BOND MARKET: When guarantees do more harm than good

The Chinese government has repeatedly bailed out state-owned enterprises to stop them defaulting on loans, a habit that confounds bond prices. Dave Waller reports.

In April, something major happened in the Chinese bond market. Baoding Tianwei Group, a power equipment manufacturer, announced that it was unable to pay an 86 million renminbi (€12 million) interest payment on bonds issued in 2011. This was hugely significant: the Chinese government had always stepped in to bail out any state-owned enterprises (SOE) threatening to default. Now the market would learn what happened when the government didn’t reach out to an SOE with a life-vest. 

And then? The government reached out to the SOE with a life-vest. Mainland Chinese media was soon reporting that China Construction Bank, which underwrote and invested in Baoding Tianwei’s bonds, would provide undisclosed loans to help the firm meet its payments after all. Caixin News, which reported the bailout, said the loan was co-ordinated by China’s central bank.

It was an action that served only to bolster a commonly held belief: that bonds issued by Chinese SOEs carry an implicit guarantee from the state. They won’t be allowed to default. Plenty of observers have pointed out the folly here: that Beijing has to be willing to impose market discipline on loss-making state groups in order for its market to be truly fair and transparent; that failure to allow defaults creates moral hazard, where state groups can rack up debt and invest poorly, safe in the knowledge that the life-vest will always be deployed.

The tradition of state help in China is certainly strong. The government’s habit of bailing out commercially non-viable SOEs was in full evidence back in March 2014, when Shanghai Chaori Solar failed to meet an interest payment on 1 billion renminbi worth of bonds. The state-created Great Wall Asset Management stepped in with a guarantee worth 880 million renminbi.

So, why this refusal to let an organisation’s fate play out unaided? “The Chinese government probably understands that not all state-owned enterprises are created equal, and that some are of greater strategic importance than others, and that by supporting all, it is perpetuating a moral hazard problem,” says Teresa Kong, fund manager at Matthews Asia. “But it wants to err on the side of being too cautious instead of too cavalier, given the slowing economy, and is probably not ready to take on the very tough task of SOE restructuring at the current moment.”

Indeed, the government already has its hands full, with major reforms in the financial sector, changing currency regimes from a soft-peg to a managed float, and is trying to support an equity market suffering from a crisis of confidence. “You wouldn’t want to work overtime when your body is already stressed,” says Kong. “The Chinese government probably feels the same.”

It’s also had to manage this during a period of tremendous growth in the bond market, which has expanded rapidly in the past decade, from bonds largely issued by central state banks, through municipal bonds and then those issued by private companies. It’s a vast change for a relatively new system to deal with. 

“China’s market is like a giant baby,” says David Gaud, senior fund manager at Edmond de Rothschild Asset Management. “It’s already a giant but it’s still learning to walk. The Chinese financial and legal systems aren’t strong enough to let the market behave as it should. That’s why you’re still seeing heavy intervention – and it’s not a good thing.”

It certainly isn’t. The government presence means that for years, banks and bond investors have been able to lend to SOEs while paying scant attention to company fundamentals. This becomes an especially large problem when China is on track for its slowest economic growth in a quarter of a century. The government life-vest causes the market to systematically underprice the debt of SOEs, largely in struggling industries such as construction and manufacturing, relative to their private equivalents, and leads these SOEs to take on too much leverage.

Gaud is quick to highlight the lack of transparency engendered by such rescues. “There’s no single real example where we’ve been able to test the legal framework and how investors are being taken care of,” he says. “It’s definitely a big issue. There are rules supposed to prevail when there is such a case. These defaults have been handled outside of the proper process.”

This lack of clarity naturally has implications. “Global investors are not happy with it, as it’s not good from a compliance point of view,” says Gaud. “We’re aware of all these uncertainties and so have to apply significant discounts to reflect them.”

What would happen if the government did allow a default to go ahead? Economists have pointed out that defaults help instil greater market discipline and better capital allocation. A default would be a valuable step towards the further liberalisation of China’s capital markets, and the reform of struggling SOEs. It may even serve the government’s agenda for the market to reallocate capital away from poorly managed firms towards firms in productive, strategically important and well-run industries. Those SOEs in sectors that are of more strategic importance to the state, those that are better managed, and those that have better corporate governance could secure lower funding costs.

Yet Gaud says one shouldn’t hold the Chinese bond market under too powerful a microscope: whether it’s bond defaults or bailouts, the process carries no systemic risk, he says, even if any future defaults may involve some painful pricing adjustment and volatility. It’s still early days for China, after all. “We are waiting for the first case where we go through the normal process, follow the rules and how investors are informed,” says Gaud. “The learning curve will still be long and painful, and it will see troubles. Global allocators will need to be cautious and selective, and work with local partners to get the proper picture, but people shouldn’t have such a negative view on all this as it’s a new process.”

There are signs that the Chinese approach is already changing towards one of greater clarity. The Chinese state council recently announced it was amending how it handled the debt of its provinces, with a cap on what debt would be guaranteed by the central government. This will aid the separation of good bonds and bad bonds. Such developments should help the market, even if some investors take a hit.

But will the government allow a default? Gaud believes it will. “The Chinese government has so many ways to roll over those bonds, to get banks or third parties to come to the rescue, so we may see further artificial protection for a while,” he says. “But it will still happen at some point. We need to see the development of a bottom-up approach, and for that we need to see defaults. Normalisation should be an objective.”

It will take time, as the case of China National Erzhong Group shows. In September 2015, the state-owned firm, which makes smelting and forging equipment, was on the verge of defaulting on bond payments from five-year notes sold in 2012. It owed a 56.5 million renminbi interest payment at the end of the month. For a few days, investors held their breath. Would this be the first SOE default in China? The answer was no. On September 22, the firm announced its parent company would buy all outstanding bonds, ensuring no investors would suffer a loss. For now, the state’s implicit guarantee still stands.

©2015 funds europe



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