1208_Dagong Credit Monitor_China Trust

Summary

Trust industry is a big part of China’s shadow banking industry. We review the

industry in light of new offshore bonds from the industry (issued by Zhongrong

International Trust) and on-going deterioration of trust product asset quality.

Here are the summaries of what we review in the report:

1. Latest financial performance pointed to a declining equity cushion amid

rising leverage and non-performing loans. A lack of transparency and credit

culture in China makes us worried that the worst is yet to come and trust

defaults are rising.

2. A low interest rate environment, more access for onshore investors to

invest abroad, competition from the asset management industry, and

recent bad press on rising defaults in the trust industry should slow down

growth in trust assets under management (“AUM”) in the near term.

3. Chinese banks have been funding trust products to circumvent regulations.

In our view, these trust products (called “Single Funds1”), accounting for

60% of total trust AUM in March, will likely be rescued by banks if necessary.

4. 9% of AUM or RMB1.3trn are Collective Funds1 that will mature by March

2016. We see this type of trust product as risky. Given the fact that trust

companies do not have sufficient equity cushions to redeem trust investors,

we believe the support will come from trust company’s shareholders.

5. More than 90% of trust companies are partially or majority-owned by local

governments or State-Owned Enterprises (“SOE”). We believe the central

government will encourage the rescue of a trust default.

Industry Outlook - Negative

Our negative outlook on the Chinese trust industry reflects our expectation of

rising trust product defaults. We, however, expect most defaults to be rescued

by either banks (as trust investors) or by the government (as the last resort for

trust companies owned by local governments/SOEs). On a stand-alone basis,

we believe trust companies simply do not have sufficient equity cushions to

redeem investors in case of defaults. Investors are advised to do their

homework on a trust company ownership structure before investing in a

Chinese trust company’s debt or trust products.

1 See our explanation on trust types on Page 8

Contact Warut Promboon

Chief Rating Officer

(852) 3192 7069

[email protected]

Category Industry Outlook

Location China

Industry Diversified

Financials

GICS 4020

Outlook Negative

Date 16/JUL/2015

Dagong Credit Monitor

Chinese Trust Industry – When Trust is the Question

REMO40/20150716/1208

2

Chinese Trust Industry – July 2015

REMO40/20150716/1208

Contents

Overview ............................................................................................................ 3

Dissecting the Chinese Trust Funds ................................................................ 9

Trust types ............................................................................................................................ 9

Asset classes........................................................................................................................ 9

Industry exposure breakdown .......................................................................................... 10

Structure ............................................................................................................................. 10

A list of trust companies ................................................................................................... 11

Financial Performance ............................................................................................................ 13

Asset quality ....................................................................................................................... 13

Leverage/Capital Adequacy/Liquidity ............................................................................... 13

Profitability.......................................................................................................................... 15

Major Credit Risks ........................................................................................... 16

Recent Developments ..................................................................................... 19

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Overview Chinese trust AUM rose to RMB14.4trn at the end of 1Q15 from RMB4.1trn at

the end of 3Q11 when the China Trustee Association first started collecting

data. Total assets (on-balance sheet) of the Chinese trust industry increased

to RMB367bn at the end of 1Q15 from RMB165bn at the end of 3Q11 (EXHIBIT

1).

EXHIBIT 1: Chinese trust AUM vs. Asset growth (RMBbn)

Sources: China Trustee Association

The Chinese trust AUM rose from 3.9% of Chinese bank assets at the end of

3Q11 to 8.3% at the end of 1Q15 (EXHIBIT 2 on the following page). The AUM

also rose gradually to 11.9% of bank deposits and 16.1% of bank loans at the

end of 2014. We see the growth of the AUM relative to bank assets plateauing

and expect a gradual descend (See our explanations on Page 7).

Trust AUM

continues to

grow…

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EXHIBIT 2: AUM as % of bank deposits/bank assets/ and bank loans

Sources: China Trustee Association, WIND

The Chinese trust AUM accounted for 62.8% of China’s foreign exchange

reserves at the end of 1Q15, versus 20.1% at the end of 3Q11. Compared to

China’s net international investment position (“NIIP”) which is the difference

between foreign assets and foreign liabilities, the AUM rose beyond 100% of

NIIP since 2Q14 to 128.5% in 4Q14 vs. 38.7% in 3Q11 (EXHIBIT 3).

EXHIBIT 3: AUM as % of foreign exchange reserves/NIIP

Sources: China Trustee Association, WIND

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Chinese Trust AUM growth reflects the following factors, in our view.

1. A credit tightening cycle in China:

Chinese commercial banks had been restricted by the government to expand

credit growth since 2011. The swift change from a credit easing cycle has left

many borrowers with limited refinancing options, especially in traditional

banking products. As a result, borrowers had to resort to trust loans. In

particular, local government financing vehicles (“LGFV”) and real estate

developers are the two major sectors which had had their credit facilities cut by

commercial banks (with instructions from the People’s Bank of China (“PBOC”).

These two sectors have resorted to trust loans as a consequence.

2. Loose regulations on trust companies:

In our view, trust regulations lag behind those of commercial banks, creating

advantages (over banks) for trust companies to expand product lines. While

trust companies were able to diversify its product line, they have become a

center of non-standard financial products, of which we doubt if trust companies

are able to do proper credit due diligence. Since Chinese banks fund the trust

products, the elevated credit risk is still with the banks even though it is off-

balance sheet.

3. Tightening risk-based capital rules:

The capital rule restrictions, especially after 2008 credit crisis, encourage

commercial banks to move its lending activities off-balance sheet. The banks

can also earn a higher trust return from trust products (8.1% at end of 1Q15 vs.

1-year benchmark lending rate of 4.85% at the time of this review). Tightening

risk-based capital rules also discourage banks to increase industry

concentration on their on-balance sheet loans. Banks then choose to fund trust

products to ascertain their capital ratios do not deteriorate.

4. Lack of credit culture and transparency:

A lack of credit culture, together with a lack of transparency of borrower

information, makes credit analysis difficult, in our opinion. As a result, Chinese

banks have historically preferred to lend to SOEs and local governments

instead of small businesses. These small businesses or borrowers with poor

transparency have resorted to borrowing through trust products. The lack of

credit culture also encourages Chinese banks to instead fund trust products to

lend so loan exposure to small businesses or borrowers with poor disclosures

stays off-balance sheet. For the very same reason, the lack of credit culture

and unproven credit due diligence among Trust companies meant we simply

do not know how many trust product borrowers with poor disclosures are

represented in the AUM.

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5. Lack of wealth product offering in China:

China lacks wealth products for the general public to invest. As wealth grows,

Chinese high-net worth individuals are looking for more alternatives investment

products other than bank deposits, real estate, and domestic equities.

At 8.1% per year on average in 1Q15, trust products offer a decent return, in

our view, versus the highest 2-year fixed deposit rate at 4.125% at one Chinese

commercial bank, according to our survey. Our concern here is whether the

return to investors compensates the credit risk of trust products.

Regardless of how a trust industry in China is portrayed as part of the shadow

banking business, we believe trust products have enabled the Chinese

economy to grow at the time the country’s banking industry is less than perfect.

Trust products also enable investors to earn higher returns to compensate for

rising inflation. But trust product growth is so fast that the regulations may not

have caught up with. We are of opinion that China needs to develop proper

credit culture where credit risk is more correctly priced and communicated to

the general public.

Though the trust industry continues to expand in terms of assets, the growth

rate has declined. EXHIBIT 4 shows the YoY growth rate of the trust AUM

coming down to 22.9% in 1Q15, versus the recent peak of 70.7% in 2Q13. The

QoQ growth rate of the trust AUM also dropped to 3.1% in 1Q15 versus the

recent peak of 16.9% in 1Q13.

EXHIBIT 4: Year-on-year and quarter-on-quarter AUM growth rates

Sources: China Trustee Association

But growth rate

has slowed

since beginning

of 2013

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We believe there are a few factors that have contributed to the slow-down in

the trust AUM growth rate. These factors will continue to slow down the growth,

in our view.

1. Asset quality deterioration:

As Chinese economy slows and we started to see more onshore defaults,

negative headlines on defaults in the trust industry have scared investors

away, in our view.

2. Tighter regulations on trust industry:

Trust industry’s credit risk is apparent and under microscope of the

regulators. As a result, we expect the regulators to tighten regulations on

the trust industry and that should slow the growth of the trust AUM, in our

judgment.

3. Broadening access for onshore investors to invest abroad:

There have been many new programs to allow onshore investors to invest

abroad such as RMB Qualified Domestic Instructional Investor (“RQDII”),

Shanghai-Hong Kong Stock Connect, and the expansion of the Free

Trade Zone, all of which should take away funding that would otherwise

be available for trust products, in our view.

4. Competition from domestic asset management industry:

AUM at domestic asset management industry rose to RMB11.7trn at the

end of 2014 from RMB6.1trn the year before. We believe asset

management products have taken away seed investments from trust

products. We do not have much clarity on how these products’ credit risk

is analyzed and the rising AUM in this sector also concerns us on the

effect on Chinese economy when defaults rise.

In addition, we believe the asset management industry in China is at its

infancy stage and regulations have not caught up with the growth. As a

result, we believe the growth of this sector only extends the maturity of the

trust products and, perhaps, transfer default risk of the trust products to

asset management products.

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5. Increasing activities in securitization:

Asset-based securities (“ABS”) outstanding in China is booming.

Commercial banks are encouraged by regulators to securitize their assets

in order to improve their capital ratios. EXHIBIT 5 shows exponential

growth in China’s ABS outstanding. That said, the opening up of a

securitization market should reduce the need for banks to lend through

trust products.

EXHIBIT 5: ABS Outstanding (RMBbn)

Source: WIND

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Dissecting the Chinese Trust Funds Trust types

Trust funds are generally categorized into three categories:

1. Single Funds are trust products which are funded by a single investor,

generally banks. Thus, we believe, in the worst case scenario, those

financial institutions will be forced by the Chinese government to

redeem trust investors.

2. Collective Funds, on the other hand, are raised from individual

investors, mainly high-net-worth individuals to fund high risk projects

(in exchange for a higher return). We believe that these funds are in

more danger than the single funds. Without banks as trust investors,

the bail-out of collective funds relies on Trust companies.

3. Property Trusts include asset rights that invest in land and

infrastructure projects (i.e. a trust product that is paid by pass-through

income from projects). We see this type of trust as closely-related to

a structured note.

At 1Q15, the AUM breakdown among these 3 categories are 60%, 33%, and

7%, respectively.

Asset classes

By fund applications of single and collective funds, trust loans were the

majority type of trust products with 39.5% at the end of 1Q15, followed by

available-for-sale and held to maturities securities (22.7%) and trading

securities (14.8%) (EXHIBIT 6).

EXHIBIT 6: Trust products by asset class (1Q15)

Sources: China Trustee Association, Dagong HK

~60% of trust

products

funded by

banks

40% of trust

products were

trust loans

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Industry exposure breakdown

The industry exposure breakdown by China Trustee Association shows top

five industry exposures to financial institutions (33.4%), real estate (10.6%),

leasing and commercial (10.3%), environmental and public facilities (9.5%),

and construction (7.7%) (EXHIBIT 7). The last two categories are part of

infrastructure projects, in our view.

EXHIBIT 7: Trust products by industry exposure (1Q15)

Source: China Trustee Association

Industry exposure to the real estate sector has come down significantly from

about 50% of the trust AUM in mid-2011 on the regulator’s enforcement for a

full disclosure of real estate projects. However, a lack of transparency and

credit culture could concentrate trust product exposure in Chinese real estate

and infrastructure projects in high-risk cities (See Dagong HK’s reports on

Chinese Property Market & Developers – Unwavering despite near term

volatility, dated 27-May-2015 and 中国房地产行业– 2014 年偿债能力下降，

但 2015 年维持稳定 dated 27-May-2015).

Structure

The structure of trust products in China is quite simple. A trust company pulls

investors’ money together and invest in a project or lend to a borrower and

receives a fee in return. A project/borrower’s funding cost is the return to trust

investors plus a fee paid to a Trust company.

EXHIBIT 8 (on the following page) tracks annual returns to trust investors and

Trust companies. In 1Q15, investors earned 8.1% in annual return while trust

companies earned 40bps on average.

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We can assume that borrowers paid 8.5% (8.1% +0.4%) on average. The 8.1%

average rate that investors earned in 1Q15 was still attractive compared to

the highest 2-year deposit rates of 4.125%, in our opinion. We understand the

fee to a trust company can be as high as 100bps and an interest rate charged

to trust borrowers can be as high as 12% in some cases. The Exhibit also

shows annual return to trust investors are on the uptrend but annual return to

Trust companies has fallen from the peak of 85bps in 1Q13.

EXHIBIT 8: Annual returns to trust investors/Trust companies


A competition could play a role here. We believe declining interest rates in

China forced interest rates on trust products to fall. At the same time,

competition to attract money from trust investors is intensifying, especially

from the asset management industry and the availability of overseas

investments for wealthy Chinese. We believe the trend (of low interest rate

environment and rising competition for trust investors) will continue in the near

term.

A list of trust companies

EXHIBIT 9 (on the following page) shows 63 licensed trust companies in China,

according to WIND. CITIC Trust, Zhongrong International Trust, and CCB

Trust rounded up top three trust companies in terms of AUM at the end of

2014. Top ten trust companies accounted for 42.1% of total AUM at the end

of 2014. Bold financial figures for trust AUM, total assets, return on equity

(“ROE”), equity as a percentage of AUM, and total liabilities as a percentage

of equity signify Top Ten figures for respective categories. The table is sorted

by the AUM size.

Declining

return to Trust

companies

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EXHIBIT 9:

2014 Financial snap shots of trust companies in China (RMBbn)

Source: WIND

Trust company AUM Total assets Net income ROE Equity/AUM Total liabilities/Equity

CITIC Trust 902.07 20.88 2.81 15.4% 2.0% 14.4%

Zhongrong International Trust 710.59 12.20 2.43 25.1% 1.4% 24.7%

CCB Trust 665.84 8.10 0.87 12.1% 1.1% 11.0%

China Industrial International Trust Limited 651.15 12.38 1.41 12.7% 1.7% 11.6%

China Foreign Economy and Trade Trust 543.46 6.72 1.22 18.7% 1.2% 3.1%

Hwabao Trust 491.46 7.65 0.70 11.5% 1.2% 17.5%

China Resources SZITIC Trust 471.98 15.22 2.35 17.2% 2.9% 10.1%

Huaneng Guicheng Trust 421.56 7.34 1.28 20.5% 1.5% 17.0%

Ping An Trust 399.85 130.00 3.19 11.2% 7.1% 324.0%

Bank of Communications International Trust 397.99 5.82 0.60 10.8% 1.4% 4.7%

Shanghai International Trust 386.37 10.21 1.72 20.0% 2.2% 11.3%

Shandong International Trust Corporation 330.19 4.85 0.75 17.0% 1.3% 5.3%

Zhonghai Trust 314.25 5.25 0.97 25.3% 1.2% 36.7%

China Credit Trust 312.31 14.54 2.17 16.8% 4.1% 12.1%

Chang'An International Trust 281.66 5.43 0.96 22.7% 1.5% 28.7%

AVIC Trust 278.07 5.49 0.91 19.2% 1.7% 15.6%

Northern International Trust 273.74 3.74 0.56 17.6% 1.2% 16.7%

Yunnan International Trust 270.11 1.86 0.26 15.9% 0.6% 15.3%

Sichuan Trust 269.81 14.59 1.16 27.2% 1.6% 224.2%

Minmetals International Trust 266.41 5.22 0.88 18.1% 1.8% 7.2%

Tibet Trust 256.28 1.79 0.37 29.7% 0.5% 42.0%

Bohai International Trust 216.62 3.77 0.59 16.1% 1.7% 2.3%

China Railway Trust 210.91 9.92 1.00 21.9% 2.2% 113.9%

Yingda International Trust 210.49 4.62 0.57 13.1% 2.1% 3.8%

Guangdong Finance Trust 197.81 3.88 0.55 14.9% 1.9% 4.7%

New China Trust 182.78 4.22 0.11 3.8% 1.5% 52.2%

Jiangsu International Trust 174.35 8.29 1.15 14.1% 4.7% 1.6%

New Times Trust 167.35 3.41 0.29 8.9% 2.0% 2.9%

Anhui Guoyuan Trust 164.20 5.02 0.67 13.8% 2.9% 3.7%

Beijing International Trust 161.63 5.17 0.90 19.6% 2.8% 11.4%

China Fortune International Trust 160.82 3.29 0.52 16.7% 1.9% 5.0%

Tianjin Trust 154.39 3.58 0.78 22.9% 2.2% 5.6%

Anxin Trust 151.15 2.95 1.02 56.7% 1.2% 63.7%

Chongqing International Trust 150.72 17.15 2.44 19.1% 8.5% 29.3%

SDIC Trust 146.63 7.22 0.57 9.9% 4.0% 19.2%

Kunlun Trust 141.64 6.02 0.79 13.5% 4.1% 3.0%

Bridge Trust 138.53 4.25 0.75 20.1% 2.7% 14.3%

Founder BEA Trust 138.14 3.51 0.86 28.2% 2.2% 15.4%

ZHONGYUAN TRUST 129.66 3.47 0.81 25.4% 2.5% 9.3%

Shaanxi International Trust 124.29 4.26 0.35 9.2% 3.1% 11.6%

Xiamen International Trust 115.39 3.81 0.45 13.0% 3.0% 8.0%

JIC Trust 100.60 4.72 0.59 13.7% 4.3% 10.1%

Lujiazui International Trust 95.56 3.78 0.36 10.4% 3.6% 10.1%

Suzhou Trust 89.38 3.80 0.50 15.0% 3.7% 15.1%

China Jingu International Trust 88.52 3.62 0.10 3.1% 3.7% 9.5%

Daye Trust 86.73 1.26 0.29 27.3% 1.2% 18.0%

Huaxin Trust 81.14 7.56 1.68 23.4% 8.8% 5.2%

COFCO Trust 72.14 3.69 0.31 9.1% 4.7% 6.3%

Hunan Trust 67.51 3.08 0.54 21.4% 3.7% 22.7%

Western Trust 65.19 1.99 0.19 11.2% 2.6% 19.6%

China Minsheng Trust 63.77 3.45 0.19 5.8% 5.1% 6.1%

Shanghai Aj Trust 59.90 3.75 0.45 12.6% 6.0% 3.8%

Everbright Xinglong Trust 57.72 1.73 0.15 8.8% 2.9% 4.6%

Wanxiang Trust 57.15 1.57 0.13 8.6% 2.6% 4.8%

Zijin Trust 52.05 1.77 0.27 16.2% 3.1% 8.0%

Shanxi Trust 52.05 3.41 0.42 19.5% 4.2% 57.4%

Dongguan Trust 43.83 3.39 0.42 13.2% 7.3% 6.0%

Sino-Australian International Trust 43.76 1.61 0.15 14.9% 2.3% 57.9%

Guolian Trust 43.51 3.31 0.43 13.2% 7.4% 2.3%

Hangzhou Industrial & Commercial Trust 28.41 2.04 0.47 27.7% 5.9% 21.2%

Zheshang Jinhui Trust 24.80 0.85 0.08 11.4% 2.7% 23.9%

Xinjiang Great Wall Xinsheng Trust 17.09 0.45 0.05 12.9% 2.3% 13.9%

Huachen Trust 6.96 1.04 0.03 3.2% 13.3% 12.2%

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Financial Performance Asset quality

According to China Trustee Association, non-performing loans (“NPL”) of the

trust industry in China rose to RMB98bn (0.68% of AUM) in March from

RMB78.1bn (0.56% of AUM) last December. The trust NPL ratio is still below

that of commercial banks of 1.39% in March. China Trustee Association’s

analyst believes the NPL level is fully controllable. In our view, the absolute

NPL level remains low, compared to that of the banking system but a RMB-

19bn increase in NPL during 1Q15 is alarming and requires attention from

regulators.

Growing NPLs could be a tip of the iceberg, in our view. We list our concerns

that amass to the credit risk of the trust industry under “Major Credit Risks” in

this report. All in all, we believe the asset quality financial figures from the

China Trustee Association alone cannot be used to forecast potential trust

defaults in the future.

Leverage/Capital Adequacy/Liquidity

Total liabilities of the trust industry in China rose to 11.4% of total equity at the

end of 1Q15, vs. 10.2% at the end of 3Q11. The ratio was, however, far below

20% which is capped by the Chinese regulator. The equity cushion dropped

substantially to 2.3% of AUM at the end of 1Q15 vs. 3.6% at the end of 3Q11

(EXHIBIT 10). Given the first trust’s offshore bond issuance, we expect more

Trust companies to issue offshore bonds in order to diversify its funding source

and boost a return on equity. As such, the total liabilities to total equity ratio is

set to increase in the next 12 months, in our view.

EXHIBIT 10: Total liabilities as % of equity vs. Equity as % of AUM


Declining

equity cushion

and rising debt

Rising non-

performing

loans

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Trust companies’ assets at the end of 1Q15 comprise 70% of investments with

the remainder in loans and liquid assets (EXHIBIT 10).

EXHIBIT 11: Trust companies’ asset breakdown (1Q15)

Source: China Trustee Association, Dagong HK

Liquid assets covered 122% of total liabilities at the end of 1Q15, vs. 104% at

the end of the previous quarter. Though the ratio exceeds 100%, we do not

believe the ratio portrays the real liquidity situation of Trust companies.

On the contrary, we are of opinion that total liabilities reflect a small portion of

trust companies’ off-balance sheet liabilities, which should include

responsibilities (or a regulatory pressure) to repay investors should the trust

investments fail or borrowers default. Liquid assets only covered 47.1% of

NPLs in 1Q15, vs. 52.0% in the previous quarter. In our view, we do not

believe Trust companies have a sufficient provision against rising NPLs. As a

result, external support (i.e. from banks or government) would be necessary

in an event of defaults.

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Profitability

Quarterly operating income of the trust industry in China has remained on the

upward trend since 3Q11 (RMB23bn in 1Q15 vs. RMB 17.3bn in 4Q11) but

the annual return on average equity (“ROAE”) (on a 12-month trailing basis)

has been declining to 22.2% in 1Q15 vs. the recent peak of 25.6% in 3Q13.

We believe the decline reflects a rising equity cushion to match the AUM. The

annual return on average assets (“ROAA”) (on a 12-month trailing basis) has

also declined to 20% in 1Q15 from the recent peak of 23.1% in 3Q13 (EXHIBIT

12).

EXHIBIT 12: ROAE/ROAA vs. Operating income (1Q15)

Source: China Trustee Association, Dagong HK

We note that ROAE and ROAA of Trust companies of 22.2% and 20% in 1Q15

remain far ahead of those for the banking industry (17.76% and 1.29% in 1Q15,

respectively). We believe a hefty return on trust products vs. traditional

banking assets should continue to motivate banks to participate in the trust

industry, albeit at a less extent. In this note, we explain why we believe asset

management industry and asset securitization should slow down the growth

of trust AUM.

Still superior

return vs.

traditional

banking

services

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Major Credit Risks Lack of transparency

The details of trust investments and loans are sketchy at best, in our view.

Thus, it is difficult to analyze the credit quality of trust borrowers or projects as

well as the corresponding recovery rates. The lack of transparency also leads

the difficulty for the Trust companies to properly allocate an equity cushion

and the difficulty for trust investors and Trust company bondholders/lenders

to properly price the credit risk of the Trust companies.

Short-term tenor

The tenor of the trust products is about 1.5 to 2 years on average, according

to our survey. Since the trust products are usually used to finance long-term

projects, there is the need to constantly issue trust products to roll over the

debt and investments. At the time of slowing credit growth, this maturity

mismatch could lead to more defaults, in our opinion. EXHIBIT 13 shows a

trust product maturity schedule at the end of 1Q15.

EXHIBIT 13: Trust product maturity schedule (1Q15)


30.9% of AUM will mature by March 2016 while 9% of AUM are collective

funds (we see as riskier than single funds and property trusts) that will mature

by March next year. These collective funds are what we are most concerned

with in terms of refinancing risk for borrowers/projects that resort to funding

from trust products.

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Uncertain government support

About 90% of Trust companies are owned by either SOEs or local

governments, according to our survey. Thus, in the case of insolvency, we

expect the central government to pressure local governments or SOWs to

come in for a rescue. In our view, local governments and SOEs that are

considered “systemically important” to local economies are in a better shape

to redeem trust investors if necessary. Having said that, we believe a

SOE/local government parent company needs to be analyzed on a case-by-

case basis.

Questionable loan underwriting standards and risk management

practice

Trust companies’ risk management practice is not well-known to the public,

especially to investors outside China. We remain skeptical on how these Trust

companies account for market, credit and operational risks of their borrowers

and investments.

For example, the local government and SOE ownership in a Trust company

can lead to moral hazards. A Trust company could launch trust products to

finance or invest in local property developers which, in turn, use the proceeds

to buy land from a local government. Trust products can also invest in local

projects that benefit a local economy that eventually increases a local

government’s tax base (EXHIBIT 14). This cycle could motivate a Trust

company to invest on the basis of maximizing revenues to a local government

(as supposed to risk-return trade-off), in our view.

EXHIBIT 14: Local government funding scheme through trust products

Source: Dagong HK

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Limited research coverage and investors’ knowledge

There is very little research coverage on the trust industry in China since Trust

companies have not come out to raise offshore funds until last month.

Moreover, Chinese trust industry’s credit risk is difficult to analyze on a lack of

information disclosures even though China Trustee Association’s website

provides an overview top down information.

Rising refinancing risk

Decreasing risk appetite for trust products and increasing capital market

activities will increase refinancing risk. Given the difficulties for investors to

analyze the credit risk of borrowers or projects and eroding risk appetite for

trust products, we expect Trust companies to have a tougher time raising

funds. In addition, trust products faces intensifying competition from the

domestic asset management industry and the recent capital flow liberalization

which partially allows onshore investors to invest abroad under RQDII, the

Shanghai-Hong Kong Stock Connect, and the expansion of the Free Trade

Zone.

Since many projects that trust companies invest in have a long-term tenor, the

projects that need to resort solely to trust products for funding may not be able

to refinance its debt obligations. Rising defaults will further turn away trust

investors and we see this as a spiral effect for more trust defaults in the next

12 months.

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Recent Developments We see the following encouragements to partially mitigate the credit risks:

Tighter regulations

When it comes to a Chinese trust, Guangdong International Trust &

Investment Company (“GITIC”) comes to mind. GITIC marked the first USD

bond defaulter in China in 1998. The government’s regulation overhaul has

since disallowed trust companies from simply borrowing to lend at a higher

rate.

Trust companies, as an intermediary to match borrowers and lenders, have

no legal obligation to guarantee credit risk of its products but we believe they

are under a government pressure to provide support in the case of defaults.

We believe the Chinese government is aware of asset quality problems of the

trust products and is tightening regulations on the trust industry.

Rising activities in peer to peer lending and internet financing (i.e.

crowdfunding)

We believe these non-traditional lending platforms will slowly reduce shadow

banking activities, including trust products. These platforms are more

transparent and easier to track than many types of shadow banking products.

Increasing capital market activities

We have seen many capital market developments in China this year. Whether

it is a broader access for foreign investors to invest in the onshore bond

market, the Free Trade Zone expansion, the Stock Connect programs, or

rising securitization of bank assets, more foreign money will certainly help

develop the domestic capital markets and that would, at the same time, reduce

shadow banking activities.

We, therefore, believe some of the trust investments/loans can simply be

replaced by these conventional capital market products which are more

transparent and carry a lower funding cost. In particular, rising securitization

of bank assets should see banks being able to offload their credit risk while

using proceeds to expand their loan books. That, in effect, could make

traditional bank loans more available to traditional trust borrowers.

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Consolidation trend

The Chinese government is encouraging Trust companies to be taken over by

better capitalized suitors (i.e. banks or asset management companies).

Shanghai Pudong Development Bank has recently paid RMB16.4bn in June

to acquire Shanghai International Trust from Shanghai International Group,

Shanghai’s government investment arm. The merger trend will strengthen the

Trust companies’ credit profile, in our view.

Offshore bond issuance

Zhongrong International Trust (“Zhongrong”), China’s second largest trust

company in terms of AUM, has become the first offshore bond issuer from the

industry. Zhongrong issued 3-year USD bonds at par to yield 6% (versus 6.25%

initial offer yield. Dagong HK does not rate Zhongrong.

The order book of USD575mn covers only 2.6 times, a level, we do not believe,

reflects a strong interest in the current market. 49% of Zhongrong’s bonds

were subscribed by private bank investors with a 25-bp private bank rebate.

Reuters reported there was also a strong anchor order from China with Asia

accounting for 95% of the deal. We believe a private bank rebate and a strong

anchor order from China reflects the fact that foreign investors may have

difficulties pricing the deal and/or perhaps demand a higher yield to

compensate for the lack of transparency.

We believe this is the first step for Trust companies in China to tap

international capital markets. With Zhongrong’s bonds as a comparable issue,

we expect to see more USD and/or CNH bonds issued by Chinese Trust

companies this year. Access to offshore funding is positive for the trust

industry in the following aspects, in our view:

1. Funding diversification for the trust industry

2. Rising return on equity, which, indirectly, makes it easier for trust

companies to issue additional equity.

3. International bond issuance will require a trust company to improve

its financial reporting standards and transparency.

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Disclaimer

CREDIT RATINGS OR RESEARCH ISSUED BY DAGONG GLOBAL CREDIT RATING (HONG KONG) CO., LIMITED

(“DAGONG HK” OR “US” OR “WE” OR “OUR”) REFLECT OUR OPINION ABOUT THE CREDIT CONDITION OF THE

SUBJECT AND/OR INDUSTRY, WHICH INCLUDES THE ENTITY AND/OR ITS RELATED DEBT INSTRUMENTS (IF

APPLICABLE), AS OF THE DATE THE CREDIT RATINGS OR RESEARCH IS ISSUED. NONE OF THE INFORMATION

CONTAINED IN DAGONG HK ISSUED CREDIT RATINGS OR RESEARCH, OR THE PUBLICATION ITSELF SHALL BE

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RESEARCH PRODUCED BY US.

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