Risky borrowers are running into trouble in China and that is putting pressure on trust companies, an important corner of the country’s shadow-banking system.
The fear is that this could further reduce the credit available for private businesses, acting as a drag on an economy whose growth is already slowing. Lightly regulated trust companies have been critical lenders for these firms, as traditional banks deal mostly with favored state-owned enterprises. These problems could also bounce back on many small investors.
As of March, there were 68 trust companies with 22.5 trillion yuan ($3.3 trillion) of assets, including loans equivalent to 2.9% of China’s total banking assets, according to data from the China Trustee Association and Moody’s Investors Service.
Trust companies generally lend to finance projects like building apartments, factories or highways. They fold the loans into funds which promise higher returns than standard bank deposits.
These trust funds are unlisted—and act like debt investments—with regular fixed payments to end-investors, such as companies, financial institutions and rich individuals. When the funds mature, usually after a set period of six months to five years, those investors recover their principal. Some trust funds also dabble in other kinds of investments, like buying stocks.
Some indebted borrowers are running into trouble due to a cooling housing market and slowing economy. More than 280 billion yuan of trust assets faced “default and repayment risks” as of March, according to Moody’s.
That is a relatively small 1.26% of the sector’s total assets. But it is up 90% from a year earlier and is the highest amount since such data became publicly available in 2014.
Meanwhile, a clampdown on nonbank financing has made it more difficult for trust funds’ lending clients to refinance debts elsewhere. That can put them at greater risk of default.
In turn, some funds run by trust companies have halted payments of interest or principal to their own backers.
That could lead to a vicious cycle, prompting investors to shun trust funds which would further tighten credit conditions for private businesses. China’s banks could face even greater official pressure to plug the shortfall.
Andrew Collier, managing director at Hong Kong-based Orient Capital Research, said the trust sector had limited capital buffers to shield it from a situation where loans went sour.
“The trust sector is undercapitalized, and it has always been a soft point in the Chinese economy,” Mr. Collier said. As credit conditions tighten, “they are going to be among the first institutions to feel the pressure,” he said.
Iris Pang, an economist at ING Bank NV in Hong Kong, said the problems could also affect individual investors, since loans made by trust companies often underpinned wealth-management products. These are high-yielding investments sold to small investors by brokers or at bank branches.
“When small firms default on their creditors, that will affect the trust products and therefore will also affect wealth management products,” she said.
Banks sometimes sell wealth-management products to investors on behalf of trust companies and invest the money raised in a new, dedicated trust fund. In other cases, banks act as distributors for existing trust funds.
Trust companies have limited disclosure requirements, so many defaults only become public through media reports or in court cases, said Mr. Collier.
One exception is Anxin Trust Co. 600816 +0.63% , one of the few publicly listed trust companies. In June, Anxin Trust said it missed interest or principal payments due on 25 trust funds with a total size of over 10 billion yuan.
It blamed short-term liquidity issues that it said were caused by macroeconomic and market conditions. Last year, the company’s stock of problematic—or “special mention” loans—soared. They rose to 4.36 billion yuan, or nearly 28% of its total trust loan book, from just 460 million yuan a year earlier.
Moody’s analyst George Xu said while “rising asset-quality challenges” were affecting the whole sector, some trust companies were particularly suffering after expanding aggressively.
Anxin Trust’s woes also reflect how this corner of Chinese finance is exposed to real estate downturns. For example, Anxin Trust is owed 550 million yuan by developer ZhonghongZhuoye Group Co.
Overall trust flows in property have risen in recent years, even as total sector assets have fallen, according to Wind Information Co., a data provider.
Regulators have told many trust companies to curb lending to developers, or in some cases stop financing them altogether, the state-run Securities Times newspaper reported recently.
Bailouts could contain the problem. Many trust companies have local governments or state-owned companies as shareholders, according to their annual reports, and some loans support regional infrastructure projects. As a result, trust products are often seen as having implicit state guarantees.
In theory, local governments don’t have to help trust-fund investors and allowing more failures could help reduce reckless behavior by investors. In practice, however, the state entities that own stakes in trust companies could decide to make fund investors whole.
Mr. Collier said it could become “a reputational issue, a question of losing face and not a question of financial obligation.” In addition, since losses would often affect individual investors, for local governments, this could also help maintain social stability.
By Zhou Wei in Shanghai