The trend of rising defaults in China’s domestic bond market will extend its run in the foreseeable future as the allocation of debt becomes more disciplined amid Beijing’s growing tolerance for such episodes.
Bond defaults in China rose to a record 130 billion yuan in 2019 from less than one billion five years ago, according to S&P Global, which said issuers from inland provinces had higher default rates due to weaker operating performances and tight funding conditions.
It said some provinces like Qinghai and Ningxia had registered cumulative default rates of above 10%.
“The market’s tolerance for defaults appears to be increasing and defaults will likely continue to rise. But the relaxation of liquidity will mitigate some of the hardship. The economy is slowing but we do see PBOC is trying to relax liquidity conditions, which means they are aware of the refinancing difficulties especially for POEs,” said Joyce Huang, senior director at Lianhe Global.
Indeed, China set the tone for the year ahead by announcing, on January 1, a reduction in the money that banks have to hold in reserve, which releases an estimated 800 billion yuan (US$114.6 billion) into the banking system.
The PBOC said its decision to cut the Reserve Requirement Ratio (RRR) by 50 basis points would “support the development of the real economy and reduce the actual cost of social financing,” taking effect from January 6.
Still, that would not change the direction of this trend with S&P expecting defaults to continue to rise, due to persistently tight liquidity for private companies and increasing divergence in the financial performances between strong and weak state-owned companies and local government finance vehicles.
“Increasing cases of puttable resales and off-exchange settlement point to rising liquidity distress among Chinese companies and potentially understate defaults,” S&P analysts said in a report.” The extent of the increase in defaults will depend on the transition of removing implicit government support.”
Debt restructuring expertise and well-defined bankruptcy laws are critical to the development of any bond market and China is making progress in those areas as well.
The PBOC said in a statement that bonds whose issuers fail to meet repayment obligations can change hands via the interbank market or through trustee and settlement agencies.
“They are injecting more discipline into the market, the defaults are ensuring credit will go to the deserving and ensure better corporate health in the long run. We have seen from recent cases that the companies with unmanageable debt are starting to restructure,” said Leonard Kwan, Emerging Markets Fixed Income Portfolio Manager at T. Rowe Price Group.
He said the wider spread between the AAA and AA credits would reflect ongoing credit differentiation, despite which inflows have stepped up in the past 2-3 years from foreign investors.
The spread between AAA-rated companies, the strongest borrowers, and those rated AA, a notch below, has doubled to more than 300 basis points (bps) from 150 bps in 2017. This is much wider than the 100 bps differential in 2010, according to Fitch Ratings.
Implicit guarantees are a thing of the past as even SOEs are not assured of a bailout.
In December, Hohhot Economic and Technological Development Zone, an entity owned by a local government, failed to meet a bond repayment deadline. Tewoo Group, a Chinese state-owned commodities trader and government-owned holding company Peking University Founder Group are both struggling to pay their debts.
“Investors need to pay more attention to an SOE’s standalone credit strength in addition to its ownership structure and the strength of the linkages with its government owner,” said Lianhe’s Huang.
She said the government owner’s fiscal strength underpins the strength of its support while the willingness of the government to provide support would depend on factors like the importance of the company or sector to the economy and the quality of the linkages – track record of government support, whether it is owned directly, to what extent and if it is owned through a subsidiary.