Some Silver Linings in China’s Corporate Default Cloud
Corporate defaults in China are rising, but they are still relatively few and are to be expected as the government rebalances the economy. Our bigger concern lies in whether defaults, recoveries and liquidations will be managed in an orderly and transparent way.
Since 2014, 16 borrowers in China’s public onshore bond market have defaulted on 25 issues. If we include the private market, the number of defaulted issues comes to 41.
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As the combined value of the defaulting 25 issues amounts to only 0.24% of the total public onshore market, there is no great cause for alarm. The rate of defaults is increasing, however, with 11 occurring so far this year.
The rising trend is worth watching, as it highlights issues which, if not managed well, could create some bumps in China’s road to modernization.
Defaults: The Good News
To some extent the defaults reflect the slowdown in China’s growth. This isn’t the whole story, however: the kinds of companies going into default—state-owned enterprises (SOEs), metals and mining—belong to the old economy that China is trying to diversify.
So rather than being unambiguously bad, the defaults may actually be a measure of the progress China is making in rebalancing its economy to make it less dependent on heavy industry and exports, and more inclusive of consumption and services.
It’s also possible to see the defaults as positive from the point of view of China’s reform program, which aims at making the microeconomic changes necessary for rebalancing to take place.
In the more open, market-driven economy that China is trying to create, it will be important for insolvent companies to be allowed to fail, as government support for such companies would effectively reward inefficiencies and prevent capital from being allocated rationally. The potential for failure will also create an incentive for company managers to be disciplined and conscientious in running their businesses.
Alongside these positives, some notable negatives lurk in the way that default recoveries and corporate restructurings continue to be handled.
Ambiguity Creates Uncertainty
The main problem is the lack of transparency and consistency in the system. For example, of the 16 issuers that have defaulted since 2014, seven—all of them private companies—have redeemed their defaulting issues in full. This suggests that private companies are very willing to repay their debts.
There is little to no clarity, however, as to how these defaults were resolved. Presumably asset sales, bank refinancing and/or company restructurings played a part, but not enough is known to determine how 100% restitution was achieved, or at what expense to shareholders.
The main inconsistency concerns the difference in default outcomes between private companies and SOEs. Local or regional SOEs (as distinct from those in major cities) are particularly prone to low profitability and stretched balance sheets. This—together with their relatively large size and complexity—can mean they take considerably longer to recover from default than private companies.
As with the recovery process for private companies, a lack of transparency applies to the SOEs: very little information is disclosed as to how the government deals with specific cases. An additional complication is the government’s intention, as part of its economic reforms, to privatize or part-privatize SOEs and expose them to the rigors of the marketplace.
To what extent, if at all, does this influence the way in which SOE defaults are managed? How does it contribute to the time taken?
These questions are important, because SOEs account for more than half of China’s corporate bond issuance in both the onshore and offshore markets. The main risk here is one of ambiguity.
On the one hand, the lack of transparency around the SOE default management process is bound to make holders of defaulted bonds nervous, especially in light of the government’s intention to reform the sector. In the worst-case scenario, a mismanaged restructuring of an SOE and/or a disappointing recovery value could create a ripple effect, causing a short-term liquidity squeeze, market disruption or malfunction, and a significant rise in yields that would increase funding costs across the economy.
On the other hand, the fact that the government is involved should mean that default recoveries and corporate restructurings will be to some extent orderly, so as not to alienate foreign investors.
The bottom line? There’s just a lot of uncertainty.
Progress Will Be Slow
China will likely muddle through with its corporate reforms and achieve greater transparency and consistency in this area within the next year or two. Despite higher yields in response to the wave of defaults, we don’t see much value in Chinese corporate bonds just yet. It will take at least a year, in our view, before credit risk in the onshore bond market becomes properly priced.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.