Bond fund manager Bill Gross once called Chinese companies “mystery meat”, and many other investing sceptics have been warning about the opaque nature of their accounting for years.
Still risk-hungry investors have invested aggressively in Chinese corporate debt, mostly because there always seemed to be a silent guarantee from the central government that fragile foreigners would be safe from major credit events, like a default.
But after two high profile defaults this week, it’s clear that promise has now been broken. Here’s JP Morgan [emphasis ours].
In China, a shift appears to be taking place concerning the issue of moral hazard. Chinese companies have borrowed heavily in both the onshore and offshore markets in recent years, yet defaults have been very rare due to government intervention. This policy has encouraged investors to lend to companies without proper regard for the underlying risk involved.
For the second day in a row, a Chinese company has defaulted on its debt. Yesterday property developer Kaisa Group missed its interest payment on its dollar-denominated debt. Today state-owned power equipment manufacturer Baoding Tianwei Group failed to make a payment on its domestic debt. A shift in policy toward allowing troubled companies to default would put teeth in the government’s agenda to promote the more efficient allocation of capital and curtail unproductive investment.
This reform in China’s financial markets is the agenda that the government is actively trying to pursue. So the “teeth” must be there, and investors must get bitten.
Baoding is an even better example of how serious the government is about allowing companies to default without regard for investors than Kaisa. Baoding, after all, is state-owned.
But, China has a growth problem.
China is trying to transition its economy from one based on foreign investment, to one based on domestic consumption. That means companies need to rely on growing profits, rather than an inflow of debt, to stay cash rich.
The problem with that is that the economy is also slowing, which has caused sales growth to stagnate and profit margins to thin. Furthermore, prices are falling. China’s producer price index, a measure of how much sellers are getting for their goods, has been deflating for some time. This is making it even harder for Chinese companies to pay back debt.
Societe Generale economist Wei Yao has been warning of this for months.
“China’s debt problem lies with the corporate sector, and so PPI deflation can cause more damage to debt dynamics… The cure should be capacity consolidation and debt restructuring, rather than another stimulus package targeted to boost investment demand,” she wrote in a research note last year.
Restructuring means the backstops have to go. China has already promised to do that for local government financing vehicles (LGFVs). They allowed local governments to raise money without having to go through banks, and these bonds have become an $US820 billion market.
That’s one third of China’s corporate bond market.
So all bets, all guarantees, are off. Cross your fingers.