Huarong Asset Management, one of four distressed-debt firms created 20 years ago to dispose of the bad assets of China’s big state-owned banks, may not survive in its present form. But the other three distressed asset managers – Cinda, China Orient and Great Wall Asset Management – show no signs of trouble.
The price of Huarong’s US dollar bond due in May 2029 fell on Monday to just US$77 from $105 the day before, but the price of the 2029 local-currency bonds of its peer Great Wall Asset Management rose slightly. So did similar-maturity debt of Cinda Asset Management and China Orient Management.
The Bloomberg Barclays China Aggregate Bond Index rose in price. One wouldn’t expect that after reading Bloomberg News, which began an April 13 dispatch, “Growing panic over the financial health of one of China’s largest bad-debt managers spilled into the broader market.”
On the contrary, the broad market barely budged; corporate spreads (the extra yield paid above Treasury bonds) on Chinese investment-grade corporate bonds issued in US dollars widened about 8/100 of a percent. That’s roughly the standard deviation of weekly changes in Chinese corporate bond spreads during the past three years.
And as noted, Huarong’s problems didn’t affect the other three distressed asset managers. China’s distressed asset managers – except for Huarong – are in no danger.
But that is small consolation to China’s regulators, who are struggling to create a market mechanism for efficient credit allocation. There is no effective market for distressed debt in China because the high-yield debt market remains illiquid and opaque.
It remains an insider’s market dominated by a few institutions rather than a funding vehicle with support from a broad domestic as well as international investor base.
China’s credit rating agencies have become an embarrassment to financial regulators, who suspended the operations of the country’s largest rating agency for alleged malfeasance earlier this year.
The job of distressed asset managers is to either liquidate or recapitalize troubled companies, and raise salvageable businesses out of distress. If investors do not have the tools to assess the risk of high-yield companies, they will stay clear of distressed companies. The state-sponsored distressed managers remain a dead weight on the market.
Although Cinda Asset Management’s bonds traded well despite Huarong’s problems, its stock price in Hong Kong trades at half the 2017 price.
Huarong appears to be a uniquely egregious instance of mismanagement. Its ex-chairman, Lai Xiaomin, was just condemned to death on bribery charges.
As Ling Huawei wrote April 13 in Caixin Global daily:
Lai Xiaomin, a former chairman of Huarong who came under investigation in April 2018, was sentenced to death this January in the country’s biggest financial corruption case since the founding of the People’s Republic of China in 1949. Some believe that Lai’s misconduct as chairman left Huarong with a huge financial black hole. The complexity of Lai’s case made it difficult to unwind some of Huarong’s more problematic projects, so it’s unrealistic to expect Huarong to fill that hole all on its own.
Ling’s column in Caixin warned that “although Huarong has total assets upward of 1.7 trillion yuan ($259 billion), the central bank does not regard it as a systemically important financial institution,” and it may be forced to reorganize, perhaps even “facing debt restructuring or bankruptcy.”
Huarong delayed publishing its 2020 annual results at the end of last month and trading in its stock was suspended. The Caixin report prompted a general selloff of its bonds.
China’s authorities are serious about imposing market discipline on a credit system that grew haphazardly on the back of state guarantees. The Finance Ministry owns 62% of Huarong, but its debt does not bear a state guarantee.
It is impossible to know just how bad its balance sheet is, but it seems likely that the Chinese government will impose some losses on bondholders in the event of a government-backed recapitalization, as an anti-venom against moral hazard.
China’s $4.1 trillion corporate bond market should provide credit more efficiently than the state-owned banks, which through most of their history dispensed loans to state-owned companies as de facto agencies of the government. It is a long way from providing an efficient mechanism for credit allocation, however.
More than 5,000 bonds are traded on China’s securities exchanges in Shanghai and Shenzhen, or priced electronically on interbank trading platforms. But in the higher-yielding segment of the market, where credit risk is concentrated, bonds trade infrequently and with poor liquidity.
China’s corporate bond market really is two quite different markets. The histogram below shows the distribution of bond yields, grouping them neatly into a low-yield, high quality bucket and a high-yield, higher-risk bucket.
On the high-yield side of the distribution, information is scarce, and credit ratings are fictitious.
Earlier this year China’s largest rating agency, China Chengxin International Credit Rating Co., was suspended for three months after a state-owned utility, Yongcheng Coal, defaulted on a short-term RMB 1 billion bond issue shortly after the agency assigned the bond a top AAA rating. The default had knock-on effects among provincial issuers and mining companies.
China’s National Development and Reform Commission ranked the suspended firm as the best among the country’s credit rating agencies, and it was the largest provider of ratings during the third quarter of 2020.
China would do well to borrow some ideas from America’s capital markets. Until the mid-1980s, home mortgage lending was the largest fixed-income market in the United States, but it was dominated by more than 10,000 local savings banks with limited financial flexibility.
When the US raised interest rates in the early 1980s to control inflation, the whole savings-bank sector became insolvent; it had borrowed short-term deposits in order to make long-term loans, and the cost of new money rose above the yield on its existing portfolio.
The US solved the problem by introducing mortgage-backed securities, which allowed local banks to sell packages of mortgages to bond investors. But the creation of a large and liquid market in mortgage-backed securities required a new generation of valuation models, which made it possible for investors to put a price on these complex instruments.
Another generation of valuation models transformed the market for corporate bonds during the 2000s, allowing investors to buy different tranches of pooled credits with varying degrees of default risk and corresponding risk compensation.
The crisis of 2008 was due not to the failure of these models, but rather to the willful decision of financial institutions to ignore their own risk models in order to maintain profitability, as I explained in a 2012 study for the Journal of Applied Corporate Finance.
China’s authorities are determined to improve credit risk management throughout the financial system.
They succeeded last week in requiring Ant Financial to reorganize as a bank holding company to ensure that Jack Ma’s fintech vehicle would not become a source of excessive leverage. And they have shut down a variety of internet loan sharks masquerading as fintech companies.
These are heavy-handed measures and reasonable on their own merit. But the market requires recognized gauges of risk to price, trade, and structure debt in order to turn China’s corporate bond market into an efficient credit allocation mechanism.