By Scott Kennedy & Tang Tianyi
A Chinese power-equipment manufacturer defaulted on its bond on April 21 and was unable to make a $13.8 million interest payment due to incurring huge business losses last year. Although there have been a few cases of defaults, this is the first where the issuer is a state-owned enterprise (SOE), which indicates that even the government’s own companies won’t be rescued when facing bankruptcy. Given that total debt in China is north of 250 percent of gross domestic product and a large portion of this is corporate loans and bonds, some observers worry that a growing trickle of defaults is coming that could, intentionally or otherwise, become a tidal wave that could generate a more fundamental financial crisis. A financial crisis is not likely. Despite the challenges for China’s banks, the rising number of corporate defaults is better viewed as part of growing pains in China’s securities markets. Although China is walking a tightrope in trying to permit but control the extent of defaults, its leaders likely will be able to pull this off.
The Baoding Tianwei Group, located in Hebei province just south of Beijing, issued a five-year bond called a “medium-term note” (zhongqi piaoju) on April 20, 2011. It was originally given an ‘AA+’ rating by Lianhe Credit Rating, one of five Chinese domestic rating agencies approved to provide ratings on domestic renminbi (RMB) debt. When China’s corporate bond market started developing in 2003-04, the rating agencies handed out ‘AAA’ ratings like candy, but now less than 10 percent of corporate bonds receive the gold standard, with ‘AA+’ or ‘AA’ the norm these days. The coupon rate for the bond was initially set at 5.60 percent, which was on average 30 basis points lower than other 230-plus 5-year medium-term notes issued in 2011. This meant that there was a high degree of confidence that default was very unlikely, at that time. In December 2014, sensing problems, Lianhe downgraded the bond to ‘BBB’, which in China is equivalent to junk-bond status. And as the latest interest payment grew nearer, the bond was downgraded again at the end of March to ‘BB’.
Observers should expect that additional Chinese corporate bonds will default this year, and in the years ahead. To some extent, one may see this coming through rating downgrades, but usually there are signs of problems long before. These signs are most easily seen in firms that are listed on stock exchanges in China and abroad. The central bank and other regulators of this market are trying to end the moral hazard problem that has gripped China’s financial sector, where banks, bond issuers, and investors all believe the government will step in to bailout investments gone bad. However, expect the government will condone only enough defaults so that the market will begin taking investment risk seriously and pricing it into the new issuances. Beyond formal defaults, the market likely will see some near misses where local authorities and banks step in to pay off investors at least a portion of their holdings. But more common will be short-term corporate bonds that are coming due rolled being over into stock options and longer-maturity bonds, some of which will be new municipal bonds issued directly by local governments. Beijing wants the buck — or RMB — to stop at companies’ and provinces’ doors, not its own.
Although there is a chance this process could get out of control, the central bank has many tools at its disposal to help guide China’s securities markets into a new era. Going forward, investors should follow the wise advice of most brokers: buyer beware.
Dr. Scott Kennedy is Deputy Director of the Freeman Chair in China Studies and Director, Program on Chinese Business and Political Economy at CSIS. Follow him on twitter @KennedyCSIS. Ms. Tang Tianyi is a research intern with the Freeman Chair.
Dr. Scott Kennedy is senior adviser and Trustee Chair in Chinese Business and Economics at CSIS.