficiency of state-owned enterprises could also redress the economic distortions built up through cheap and misallocated credit and implicit guarantees. To let the market play the decisive role, the government should empower investors to impose market discipline. And the best way of doing so is to equip investors with more transparency and information that can help them to make wise investment decisions.

Related Research
More Distressed Trust Products Are Likely To Emerge In China This Year, Says S&P, Jan. 29, 2014 A Key Test Case Looms For China's Shadow Banking System, Jan. 24, 2014 2012 Default And Rating Transition Reports, April 3, 2013 Credit FAQ: Why Shadow Banking Is Yet To Destabilize China's Financial System, March 27, 2013

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