China dodges major shadow banking default

Shadow banking has expanded rapidly in recent years. For instance, trust assets surged to about 10 trillion yuan by the third quarter last year, up 60 percent on the previous year.

Chinese banks are only allowed to offer official rates to depositors, and those rates are flat with inflation, which has left Chinese savers ready to turn to other investments.

Banks are banned from lending money to industries with overcapacity or local government financing vehicles. When borrowers from these categories knock on a bank's door for money, they will be offered a high interest loan from other funding channels. The money is often raised through banks' networks.

As a chunk of non-banking products are due later this year, fear of default is weakening investor confidence in shadow banking system and clogging money pipelines.

As people become less willing to buy shadow banking products, it will likely lead to less liquidity and a credit crunch, said Wang Tao, chief China economist at UBS.

Wang said liquidity would most likely flow back to the banking system, but banks could not automatically expand their balance sheet to offset the shrinkage in shadow banking, as they are constrained by loan quotas, lending restrictions and high reserve requirements.

Some analysts, however, believe borrowing costs in the shadow banking sector may not necessarily rise on default.

"Investors will become more cautious, so they will retrieve their money invested in high-risk areas and purchase more products with lower risks," Ding said. "High-risk projects may see a spike in borrowing costs while low-risk ones can enjoy less costs."

While the high-profile trust incident nerved the market and could lead to tighter regulation on non-banking financing, few expected the authorities to reverse the efforts to liberalize China's financial system.

"Policymakers' ultimate intention is not to halt the trust business, but to ensure clear separation of responsibility between borrower, fund-raising channel and investor, and to prevent risk contagion," wrote Helen Qiao, chief Greater China economist at Morgan Stanley.

If partial defaults can help restore the risk pricing mechanism, financial liberalization will improve efficiency in capital allocation by introducing more competition, and should be encouraged instead of reversed, according to Qiao.