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Whistling Past The Graveyard After China's 1st Ever Bond Default
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On Friday, Shanghai Chaori Solar Energy Science & Technology
Co. failed to make an 89.8 million yuan ($14.7 million) interest
payment, the first domestic corporate bond default in the history of the
People’s Republic of China.
The company, in the red for
three straight years, narrowly avoided missing an interest payment on
its five-year, billion yuan obligation in January 2013. Then, the Shanghai municipality leaned on banks to not press claims on overdue loans so that Chaori could pay bondholders.
This time, Shanghai officials sat on their hands
after the company issued a warning on Tuesday that it was able to pay
only a small portion—less than five percent—of the interest coming due. Even
more remarkably, authorities let Chaori default during the annual
meeting of the National People’s Congress, a particularly sensitive
moment in the Chinese political calendar.
Analysts correctly praised Beijing for not rescuing the solar panel company. After
all, the missed payment for the first time introduced the concept of
risk in the $1.4 trillion corporate bond market, where investors were
blindly chasing offerings with the highest coupons regardless of the
creditworthiness of issuers.
Central government technocrats were smart to pick a
marginal issuer for the first failure, yet there is nonetheless cause
for concern. Bank of America BAC -0.12% Merrill Lynch, in aresearch note issued on the Wednesday after the company’s warning, called the then-potential default China’s “Bear Stearns moment.”
That assessment angered Xinhua News Agency. “Indeed,” the official Chinese organ noted in a commentary,
“it is hard to grasp how a potential default of the bond—163 million
U.S. dollars in principal and rated as junk by Shenzhen-based Pengyuan
Credit—could be likened to the systemically important investment bank
Bear Stearns with hundreds of billions of dollars on its balance sheet
at the time.”
Clearly, Chaori is not Bear
Stearns, but what the Bank of America Merrill Lynch strategists were
referring to was the July 2007 disclosure of problems at two Bear
Stearns subprime hedge funds. That event is considered to have ignited a burn that eventually triggered the global panic the following year. As
the strategists noted, “We doubt that the financial system in China
will experience a liquidity crunch immediately because of this default
but we think the chain reaction will probably start.”
Will it? Most observers think not. “Though
China’s financial system faces many serious challenges, the government
has far greater power to prevent a disorderly collapse than its Western
counterparts did,” notes Reuters’s Peter Thal Larsen, writing on the Dealbook site of the New York Times. “If
fears of a Bear Stearns moment have any value, it is to serve as a
reminder to the Chinese authorities which mistakes they must avoid at
all costs.”
Yes, Chinese authorities have the benefit of hindsight, but they face an almost-impossible situation. Even if they make every decision correctly, they will, in all probability, be the victim of what Philip Li of China Chengxin International Credit Rating last week called “a domino effect.”
Consider the challenges. It is no secret why Chaori defaulted. The solar industry in China is notorious for overcapacity and weak prices. The country, of course, is littered with Chaoris, but solar panel overproduction is just the beginning of the story. In the “green” sector, you will find excess wind turbine factories, for instance. And there are far too many coal mines, steel mills, smelters, and ship yards. Need glass or cement? China is certainly the place to go to hook up with an idle producer. Gross overproduction helps explain why the producer price index, which measures factory gate prices, fell in February for the 24th consecutive month.
Up to now, Beijing has been able to bail out loss-making industries, but that has to change because the economy is slowing fast. The manufacturing sector, measured by the HSBC purchasing managers’ index, contracted in both January and February. In
the first two months of this year—aggregated for statistical purposes
to eliminate the distortion caused by the Lunar New Year holiday—exports
fell 1.6% over the same period in 2013. The number of urban job openings, as evidenced by surveys announced by the Ministry of Human Resources and Social Security, fell both year-on-year and quarter-on-quarter in the third and fourth quarters of last year. Tellingly, city jobs in Q4 fell a stunning 13.7% from the preceding quarter.
If the economy continues to erode, there must be a series of defaults. Expect troubles soon, especially in the second half of this year. Haitong
Securities, China’s second-largest brokerage, estimates that 5.3
trillion yuan of trust products will come due this year.
Businesses could have an especially hard time rolling over obligations. Chaori, as small and unimportant as it is, appears to be already affecting China’s credit markets. In
the last few days, four debt issuers postponed offerings, and at last
count at least 6.6 billion yuan of domestic bond sales have been
delayed. One of the disappointed companies, Suining Chuanzhong Economic Technology Development, blamed Chaori, saying it had “triggered severe upheaval in the bond market.” Observers think high-yield issuers will soon be paying 200 basis points more for money.
“In the U.S., it took about a
year to reach the Lehman stage when the market panicked and the shadow
banking sector froze,” the Bank of America Merrill Lynch note pointed out last week. “It may take less time in China as the market is less transparent.”
In any event, there is now too much debt for Beijing to handle. Since the end of 2007, the amount of corporate bonds has risen more than 10 times. Assets in trusts—most of them risky—skyrocketed 46% last year. Even though China’s economy, if properly reported, is about half that of the U.S., the amount of Chinese corporate debt could overtake America’s this year.
China, in recent years, has created too much indebtedness too fast. Chaori’s default on Friday is a warning of what will inevitably occur next.
Follow me on Twitter @GordonGChang and on Forbes
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