China: programming the country for defaults

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Two years on from the first credit default in China, the country has seen 11 issuers defaulting this year. For the third largest bond market in the world, letting defaults happen is a challenge. The government’s implicit guarantee seems to be continuing to hold, even though investors are starting to accept that bond defaults can occur in China too.

Just the beginning

Condoning defaults in the bond market will likely be a slow process as the government wants to avoid systemic risk. So far, a total of 20 issuers have defaulted and investors’ concerns over this issue began to increase earlier this year. The belief that central state-owned enterprises cannot default was shattered last October when Sinosteel defaulted. Investors hoping for a bailout are still waiting – the mining, trading, equipment manufacturing and engineering company has already postponed payment 15 times since last October.

Exhibit 1: Number of issuers defaulting in China

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Source: BNP Paribas Asset Management, Wind, August 2016.

Not just private companies, why?

Most of the issuers that have come out of defaults are private enterprises that have been in the process of asset restructuring or bank loan refinancing. However, default resolution has been harder for state-owned enterprises, as it takes them much longer to have their asset restructuring or debt reorganisation plans approved and implemented.

Part of the reason for such supply-side reforms, which the government launched at the end of last year and are focused on the so-called overcapacity industries, is to help accelerate the asset restructuring and concentration of industries such as coal and steel. Forty percent of the outstanding corporate debt that has so far fallen into default has been issued by steel, cement or coal companies, of which half are local or central state-owned enterprises.

Exhibit 2: Breakdown of private versus state-owned enterprises, by outstanding amount (in RMB bn) in default

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Source: BNP Paribas Asset Management, Wind, August 2016.

However, the State Council recently sought to regain financial market confidence in the credit-worthiness of state-owned companies. China Railway Materials is a case in point. The State-owned Assets Supervision and Administration Commission (SASAC), met some China Railway Materials debtors – themselves state-owned companies – to ask them to make repayments as soon as they could to help maintain state firms’ credibility in the bond market. In addition, SASAC tried to reassure the market by stating: “Although central government enterprises are facing difficulties such as the slowing economy, their operations are trending better and their financial indicators are stable. Overall, their debt risk is controllable.”

How can the implicit guarantee status quo be broken?

Firstly, credit rating agencies in China do not operate in the same way as rating agencies in developed markets. With 56% of the Chinese bond market rated higher than AA-, the rating differentiation is clearly minor. Despite using a rating matrix similar to that used for developed markets (after all, Moody’s and Fitch Ratings each own 49% of two of China’s largest credit rating agencies, respectively China Chengxin and China Lianhe), the difference with developed markets lies in the final rating itself.

The rating process has been accepted as a compulsory checkpoint to be able to access funding in the market. It is often specified in the bond registration process that an issuer must be rated to access the market. For example, to be able to issue a super or short-term commercial paper, the issuer must be rated AAA by a local credit rating agency.

From now on, we believe we will see greater differentiation and hence a more meaningful difference in pricing between a ‘good quality’ AA and a ‘poorer quality’ AA. This is taking time as spreads have not widened by much since the start of this trend. We believe that when this process is much further advanced, the government will decide to scrap the implicit guarantee.

The second point is that the regulator itself has a large role to play, by letting the market decide who has the right to issue. In addition, investors themselves should request a better quality of covenants. The underwriting business should be more controlled as well.

The China Securities Regulatory Commission said in April that “on-site investigations of brokerages found a number of problems in their underwriting, including a lack of thorough due diligence on issuers”. In our view, the only way to scrap the implicit guarantee is to change the covenant wording, improving the underwriting process which would allow for a more accurate pricing of risky assets.

Implications: widening spreads, tightening liquidity

Should investors be able to properly price the risk, credit spreads would widen, in our view. We would expect risk appetite to fall, which would increase corporate financing costs. Funding cost factors for corporate bond issuers include benchmark interest rates and credit spreads. In terms of the benchmark interest rate, because the People’s Bank of China recently moderated its monetary policy easing, companies in financial stress can no longer benefit from multiple rate cuts.

This, combined with increasing credit spreads, can only serve to raise funding costs, making refinancing more difficult, especially for companies with weaker fundamentals. Lastly, we expect to see lower issuance and less liquidity as a result. [divider] [/divider]

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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This article was written by Emmanuelle Wilbrod on 25 August 2016 in Paris


The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.

Emmanuelle Wilbrod

Investment Specialist

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