China's Central Bank Says Some Investment Products Should Fail

BEIJING--Some high-risk investment products should be allowed to fail in an orderly way, the People's Bank of China said Tuesday in its annual Financial Stability Report.

Investors need to be aware of the risks of "wealth management products" and can't assume a cast-iron guarantee, the central bank said, with defaults allowed to happen "naturally."

Wealth management products, often sold to customers through Chinese banks, offer higher returns than traditional deposits but are widely considered a safe bet by retail investors. While many are invested in bonds and other relatively safe financial instruments, some are repackaged as loans to riskier borrowers.

The PBOC also emphasized the need to control risks stemming from off-balance-sheet lending by banks.

The central bank said online financial products should be kept under regulatory supervision and need to be subject to capital constraints. Since last year, Chinese Internet companies such as Tencent Holdings Ltd. and an affiliate of Alibaba Group Holding Ltd. have started offering deposit-like services, which have been highly popular with investors, though they remain lightly regulated.

The development of Internet finance will help push forward interest rate liberalization but shouldn't raise funding costs for borrowers in the real economy, the PBOC said.

The central bank repeated previous pledges to push ahead with financial reforms that include a liberalization of interest rates. The central bank still keeps a ceiling on deposit rates in the state-dominated banking system.

The PBOC also said it would improve regulation ahead of the introduction of privately run banks. Virtually all China's existing financial institutions are majority state-owned.

One key objective of financial reform is to reduce the room for underground lending, which has thrived because of the failure of banks to meet the needs for credit from many smaller private businesses.

The PBOC report also used particularly harsh words to describe the virtual currency bitcoin, calling it a "tool for speculation."

The central bank also said it carried out stress tests on 17 major banks based on financial information from the end of 2013, and found the banking system's ability to withstand shocks "relatively strong."

The tests, however, showed the need to pay attention to risks from the property sector, wealth management products and local government debt, according to the central bank.

Local government debt, another class of lending sometimes thought to carry an implicit guarantee from the central government, should be resolved through "market means," the PBOC said.

China's local governments have borrowed heavily in recent years, partly to fund needed infrastructure projects but also for use on riskier real-estate investments. There have been increasing concerns about the ability of some of these local governments to repay their debts.

Banks should strictly control lending to industries with excess capacity problems, the report said. Although it didn't list the sectors explicitly, these areas of the economy generally include metals, cement and chemicals.

The central bank also said it would seek to reduce regulatory arbitrage, or the opportunity to take advantage of loopholes in the regulatory system.

Richard Silk and Grace Zhu