Taking stock of Chinese onshore bond defaults
A slew of onshore bond defaults by Chinese state-owned entities has sent a chill through the market over the past couple of months, with more expected to be in store. But with the market calming down in May, it’s time to take stock and realise that such defaults are part of China’s transition to a market-driven economy — and are essential for the long-term health of the country’s debt market.
It has been an epic ride for the mainland domestic bond market.
It all began with a rapid succession of bond defaults by state-run enterprises at the start of the year, with Baoding Tianwei failing to pay its onshore debt in late February. That was quickly followed by Dongbei Special Steel, which became the first local state-owned enterprise (SOE) to default on a public bond in late March. Things were no better on the corporate side, with Inner Mongolia Nailun Group becoming the first to default in the exchange market in early May.
According to S&P Global, more than 20 bonds have defaulted so far this year across China’s exchange and interbank bond markets — more than twice the total of 2014 and 2015 combined. And in March and April alone, over 140 deals were either pulled or delayed.
Given such defaults, particularly from SOEs, are a rare feature in China, the market reacted violently. This year the spread differential between double-A credits and triple-A with three year maturity widened to 130bp from around 80bp.
Admittedly, the market regained some of its composure in May as onshore defaults slowed down. But given most market watchers are predicting an uptick in the numbers, more pain is likely headed the way of both issuers and investors. And this may be no bad thing in the long run.
Despite all the hullaballoo over the past couple of months, the default rate is nowhere close to a full-fledged crisis. For starters, the volume of defaulted bonds is less than Rmb100bn ($15.2bn), from a total outstanding in the onshore bond market of around $7.5tn, according to analysts at S&P Capital.
The numbers have spiked when compared to the past, and there is fear that investor panic could lead to tighter credit conditions onshore. But the defaults also give China an opportunity to reform and restructure SOEs that are plagued with problems of low productivity.
As transparency improves because of the defaults, the government can tackle supply side reforms, which include closing and liquidating financially strained SOEs in heavy industries, in a bid to tackle inventory overhang and overcapacity, as well as reduce costs.
The assumption is typically that if an SOE is in trouble, the central government would have its back. But the recent defaults show that China is slowly, but steadily, stepping away.
Guangxi Nonferrous Metals, for example, managed to avert a default in June 2015 thanks to support from the local government. But in early March the company threw in the towel as the local government refused to rescue it from defaulting on its privately placed bonds.
Investors too will now be forced to look at the real standalopne credit risk of the borrower, as they can no longer rely on government support, a helpful development for China’s capital markets, especially given the bond market only recently opened up.
Of course, the government hasn't stepped back completely — while it is taking a back seat, it is unlikely to let the defaults build into a major blow-up. But in the meantime, more firm failures will help, not hinder the Chinese bond market.