A company announces that it is on the verge of default. The financial authorities allow it to fail. And the financial markets worry that it represents the first in a long line of distressed credits that could disrupt the wider economy.
If this sounds familiar, it is not just because it reflects a pressing theme in China today. The same thing happened back in 1998 as well when Guangdong International Trust and Investment Corporation (GITIC) defaulted on an $8.75 million coupon payment on one of its international bonds. GITIC’s case subsequently became China’s largest bankruptcy even though the provincial government could easily have covered its debt.
Why? Because then premier Zhu Rongji was determined to punish a wayward province, as well as to teach the financial markets to price credit on its own merits, without assuming an implicit government guarantee.
Given the manner in which history seems to be repeating itself, it seems that Zhu’s lesson has largely been forgotten. The government is trying to get the same message across to investors once again. Only now the stakes are higher. Outstanding domestic bond market debt was Rmb30.9 trillion ($4.99 trillion) at the end of December.
While there have been plenty of headlines about bond defaults, most of the industry commentators seem relaxed about the situation. Many see defaults as a healthy and long overdue step on the road to pricing risk correctly. Few seem to fear that defaults might damage the real economy too badly. But there are two short-term concerns, which could change that view if they start to have a snowballing effect. One surrounds the heavy spike in repayments due during 2014. This includes Rmb4.5 trillion of Rmb10.9 trillion in trust payments and Rmb2.75 trillion in corporate bonds. The trust payments are a concern because of a maturity mismatch between when the debt is due (now) and when the projects will start to generate income streams to fund repayments (some years in the future, if ever).
Anxiety about corporate bonds is similar. Over half the debt was pretty short-term in the first place – commercial paper taken out in 2013.
The second concern has been prompted by the way investors have responded to recent events. As HSBC points out in a recent research report, Beijing’s apparent readiness to to let some companies fall by the wayside has led investors to shun private sector debt.
Instead, they have been flocking back to state-owned enterprise (SOE) bonds. Ironically, this is due to the belief that the government has to stand by “implicit guarantees” to that sector. This is a perverse outcome for a government that has stated that it wants more funding to be made available to entrepreneurs and less to its SOEs.
The Beijing Put, it seems, is still very much alive and kicking– if you are an SOE. One WiC reader and a former Hong Kong investment banking head believes this is deeply unfair on privately-held firms. As he pointed out in an email: “How can the private sector and market forces ever have a leading or relevant role in China if the Beijing Put creates such a tilted playing field?” he asks.
The view has been borne out by a considerable widening of the spread between public and private sector debt since Shanghai-based Chaori Solar Energy defaulted on an Rmb89.8 million coupon payment in March – the first onshore bond issuer to do so (see WiC229).
There was an immediate spike in spread between private sector issuers and SOEs, amounting to 178 basis points (bps) for double-A (locally) rated private sector companies and an even higher 215bps for single-A rated ones.
The premium that private firms are paying over their public sector peers has stayed at that level, as the list of defaults has grown longer.
In mid-March Xingrun Real Estate in eastern Zhejiang collapsed with Rmb2.4 billion ($565 million) of debt. The 21CN Business Herald says the government plans to assume 70% of its liabilities, forcing banks to write off the remaining 30%.
Last week 21CN also reported that construction materials group Xuzhou Zhongsen Tonghao New Board Company had failed to make an interest payment worth Rmb18 million. This marks the first default in the private placement high-yield bond market set up two years ago to give smaller companies better access to funding.
In this instance there was a guarantor, Sino Capital Guaranty Trust, although it has tried to wriggle out of its responsibilities on the grounds that its head office had not approved the original guarantee.
By last Friday, however, the stock market regulator, the CSRC had stepped in with an announcement that Sino Capital would be meeting its obligations within the next 30 days.
Is this a foretaste of problems to come among other guarantors – an ‘AIG moment’ that might prove the successor to what some have likened to China’s version of the Bear Stearns collapse, i.e. when Chaori’s bonds defaulted?
Chaori itself has moved closer towards bankruptcy following news that one of its creditors has filed an application with the Shanghai courts. In Hong Kong, IFR reports that two other companies have had their shares suspended and are close to breaching their loan covenants.
Share trading in chemicals group China Lumena New Materials Corp was also halted after it announced that it needed extra time to finalise its annual results. It will be in breach of its loan covenants unless it announces them by April 11.
Likewise, Labixiaoxin Snacks Group has asked lenders to waive covenants after failing to publish its own financial results on time. Both companies have had the accuracy of their financial reporting questioned recently – Lumena by Glaucus Research and Labixiaoxin by China Weekly.
The Hong Kong Monetary Authority has responded to signs of credit stress by issuing new guidance to reduce lending to Chinese entities. China’s central bank also continues to drain liquidity from the domestic interbank market to try to curtail credit excesses. A seven-week drainage of liquidity is the longest period of tightening since April 2010.
As ever the question is how much pain the government thinks it can inflict on delinquent borrowers and creditors before the knock-on effects start to have a wider impact on the real economy.
Most analysts believe that macro-economic weakness means that there will be more defaults over the coming months. HSBC has tried to quantify them in its research report. It notes that SOEs are responsible for about 90% of repayments falling due this year, with the heaviest burden falling on four capital-intensive sectors: industrials, materials, energy and utilities.
It also says that about 80% of the repayments are principal rather than coupon-related and argues that – if a company defaults on principal – the market may not shrug it off as lightly as recently, when defaulters have failed on coupon payments. In particular, HSBC highlights 35 companies which owe a total of Rmb5.88 billion this year. None of this group has guarantees; all are locally-rated at AA or below; all reported net losses in both 2012 and the first three quarters of 2013. The list includes 10 listed entities. Telling Telecommunications leads the pack with Rmb429 million to repay, followed by Sinovel Wind on Rmb168 million.
To date, the debt markets are still open for public sector entities. Last week, four counties in Liaoning province raised Rmb2.2 billion ($354 million) for urban construction via a collective bond, although the combination of the four counties in the fundraising implies that they wouldn’t have been able to issue on a stand-alone basis. Local investment bank CICC reports too that local government financing vehicles (LGFVs) raised a record Rmb90 billion last month, adding to their pre-existing debt pile.
Analysts say the government wants to see private firms play more of a role in ensuring that the bulk of credit is allocated to the most productive sectors of the economy.
How will it do that? The aforementioned WiC reader has two ideas. “The Beijing Put can’t continue indefinitely because it perpetuates inefficiency in the state sector and encourages dumb investment,” he concludes. “One alternative would be to charge the state sector for guaranteeing its debt. Another would be to reduce the cover, either on the amount of debt covered, or withdraw cover from those SOEs that aren’t considered essential.”
The danger? That if the government abruptly changed its approach, it might precipitate a new wave of bankruptcies among smaller SOEs.
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