(Bubble Alert! New bubble forming… How big will it get? When will it burst? How much paper dragon does it take to burn down the world?)
Two days ago, we learned that the Chinese government was behind the bailout earlier this year of a trust product—a type of financial product that the central government has heretofore emphatically distanced itself from. … This is a notable event that changes the way that analysts look at shadow banking financial products. Up until this point, there appeared to be a firewall between the traditional banking system and the shadow banking sector.
… Until this point, the central government has not been on the hook for shadow banking liabilities. … A central-government guarantee of the shadow banking system would extend its financial responsibility from 71.90 trillion … to 110 trillion RMB … an increase of over 50%. The central government has been loath to extend guarantees to the shadow banking sector, which inherently carries far greater risks.
Can the central government support this new scale of debt? Not comfortably. … Does this increase moral hazard among non-state financial entities? You bet. Knowing that the central government has set the precedent of contradicting its own terms and bailed out a failing financial product will increase the likelihood that shadow lenders will take risks. … Somehow the shadow-banking system needs to be made less of a liability. The leadership is well aware of this issue, but addressing it is difficult and complex. The Huarong bailout may have made the process of reducing risk in the financial system even harder.