Here's Why A Scary Debt Default Could Be The Best Thing To Happen In China Right Now

But in a market that has seen no defaults, it can be a good thing because suddenly investors will have more information to better price risk.

China

In January, we saw a resurgence in concerns over Chinese trust default risk.

That was when Industrial & Commercial Bank of China (ICBC) said it would not repay a 3 billion yuan ($495 million) trust product that was expected to mature on Jan. 31.

ICBC, China's largest state-owned bank, distributed "2010 China Credit/Credit Equals Gold #1 Collective Trust Product" to raise funds for coal-miner Shanxi Zhenfu Energy Group.

This wasn't the only trust product that raised red flags.

There was the product sold by Shaanxi International Trust Co. Ltd. and AnXin Trust & Investment Co. Ltd was in trouble after a property developer missed the deadline to repay its debt.

However, fears about systemic risk (in terms of wider defaults) and investment risk (in terms of the loss of investor confidence) forced policymakers to intervene. In each of these instances a last minute plan was cobbled together to make sure investors got their money back.

By preventing these defaults, China arguably did more harm than good.

A missed opportunity

"If you talk to anyone in China, if you talk to them about the prospect of a financial crisis, the first thing out of their mouths will be that the government will never let that happen," Patrick Chovanec at Silvercrest Asset Management told Business Insider in January. "And until you shake that belief you won't have efficient allocation of resources."

"At some point the financial system does have to turn the corner, where there's real risk and there's real pricing of risk," Chovanec added.

Bloomberg BRIEF economist Tom Orlik thinks by failing to allow Credit Equals Gold to fail, China missed a key opportunity to reform its financial system.

"A default, which encourages lenders to price in credit risk, would be a positive development," Orlik wrote in a Bloomberg BRIEF note late last month. From Orlik (emphasis added):

"Credit Equals Gold was an ideal product to be allowed to fail. An 11 percent return made clear to all but the most knuckle- headed investors there was a significant risk. Problems at the borrower - a coal mine whose boss was arrested - have been public information since 2012, removing the element of surprise. That should have limited the fallout to the rest of the financial system.

...The situation today is very different. Nominal growth has more than halved to 9 percent in 2013 from close to 23 percent in 2007. Borrowers from trusts and other parts of the shadow financial system face interest rates in excess of 20 percent. An explosion in lending has increased the burden of repayment to more than 30 percent of GDP at the end of 2013 from about 19 percent at the end of 2008.

Lower growth, higher borrowing costs, and mounting repayment costs mean defaults by borrowers and even bankruptcy at some small lenders are likely. After an initial period of turmoil, that may actually be beneficial for China's risky assets. In a market that better distinguishes between high- and low-risk assets, yields on low- risk assets like Ministry of Finance bonds should fall. That may push investors into riskier assets like equities as they look to keep returns high.

Fear of an overstretched financial system is one of the reasons China's equity markets were amongst the worst in the world in 2013. By pushing greater discrimination in lending, a default may help turn that around."

The sort-of silver lining, though, is that regulators will have more such opportunities going forward.

"Conditions in China's financial system have changed, significantly raising the risk of investments turning bad," according to Orlik.