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Debt capital markets have become so used to the Federal Reserve’s easy money policy since the global financial crisis that when talk was first mooted in May last year of a pull-back in QE, markets took fright. Equities tumbled and primary debt markets shut. With a normalisation of Fed policy arguably priced in, the question now is whether an economic hard landing in China and consequent mass defaults is going to be the next instigator of dangerous global market volatility.
Despite registering around 10% annual growth rates since the economic reforms introduced by premier Deng Xiaoping in 1978, China’s economy remains a strange beast, geared towards government spending and exports, while the domestic demand component, which is a necessary balance in a mature economy, is muted.
China’s economy is badly in need of structural reform and the administration of Xi Jinping is under no illusions as to what needs to be done to address the array of structural imbalances it confronts.
Nomura Securities forecast the Chinese economy to grow by 7.5% this year, above the critical 7% level that the Chinese authorities believe to be the tipping point for civil unrest in the country, but some way off the heady pace of the past 15-odd years. The Japanese house believes China’s growth will fall to 6.8% in 2015 and sees the country’s sluggish property sector, which is dogged by over-investment, as leading the drag on growth.
In April, Christine Lagarde, the managing director of the IMF, set out in a Global Policy Agenda the risks of a hard economic landing in China, particularly to emerging markets, and singled out the country’s poor asset quality, the inefficient allocation of credit thanks to a still over-regulated financial market where state-directed lending remains the basic modus operandi, and the risks inherent in China’s vast shadow banking industry.
But China’s vice finance minister Zhu Guangyao took issue with this analysis and said that the Chinese authorities were cognisant of the problem’s facing the economy:
“We are beginning to take action, including strengthening management, monitoring and supervision. Compared with how the US and the Europeans handled Lehman Brothers and the sovereign debt issue, we think that China is the most successful, so far,” said Zhu at a meeting on the sidelines of the IMF and World Bank spring meeting in Washington in April.
This reaction would strike many as complacent, however, and numerous market players are voicing concerns that a variety of phenomena point to the likelihood of a hard landing in China, including the recent weakness of the renminbi, logjams in the Chinese money markets, witnessed a few times last year, and a series of domestic bond defaults.
Lombard Street Research estimates the renminbi to be overvalued by between 15% and 25% and there is massive arbitrage speculation based on the view that the renminbi would continue to appreciate.
A recent widening of the trading band by the authorities is seen as the prelude to further falls in the currency and there are fears that a mass unwind of arbitrage positions could produce huge financial losses. The renminbi has fallen around 2.5% versus the US dollar this year.
Meanwhile, the big shock for China’s domestic bond market came in March when Shanghai Chaori Solar Energy Science and Technology produced the first default in China’s onshore bond market after trading in the paper had been suspended since July 2013. The solar and wind power segments of China’s debt market have long been vulnerable to the cyclicality of the industry, which has been allowed to leverage up to the hilt in recent years.
Indeed, in a recent research report in which Deutsche Bank identified US$28.6bn-equivalent of domestic paper at risk from default, the solar and wind sector accounts for about a third of the 22 issues that Deutsche sees as at risk.
Shanghai Chaori missed a coupon payment in early March on Rmb1bn of debt and was seeking a quorum of at least 50% of debt-holders in order to begin restructuring proceedings, but as of the end of May only 21% of holders had registered.
This demonstrates the somewhat opaque nature of China’s domestic bond markets, but also perhaps the lack of faith in the restructuring process, which is basically untested and based on bankruptcy laws that are often sketchy at best.
The question is whether Chaori’s default represents a one-off event from a weak name in a challenged market sector or whether it is the marker for much worse to come as China confronts economic slowdown in the face of leverage across all segments of the economy and at local government level as well.
Recent evidence suggests that investors are sanguine about debt service at the local government level, even in the face of an overall Chinese economic slowdown, and they take the view that the central government will step in with support should there be any stress.
In April, a Rmb2.2bn (US$354m) collective bond issue by four counties in Liaoning province was successfully sold, albeit at around 100bp back of comparables, indicating that although the primary market for local authority Chinese debt is not shut, it remains open with a higher premium across the yield curve.
“The fact that collective bonds from as low as the county-level government could clear the market shows investors still have confidence in government-funding vehicles,” said Ivan Chung, senior credit officer for project and infrastructure at Moody’s.
Still, despite this rather surprising result, there’s no doubt that China has cast a shadow over financial markets this year, more in terms of potential rather than actual damage, given that debt issuance has proceeded at a record clip, with Asia once again blazing a trail, and with China’s public and private sectors well represented.
GDP data have been consistently disappointing and credit protection costs have risen as a result of rising defaults, with five-year China sovereign protection gaining 10bp on the day Chaori defaulted. It has since pulled back but there are lingering fears that a raft of defaults await China’s private sector.
In April, Sinovel Wind Group’s Rmb2.8bn due 2016 bonds and Jiangsu Zhongneng Technology Development’s Rmb1.5bn due 2018s were suspended from trading and there seems to be the likelihood of technical default before both companies, operating in the wind and solar power business, seek to enter restructuring.
HSBC’s analysts in a May report titled “China’s challenges – daunting but not unprecedented” note that China does indeed face some stern economic challenges in the form of rising bad debt, uncertainty on real estate prices and slowing growth.
However, they point out that China has been in such a predicament before, in the early 1990s, when non-performing loan ratios were at around 30%, half of the country’s state-owned enterprises were losing money and China’s price level was crazily schizophrenic, veering from deflation to 25% inflation. The bank’s analysts suggest that this lesson had a profound impact on China’s leaders and that they are in a stronger position today to deal with the problems facing the Chinese economy.
“While we don’t underestimate the challenges, we think China is in a stronger position today to avert a hard landing. There is a much larger buffer in terms of foreign reserves and national savings. Due to tax reforms in the 1990s, government revenues are also a much healthier and more stable proportion of GDP. Far from being another downside risk to growth, structural reform is the only feasible way of resolving these problems,” wrote HSBC’s analysts John Zhu and Qu Hongbin.
Former premier Wen Jiabao in 2007 characterised China’s economy as “unstable, unbalanced, unco-ordinated and ultimately unsustainable”.
These were profoundly realistic words, and China’s authorities remain similarly under no illusions about the task they face. China’s debt pile at the private and public sector level is something that must be addressed and that again has echoes of the NPL crisis of the 1990s.
The crisis was resolved by the establishment of four asset management companies that took the bad debts off the balance sheets of China’s banks – principally the “big four” banks: BOC, ICBC, CCB and ABC – so that they could begin lending effectively again. That move undoubtedly helped unleash the growth spurt of the first decade of the 21st century and it seems likely that the country again may need the services of a “bad bank” to clean up a growing NPL mess.
“There is much still to be done, such as financial sector reform and creating a more competitive market for smaller private enterprises. Some trade-offs may be inevitable but policymakers now have greater policy flexibility as well as a more robust economy – a result of previous rounds of reforms. China did not stand still two decades ago, and it should not stand still now,” wrote HSBC’s Zhu and Hongbin.
When contemplating a China hard landing it’s as well to remember the dramas of the late 1990s and China’s investment companies known as the “ITICS”. These were investment companies banded together as international trust and investment corporations and they suffered severe losses of a magnitude that prompted many to write off China’s viability.
Guangdong International Trust and Investment Corp dropped a fortune in real estate and stock speculation and went bust to the tune of US$4.5bn in 1999, and it was thought that China would be shut off from offshore credit markets for the foreseeable future.
In the event, China was shut out for just a few years, with the markets’ reliable short-term memory kicking in to produce almost 15 years of rampant borrowing and debt issuance both onshore and offshore. While lower growth seems likely as structural reform kicks in, it would seem most likely to fall under the parameter of measured decline rather than the plummet after a period of heady growth that is the mark of the economic hard landing.