A ticking timebomb?

The world is witnessing the birth of a new type of sugar daddy. That is according to one of the world’s most famous bond fund managers, Mohamed El-Erian.

Pimco’s former CEO and CIO recently described the Federal Reserve as a rich uncle to the world’s financial markets: always on hand to bail them out whenever times look like they might be about to get tough.

Instance one: a backtracking in 2013, when Wall Street threw a ‘taper tantrum’ after the Fed started slowing down its quantitative easing (QE) programme. And the Fed did the same again this January when investors reacted badly to its forecast of two more interest rate hikes in 2019. ­

But perhaps El-Erian should be looking further to the East, because there is another sugar daddy in town (the Chinese government) and it also feels the need to splash the cash. While 2018 was all about deleveraging and credit tightening, the signs in 2019 are that China is embarking on its own form of QE.

The credit stress Beijing hopes to abate was amply demonstrated last week when news broke that China Minsheng Investment Group (CMIG) had missed a repayment on a Rmb3 billion ($445.8 million) bond maturing in 2020. The technical default of such a large and well-connected borrower waves a red flag for those who worry about default risks within China’s private sector.

CMIG was set up in 2014 by 59 leading businessmen under the lead of former Minsheng Bank chairman Dong Wenbiao (see WiC237). In less than five years the company has amassed debts of at least Rmb232 billion ($35 billion), with Rmb50 billion due this year.

Many of its bets have been made on the transformation of sectors suffering from overcapacity such as steel, shipping and solar power. However, analysts say CMIG has made the classic mistake of financing these long-term investments with shorter-term borrowing.

Fortunately, the rich ‘uncle’ appears to have come to CMIG’s rescue. 21CN Business Herald reported that the government helped CMIG to repay its debt last week. To do so CMIG sold a prized asset, reports the Economic Observer. Greenland Holdings, a property giant backed by the Shanghai government, announced on February 14 that it would acquire from CMIG a real estate project on the Shanghai Bund for Rmb12 billion.

CMIG is now looking for strategic investors and is planning to sell more assets. But fears about the precarious state of private sector balance sheets has prompted the National Development Reform Commission to run a health check of the country’s corporate bond market.

The government itself appears to have studied the Fed and the European Central Bank playbook very closely as it seeks to keep funds flowing.

China has already approved two bank reserve ratio cuts so far this year. The problem is that liquidity infusions do not help the debt pile go down. Economists worry the stakes simply get higher the next time round as the borrowings grow.

China’s own form of QE was signalled in late January when the regulator widened the issuance net for perpetual bonds. It also set up a bond swap facility allowing banks to swap perpetual debt for central bank bills, which they can then use as borrowing collateral.

This means that instead of directly recapitalising the banking sector, it put an alternate mechanism in place, which effectively does the same job and should encourage greater lending to boot.

Guotai Junan economist Hua Changchun predicted that the PBOC could quite conceivably start buying central government bonds and financial and corporate sector bonds further down the road to keep the bond markets happy and the economy ticking along.

China has moved towards QE because growth dropped to 6.6% in 2018, its lowest level in 20 years. Its previous efforts to deleverage the economy and unwind the shadow banking sector have, therefore, taken a back seat while it frets about the likely impact of the Sino-US trade war and how to maintain social stability. HSBC said as much last summer when its analysts forecast that the government would adopt a “lengthy zigzag approach” with “technical policy easing being switched on and off as a way to make sure the overall financing environment remains stable”.

However, the regulator’s earlier success in shrinking the shadow banking sector has only made clear just how dependent the country’s private sector borrowers had become on it. Defaults rose as they found themselves unable to source the shortfall from traditional banking channels, which are far keener to finance state-owned entities because they have explicit or implicit government guarantees.

Indeed, the government’s deleveraging efforts prompted a flight to quality that made bond market financing difficult as well. The lowest rated double-A credits severely underperformed a market that was otherwise benefiting from a decline in government bond yields.

Borrowers have resorted to all sorts of tactics to convince the market that things are rosier than they are. Chief among them has been buying their own debt to inflate order books for primary market deals in the hope of securing cheaper pricing.

Transparency may improve following the news that Standard & Poor’s has been allowed to set up a wholly owned subsidiary in the country (see WiC440) – one of the positive knock on effects of the negotiations in the Sino-US trade war.

Yet private sector financing will remain difficult until investors believe that a borrower’s credit worthiness is based on its balance sheet rather than its government connections. Concerns are compounded by the fact that the domestic market desperately lacks any kind of resolution mechanism for defaulters. Even the most cursory glance of distressed debtors shows that there is no rhyme or reason as to which creditors get paid back and by how much.

That said, the government’s QE looks to have had an instant impact. Chinese companies have issued Rmb1.07 trillion worth of bonds this year, up from Rmb661.4 billion in the same period last year. That is the busiest start to a year in at least a decade, according to data provider Wind.

But the data from Wind also points to a more unsettling trend. Some 124 bond issues with principal amounting to Rmb121 billion defaulted last year. That is a big jump from 2014, when Chaori Solar became the first corporate issuer to default on its debt, and from 2017 when Rmb34 billion of bonds went into default. (Chaori was rescued by a white knight and made a full principal repayment. But that has been the exception to the rule.)

In some instances, borrowers have defaulted on their debt, but suddenly made the odd repayment. For example, last autumn, Sina reported that Sichuan Coal had fully repaid an enterprise bond due in October, yet remained in default on other bonds dating back to 2016.

Fitch data shows that during 2018, 86.7% of defaults emanated from the private sector. They were led by CEFC China Energy, which defaulted on debts of Rmb30.6 billion after its founder, Ye Jianming, was arrested last March.

To help out the private sector, the government has made some tactical changes.

For instance, it is trying to encourage the banks to turn on the taps by tweaking its Medium Term Lending Facility, now renamed the Targeted Medium Term Lending Facility (TMLF). Banks are entitled to additional funds at a lower cost, if they lend those funds to the private sector.

In another key move, it has also overhauled the big AMCs (the state asset management companies created at the beginning of this century). It has not only forced them to refocus on their core role (buying and disposing of banks’ bad loans), but also to target their firepower where it is needed most.

As a result, there has been a shift among the big four – Huarong, Cinda, Great Wall, China AMC. Instead of buying bad loans from the main state-owned banks, they have started to switch their focus to the city banks and rural commercial banks where the credit stress is highest and capital ratios lowest.

However, HSBC believes that if the government wants to support the private sector then it needs to relax the controls on the channel that works well for them – shadow banking. Meanwhile the Financial Times pointed out this week that the string of bond defaults has only made banks warier about lending to private sector firms.

---

© ChinTell Ltd. All rights reserved.

Sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.