The Rising Mismatch In Chinese Credit Markets

Chinese Money

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There is a mismatch in the credit market in China that is becoming increasingly pronounced.On the one hand, many privately owned Chinese companies; especially manufacturing and industrial companies are in dire need for capital to cover their short term financing needs and to ramp up further expansions.

On the other hand, the domestic Chinese capital markets, dominated by large state owned banks, have been rather unresponsive to such demands. This problem was further exacerbated by the recent tightening in lending policies by the Chinese government. Indeed, despite their enormous sizes and supposed very large lending capabilities, much of the actual new loans made out by the banks have been directed only at politically favoured projects, mostly infrastructure projects, as well as real estate companies.

This mismatch is becoming further exacerbated as result of the current credit tightening policy of the Chinese banks, which has disproportionately affected small and mid-sized industrial companies.
Unable to satisfy their capital needs from the formal banking sector, many of these companies have been increasingly turning toward the informal market for private loans. Indeed, the size of the private loan market has grown tremendously and is estimated to be in the trillions of RMBs.

A few U.S based special situation type investment funds have been getting involved in the origination of such high yield short term loans. The loans are recourse, secured by physical and real estate assets of the borrowers and typically carry interest rate of between 25-30% per annum. As such, they represent very attractive fixed income investment opportunities in an environment of very low yields for U.S corporate bonds.

Doing private loans in China is definitely not for the faint of heart. The legal environment for private loans is still very murky and it is always clear what rights are available for the creditors. Furthermore, in the case of default, collection can be a tricky process. Furthermore, legal recourses that are taken for granted in the U.S are often not available for loans in China. For example, formal foreclosure is very difficult in China, especially for foreign lenders. As such, private lenders often resort to using account receivables held in offshore escrows or other means to secure their claims, rather than using onshore physical assets.In light of these facts, despite the attractive yield, U.S and other international investors are advised not to get into the high yield lending business in China directly.

Instead, investors can gain access to these investment opportunities by pooling cash by buying participation interest stakes in existing loans, effectively buying into loan syndications. For example, for a loan yielding 25% per annum, the co-investor can acquire up to 15%. This enables them to act as limited partners, be able to collect proceeds from the interest payments without direct exposure to the Chinese market. This is effectively a form of informal securitization where the loan originator/lead syndicator carries out the process while assuming the counterparty risks and the limited partners limit themselves to downstream co-lenders.
This arrangement also helps investor circumvent potential issues related to capital control. Since the loans are made offshore (usually in Hong Kong), the proceeds from interest payments and repayment of the principal do not need SAFE certificates to be repatriated out of Mainland China.

Downside protections are also available in the form of credit default swaps in case investors want to hedge against the possibility of default. This applies to a more restricted subset of companies, usually higher profile companies that can generate enough “buzz” among investors to create a reasonable amount of liquidity for the CDS that use their loans as reference assets.

After all, in order for a CDS to be issued at all, an investment banking firm would need to agree to assume the relevant counterparty risk by becoming the protection seller. Normally this is only feasible if the borrower has a good enough track records, the loan amount in question is justified by the company’s cash flow from the most recent fiscal year, as well as being supported by collateral assets. Otherwise the CDS spread/ protection premium would be so expensive that few investors would be interested.

If the size of a particular loan is too small, one can also bundle up several pieces of loans into one portfolio of reference assets to build up a critical mass. This way one constructs a basket Credit Default Swap containing several reference assets. A credit event (default) is considered to have occurred if any of the reference assets goes into default. To minimize risk, the protection seller would need to make sure that the various loans contained in the same basket have minimal correlation with each other.

The way CDS are actually used in practice means that the investors, frequently hedge funds that invest in structured products, are more interested to use these as speculative plays (the so-called naked CDS) to bet against the borrowing entities. This opens up a new venue as a way to indirectly short the Chinese companies, including those that are not publicly traded on a stock exchange. A CDS play in this case is analogous to buying a put option on the borrower of the reference asset.

The current dislocation in the Chinese credit market is likely to persist for some time as the government attempts to cool inflation and dislocations in the capital market. Adventurous investors can identify investment opportunities in China both on the upside as well as the downside, so there is money to be made for the diligent bulls and bears alike.