China’s First SOE Default: More To Come? by Teresa Kong, CFA, Matthews Asia
There has been a widespread perception amongst investors that Chinese state-owned enterprises (SOEs) will not default. This is based on the assumption that even if an SOE is not commercially viable, the Chinese government is willing and able to bail it out. This perception is now being put to the test as a power equipment manufacturer and new energy developer, Baoding Tianwei Group, just missed its coupon payment.
While the government may still step in to make the payment, I believe that this default might indeed be a strategic move by the Chinese government to further liberalize its capital markets, and to reform its SOEs. It may even serve the government’s agenda for the market to reallocate capital away from poorly managed firms in industries with over-capacity, and toward firms in productive industries that are well-run. A functioning market requires the proper pricing of risk by participants. This means that the higher the probability of default, the higher the yield an investor should demand in return for taking on its credit risk. It also requires a legal framework to ascertain recovery value should a default occur. Even when a company goes into default, not every claimant gets the same recovery. Different classes of claimants typically end up with a different recovery value, depending on the seniority and the underlying asset coverage of that claim. Indeed, the recent defaults of private enterprises—including that of Cloud Live Technology Group earlier this month and Shanghai Chaori Solar last year—have led to better pricing of risk, as evidenced by the increase in spread dispersion.
However, few believed that SOEs would default, as evidenced by the narrow spread premium that SOEs have to pay. This means that onshore bond investors are relying less on credit fundamentals, and more on the implicit guarantee of the state. This perception of implicit state support has arguably caused the market to systematically under-price the debt of SOEs relative to their private counterparts, all else being equal. In fact, this has created moral hazard on the part of SOEs. Just like other goods priced too cheaply, demand goes up, causing SOEs to take on too much leverage.
I have argued in the past—and continue to believe—that defaults are a necessary evil. If market participants are under the delusion that companies are never allowed to fail, then investors would not price in adequate risk premium for the probability of default. Indeed, this is exactly what is happening in the onshore Chinese bond market. About 90% of the bonds have a local rating of AA+ or higher because of the issuer’s state ownership. Judging from the price movement of the Baoding Tianwei Group bond, the default was a big surprise to market participants. The positive implication is that local bond investors will have to price in the probability of default and potential recovery of bonds—even those that are wholly owned by the state. The reality, however, is that not all SOEs are created equal. Some SOEs are more strategically important than others. And some are more economically viable than others.
Now that the government has allowed the first SOE to default, the market will be forever changed. Instead of pricing all SOEs based on the same credit spread, participants will also take the strategic importance of the sector and credit fundamentals into account. We expect that SOEs in sectors that are of more strategic importance to the state, those that are better managed and those that have better corporate governance will secure lower funding costs compared to SOEs involved in sectors of lower strategic relevance, in over-capacity sectors that are poorly managed.
Defaults by some SOEs can help to instill greater market discipline and reallocate capital more efficiently within the economy. While we do not expect large-scale defaults of SOEs, sporadic and isolated defaults instill market discipline and better capital allocation over the long run.
Teresa Kong, CFA
As of April 22, 2015, accounts managed by Matthews Asia held no positions in Baoding Tianwei Group, Cloud Live Technology Group and Shanghai Chaori Solar.
The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in small- and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than large companies.