Article / 23 April 2015 at 3:58 GMT

More Chinese defaults likely, but no bloodbath

Managing Director / Asia-analytica Research
China
  • A landmark Chinese property default has put offshore investors on edge
  • More defaults are likely as the economy slows
  • The risk of a bloodbath of defaults is minimal

By Pauline Loong

The rumour mill has been in overdrive since the landmark default of the Kaisa Group, the Hong Kong-listed property developer that made history on Monday as the first major Chinese company to default on overseas debt.

Shenzhen-based Kaisa Holdings failed to make a $52 million interest payment due on two dollar-denominated offshore bonds as a 30-day grace period expired.


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China looks modern and international, but it does not have a free market economy, and nearly every facet of its financial system is dominated by state players. Photo: iStock

 

The burning question for investors is not just which company is next but whether this signals the start of a big bloodbath in overseas Chinese corporate bond defaults. Is Kaisa the croaking canary in the coalmine or just a one-act drama that grabbed media attention?

We believe it is neither.

China’s slowing economy has revealed those who have been, as Warren Buffet might have said, swimming naked. Investors should be prepared for more of what is euphemistically referred to as “credit events” in the coming weeks.

But while there are plenty of corporates wobbling on the knife-edge between illiquidity and insolvency, the risk of a sector-wide bloodbath of defaults is at this point minimal.

The visible hand of government

The key is that China is not a free market economy – not by a long stretch.

Its commercial institutions are answerable to the government in ways that differ fundamentally from what happens in open market economies.  The very visible hand of government allocates resources and constrains price movements.

The political system ensures corporate support for national goals and insulates the economy from volatility in capital flows through capital and exchange rate controls.

Nearly every facet of China’s financial system is dominated by state players – from formal banking to insurance to asset management. This is true even in shadow banking, where the state has a substantial role through quasi-lenders such as finance and trust companies and state-owned enterprises surreptitiously lending their excess cash to corporates with no access to credit.

The big borrowers too are mostly state players. And the cost of funds is skewed by the decades-old practice of policy lending and relationship lending.

In this one big happy family, the usual financial market dynamics of risk discovery is suppressed. Commercial factors alone do not determine a corporate’s ultimate fate in China.

Probes and panics

Kaisa’s woes are an example of the crucial role of non-commercial factors in a corporate's fate. Problems surfaced late last year for the property developer amid a sweeping anti-corruption investigation that shook the city of Shenzhen where it is based.

The sudden resignation of its chairman and two other board members came as the government blocked sales and approvals for some the company’s property projects.

Private-sector companies in China are highly vulnerable to management changes. The line between personal and company assets and credit ratings are often blurred. If the management goes down, so does the company as we explained in a previous post on Kaisa (How to pick a stock that won't collapse with the midnight knock)   (https://www.tradingfloor.com/posts/how-to-pick-a-stock-that-wont-collapse-with-the-midnight-knock-320438)

By February, Kaisa came near to defaulting on an offshore debt. It came to light that the company had $10.4 billion in debt, far more than it had previously disclosed. An unexpected cash shortage also emerged.

Kaisa is now struggling to service 65 billion yuan ($10.5 billion) of debt owed to both onshore and offshore lenders. Media reports say the company is seeking to cram through a restructuring on some of its offshore debt that would impose losses on bondholders.

Chinese companies have some $207 billion in international corporate bonds outstanding, according to Dealogic data. Property companies account for nearly a third of that.

Busy week for corporate defaults

This has been a busy week for Chinese corporate defaults. Less than 24 hours after Kaisa’s announcement came another landmark default – the first-ever onshore bond default by a state-owned company.

Power equipment maker Baoding Tianwei Baobian Electric failed to make a 85.5 million yuan ($13.8 million) interest payment on a bond due last Tuesday. The company had earlier warned investors about possibly missing payment. The issue in question is a 1.5 billion yuan ($241.9 million) 5.7% coupon, five-year bond maturing in 2016.

The company is a subsidiary of a group owned by the Beijing-based defence contractor China South Industries Group Corporation, which is a major defence equipment maker directly owned by the central government. Until now, only private-sector companies have defaulted in China’s domestic bond market although state-owned enterprises issued the vast majority of debt.

Defaults on offshore debt and bond issues by state companies are particularly unsettling as street wisdom holds that the government will always bail out issuers. Well, this is now the new normal.

Allowing some debt defaults is the government’s way of imposing discipline on corporates and alerting complacent investors to risk. But a bloodbath of defaults is a long way off. 


– Edited by Robert Ryan

Pauline Loong is managing director of Asia-analytica Research and senior fellow of the CIMB ASEAN Research Institute.

Important notice: Nothing in this report is intended to be, or should be construed as, an offer to buy or sell, or invitation to subscribe for any securities or as advice relating to legal, technical or investment matters. This report has been prepared on the basis of information that is believed to be correct and from sources believed to be reliable. Asia-analytica makes no express or implied warranty as to the accuracy or completeness of any such information and makes no undertaking to update any such information. Opinions expressed are subject to change without notice.



5y
Neil_Flynn Neil_Flynn
The idea of a domino effect of defaults is obviously far-fetched, but investors do overreact to any negative Chinese news. Mainland equity indices are rallying with government support, but this bubble will inevitably have to end sooner rather than later. You mentioned in a previous article about how the government is waiting for the annual review of the MSCI Emerging Markets index, because of the capital inflows that inclusion would bring, so i am wondering about your thoughts on when this equity bubble will burst. From what i have read, economists' consensus is that it can't be sustained for the rest of the year
5y
Pauline Loong Pauline Loong
Neil, my take is not that offshore investors overreact to China news as that they react to the wrong news. I’ve had calls today on PMI missing consensus estimates and what that means. The simple answer is that consensus had it wrong. Growth trajectory is downhill. No amount of decimal gazing will change that. On the MSCI, much would depend on the cost of propping up market sentiment. MSCI falls into the category of nice-to-have, not must-have. (Running out of space. See next comment.)
5y
Pauline Loong Pauline Loong
Two answers on when the equity bubble will burst. In the domestic A-shares market, the bubble will burst on first signs of liquidity tightening – the expectation is enough to start a rout.

As for Chinese shares offshore, it’s all about market expectations as shaped by Wall Street analysts. The key is knowing when they will call an end to the rally – their perception of when the music is about to stop.

Never has it been truer than for Chinese stocks that getting it right is like betting on a beauty pageant. You don’t go for the one that meets the objective criteria of beauty but the one that everyone else thinks is the most beautiful.

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