There’s at least a little trouble in big China, according to a recent Bank of America Corp (NYSE:BAC) report. Bank of America makes the case that monetary tightening by China’s central bank is creating a significant risk of serious credit stresses, especially among trust companies, in mid- to late-2014.

Bank Of America

Details of Bank of America’s argument

Bin Yao, Bank of America Corp (NYSE:BAC)’s credit strategist for Asia, argues that bond yields in China are rising rapidly. He points out that yields are already at their highest levels in more than 10 years as authorities seek to slow down the expansion of the M2 money supply and excess credit. He says it is worrisome that markets are remaining “complacent” about the implications of rising bond yields.

Yao says buying credit default swaps on five-year Chinese is likely the best method to “hedge the China tail risk” as CDS prices have not risen to reflect the default risk he perceives.

Problems with trust companies

The Bank of America Corp (NYSE:BAC) report highlights trust companies as a likely problem area for Chinese debt. “We find trust loans especially troubling,” Yao said, pointing to rising interest rates and a recent domestic report on potential problems with trust companies.

He also points out that the issuance of near-term debt instruments by trust companies has leaped to $320B in 2013 from almost zero just two years ago. Yao also highlighted a recent study by the China Academy of Financial Research which states that Chinese trusts will likely have redemption issues after guaranteeing 10 to 15% returns that are looking increasingly difficult to deliver.

Chinese credit system risks

Fitch Ratings analyzed loan growth in China over the last five years, and declared that the  rapidity of the increase is unprecedented in recorded history. Overall credit has increased from 125% to more than 200% of GDP, if you include all wealth products and the many billions of dollars stashed in offshore banks. Fitch also points out the Chinese credit system has grown from less than $9 trillion in late 2008 to around $24 trillion today.

Yao cautions, however, that China’s banking system is state-controlled. This means a credit freeze after the bubble bursts is not likely to produce a dramatic economic crisis, but very well could lead to medium- and long-term credit issues for the Chinese economy.