Poisonous precedents

Despite a few instances of corporate default in China and strain at the local government financing vehicles, the will to avoid default and restructure debt where necessary means wide-scale default is unlikely.

China has the world’s largest corporate debt market and huge levels of local government debt, but default has been a rarity. Many believe recent defaults herald the beginning of a trend, although the government’s commitment to rate liberalisation and debt restructuring will allow this to proceed at a measured pace.

The beginning of what many China market observers believe will be a long tale of default in what is the world’s largest domestic corporate debt market began last March when Shanghai Chaori Solar Energy Science and Technology defaulted on the Rmb89.9m coupon on a domestic bond.

This came at the point where China’s corporate debt had risen to US$16.1trn, or roughly twice the size of the US corporate debt market, a surge from 120% of GDP to 160% in little over a year. Standard & Poor’s predicted in a report last month that this tally could balloon to US$28.5trn by 2019 and potentially unleash instability in China’s financial markets.

For China watchers searching for more telling signs of distress in the country’s heavily indebted corporate sector, the default last April by Baoding Tianwei Group, a manufacturer of power equipment, hit the spot. The company became the first state-owned enterprise in China to default on domestic debt when it failed to pay a Rmb85.5m (US$13.5m) coupon on a Rmb1.5bn bond.

“Rapid debt growth, opacity of risk and pricing (partly due to bank loans dominating funding), very high debt to GDP, and the moral hazard risk of the Chinese market make it a high risk to credit,” Standard & Poor’s wrote in the report.

Shanghai Chaori’s default underlined the somewhat remarkable fact that since China established its domestic bond market in the early 1990s there had been not one instance of an outright coupon or principal default – and although there had been cases of technical default in the early to mid-1990s, local governments had stepped in at the last minute with the necessary funds.

The Chinese financial authorities introduced restrictions in 1997 to limit the contingent liabilities of local governments, but these did not prevent the Shanghai government from stepping in to provide financial support to Chaori in 2013 when it first had trouble servicing its debts.

Markets shrugged off the Chaori default even though many observers suggested it would become the “Bear Stearns” moment for Chinese corporate debt and lead to a chain reaction of selling in the asset class.

That did not happen because investors had been preparing for such an eventuality, although tellingly, spreads between low-rated corporate paper and that at the upper reaches of the China domestic corporate credit curve began a steady widening following Chaori’s default.

At the time of that default it was felt that the authorities’ unwillingness to bail out the company – coming as it did during the China communist party’s annual political plenum – was a sign that it was signalling the concept of letting market forces prevail rather than allowing command style economics, which has been the norm in the country, to prevail.

But perhaps in the light of the recent equity market turmoil, which has seen leading Chinese equity indices plummet by more than 30% from their highs amid an atmosphere of crisis that has spread to global stock markets, that thinking has changed.

Major rethink

Certainly, the authorities’ direct intervention via the purchase of stocks following the collapse of the indices in an attempt to staunch the bleeding suggests a major rethink of what had appeared to be a new laissez faire mindset.

Despite an economic growth slowdown in China, where in the first half of the year, GDP came in at 7% – a 25-year low – credit growth in the country has remained robust.

A heady Rmb1.28trn (US$206.1bn) of new loans was provided by banks in June and the recent 50bp reduction in reserve requirements as well as a 25bp reduction in the one-year lending rate in response to the equity market crisis are likely simply to keep the lending continuing at its current torrid pace.

Early indications of the Chinese authorities’ approach to the corporate debt problem suggest that a full-scale move to shift local government debt on to the government balance sheet via swapping it into municipal bonds is the policy.

There is a plan to swap Rmb1trn of local government financing vehicle debt into munis and the odds of this expanding considerably appear low.

“There is a considerable investment overhang in China, particularly at the local government level. The authorities are cognisant of the need to reduce this and in the context of an economic slowdown and consequent rising default risks it is likely that various means, including muni bond swaps and the establishment of ‘bad banks’, will be used to address this problem,” said a Singapore-based DCM head.

LGFVs have seen funding avenues limited following restrictions introduced last October that prevented them financing through local government guarantees or comfort letters in the bank lending market.

There is considerable leverage in these vehicles, which have become a key component of the central government’s economic policy – investing in infrastructure projects. But many China market watchers expect that the large government-owned banks will continue to offer them credit support, and that default on a large scale is unlikely.

“China is liberalising interest rates. This means higher real rates, more volatile rates and a market where corporate spreads will be determined not by policy, but by markets”

It is important to place the default risk of the corporate debt sector in the context of China’s rejigging of its basic economic model.

Over the past few years the country has engaged in the liberalisation of interest rates as well as deepening the onshore bond market through the development of local government and mortgage bonds as well as the buyside via the growth of mutual funds and the opening up of the domestic bond market to offshore investors through the Qualified Foreign Institutional Investor programme.

A push towards disintermediation away from bank debt and towards bond financing will bring greater transparency to local government funding and bring with it a comprehensive complex of yield curves that will lower funding costs and usher in price discipline.

“China is liberalising interest rates. This means higher real rates, more volatile rates and a market where corporate spreads will be determined not by policy, but by markets. This will undoubtedly push up default rates in China, but its default rates are far lower than in other countries. Default rates in China must rise at least to the average level across other countries,” said Jan Dehn, head of research at Ashmore in London.

“Government will allow higher default rates. This is the whole point of moving to a market-based economy. The Chinese government will only intervene to the extent that the market panics or otherwise overreacts in response to reforms, and if so, only on a temporary basis with a view to stabilising the situation, not to reverse direction.”

Dehn believes that the development of the municipal bond market in China is a key plank in the Chinese authorities overall bond market strategy and that as this market emerges, it will reduce refinancing risk for local government, extend the duration profile and enforce market discipline on those borrowers that have come to rely heavily on bank financing.

He sees the China muni market as likely to exceed Rmb10trn, a figure that if reached would equal the entire EM corporate US dollar bond market.

“Local government financing vehicles have now been prohibited,” said Dehn. “Local governments now have to finance by issuing bonds, whose values will be determined by the market. The government is swapping existing local government loans into tradeable municipal bonds. There are some Rmb11trn of local government loans that will be swapped to muni bonds.

“So far, Rmb2trn has been swapped. Eventually all of it will be swapped, creating the world’s second-largest municipal bond market. Local government financing vehicles are not systemically important in China and will eventually completely disappear.”

Markets think this is a healthy development. Unless and until default rates rise at least to the level of other countries, we see no reason to be concerned.