Bond defaults signal moment of truth for China ratings agencies, banks
Investors have assumed government concern about slowing growth will make the authorities less willing to let market discipline run its course
Beijing looks set to allow more bond defaults as part of its market reform agenda, but domestic ratings agencies and bond investors are still betting it will lose its nerve, for fear of hammering mainland banks.
Critics say the US$4 trillion mainland bond market, the world’s third largest, has misallocated its vast sums to some of China’s most inefficient companies, such as state-owned dinosaurs in sunset industries or opaque local government financing vehicles.
The market’s assumption that such issuers have an unwritten state guarantee has kept bond yields low, while demand among investors is high, especially after a summer stock market crash sent many fleeing to relative safety.
“China is still experiencing an onshore debt boom,” said Lucror Analytics credit analyst Mervyn Teo, while adding that recent defaults argued for more caution.
As recently as Thursday, China Shanshui Cement defaulted on a 2 billion yuan (HK$2.4 billion) onshore debt payment, and in April Baoding Tianwei Baobian Electric became the first state-owned firm to default, while another, metals trader Sinosteel, deferred interest payments last month.
All of which suggests the mainland authorities, which used to work feverishly to prevent defaults, are growing more willing to let weak firms fail.
Despite such defaults, the spread between benchmark yields on safe AAA-rated bonds and riskier AA-rated bonds has fallen sharply in recent months, indicating that people see them as less, not more, risky.
Indeed, it has been declining gradually all year, as investors have instead assumed that government concern about slowing growth will make them less willing to let market discipline run its course, especially in the state sector.
“In the past there were no defaults, because almost all issuers were SOEs or government backed,” said Phillip Li, managing director at China Chengxin Asia Pacific Credit Ratings. “This cannot continue. In order for the debt market to be normal, unhealthy debt should be identified.”
Domestic debt rating agencies ought to perform that function, but industry insiders say they are instead engaging in a price war for clients, in many cases offering optimistic ratings in exchange for the contract.
Their ratings certainly paint a rosier picture of local firms than their foreign counterparts.
The local agencies say their ratings take into account the fact of regular government intervention, an unwritten assumption that foreign rivals are less likely to rely upon.
But at the bottom of the heap, distressed debts all smelled equally bad, said Kalai Pillay, Fitch Ratings director in Singapore, so their domestic and foreign ratings ought to converge.
“A ‘D’ is a ‘D’ – there is no ambiguity,” he said.
Policymakers in Beijing are faced with a sticky dilemma.
Let more of its industrial dinosaurs go extinct, prompting domestic debt rating agencies to downgrade the bonds of similar companies, which in turn could trigger a crisis for China’s banks, by far the biggest bondholders.
Or let an unreformed bond market continue to set artificially low yields and throw good money after bad, which exacerbates China’s industrial overcapacity and increases the likelihood of falling prices and economic stagnation.
“Avoiding a crisis and the spread of systemic risk is always the No1 priority of the government,” said Oliver Barron, policy research analyst at China-focused investment bank NSBO. “This means that some companies that shouldn’t be bailed out will be, perpetuating the current moral hazard and leading to wasted capital.”