The Shanghai Composite is tumbling... to six month lows (and back near 2,000 for the firs time since July)...

and its closest (nominally) to the S&P 500 in almost 8 years...

As we previously noted,

...borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).

Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.

Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.

So the PBOC's efforts are merely exacerbating the situation for the worst companies... for example... Zhenfu Energy...

As Reuters reports,

Industrial and Commercial Bank of China, the world's largest bank by assets, said on Thursday that it has no plans to use its own money to repay investors in a troubled off-balance-sheet investment product that it helped to market.

ICBC's shares have fallen this week amid speculation that the bank would be forced to help repay investors in a 3 billion yuan ($496.20 million) high-yield investment product issued by China Credit Trust Co Ltd but marketed through ICBC branches. The product is due to mature on Jan. 31.

"Regarding this unsubstantiated rumour, a situation completely does not exist in which ICBC will assume the main responsibility (for the trust product)," an ICBC spokesman told Reuters by phone on Tuesday.

The trust product, called "2010 China Credit / Credit Equals Gold #1 Collective Trust Product", used the funds it raised from wealthy investors in 2010 to make a loan to unlisted coal company Shanxi Zhenfu Energy Group Ltd.

But in May 2012, Zhenfu Energy's vice chairman, Wang Ping Yan, was arrested for accepting deposits without a banking licence.

Which Barclays warns:

In our view, despite the trust issuer, distributor bank and local government perhaps trying to bail out the mining company, the regulators and central government could probably allow the trust product default to happen as:

1. government appears fairly determined to reform the financial system and cut off the implicit guarantee of financial institutions;
2. the State Council is reportedly streamlining regulation of shadow banking including trust business; and
3. the default of trust products could have less social impact than the default of WMPs, bonds and other products sold to the general public or have problematic practices, such as asset-pool investments.

In our view, the default of trust products could trigger some short-term negative impacts on China’s financial sector and the reputation of financial institutions. However, we believe it is positive for the healthy development of financial system in the long run because the default could do the following:

1. Be a step to reduce the implicit guarantee of financial institutions for investment products. Banks could shift their financial liabilities back to the investors.
2. Increase the risk awareness of both investors and financial institutions, which could correct the pricing of investment products to more risk-oriented.

If the trust product goes into default, we believe it would be the first default to test the financial system.

Here is the product...

And the growth of such products has been enormous as we have explained in great detail previously...

As Michael Pettis, Jim Chanos, Zero Hedge (numerous times), and now George Soros have explained. Simply put -

"There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years."

http://www.blacklistednews.com/Chinese_Stocks_Tumble_On_Contagion_C...