Investors rarely see a rise in bond defaults as a good thing. But in China’s case, an exception can be made.

The news that Yongcheng Coal and Electricity Holding Company and technology company Tsinghua Unigroup – both regional government-owned borrowers – had defaulted on bond payments during November has served to undercut investor assumptions about the willingness of Beijing to stand behind every state-linked debtor.

They are not the first state-linked borrowers to default – Fitch Ratings says that five Chinese state-owned enterprises (SOEs) did so during the first 10 months of 2020 – but their size and the immediacy of the defaults served to underline the fact that China Inc is not willing to stand behind every bond issued by a profligate or money-losing SOE.

Indeed, instead of the central government acting as a backstop of last resort, vice-prime minister Liu He has warned that Beijing is taking a “zero tolerance” policy to companies that seek to evade their outstanding debt payments.

Investors have noticed – and panicked. According to Bloomberg on November 23, the 'AAA' rated local bonds of Pingdingshan Tianan Coal Mining, Jizhong Energy Group, Tianjin TEDA Investment Holding and Yunnan Health & Culture Tourism Holding Group have all dropped by 14% since November 10. 

Beijing's assertion that it will not stand behind Chinese SOE bonds confirms a growing suspicion among many investors. For years the Chinese government had offered an implicit but seemingly ironclad support of this debt. At the same time, many SOEs were encouraged to borrow heavily, to help sustain the country’s economic health.

As a consequence, China's overall debt position has boomed. Its debt to GDP ratio is set to rise 23 percentage points to reach 273% of GDP at the end of this year, according to S&P Global Ratings. The country’s corporates have grown their annual borrowing by between 11% and 15% between 2012 and 2020; JP Morgan Asset Management estimated in June that the country's local bond market had reached $14 trillion, up from $9.3 trillion in 2016. It is the world's second-largest fixed income market.

In contrast, China’s economy grew by an average of 7.09% between 2010 and 2019 – and is likely to rise by just 1.2% this year.

What's more, many corporate borrowers operate in sectors that are vulnerable to slowdowns in economic activity (for example property, tourism, construction); others have depended on the whims of central fiscal policy. And yet, because of the support of Beijing or regional governments, these corporates have been able to issue at extremely tight bond levels, while 90% are rated no lower than ‘AA’ by local rating agencies.

The abandonment of wholesale support for SOE debt overturns these practices. Now investors will have to grapple with the fact that they may lose their money on some such deals.

That is a good thing

ENCOURAGING FOREIGN INVESTMENT

For the immediate future, the lack of a state backstop is likely to cause concern among international investors. Many were already cautious about risking money in China's local bond market, in particular, concerned over the opaqueness of local companies and the uncertainty of the legal process in the event that bond payments were delayed.

With government support now confirmed as no longer existing for at least some SOEs, investors will likely retreat to only the top-tier state borrowers and banks.

But over the longer-term, this will benefit China’s debt market development. Foreign investors have long been aware of the distortion of the country’s unofficial bond backstop. And as the country’s economy has slowed, they have been reluctant to invest in its corporate debt.

Now, unable to assume a regional or central government will hand them back their money in the event an SOE borrower falls into problems, investors and analysts will have to pay attention to the default or downgrade risks that each company in China poses.

They can demand more borrower transparency, better credit analysis and wider rating differentiation, which will improve market pricing transparency. And in many cases, they will demand higher returns for the risks they need to take.

As the differences in local credit quality become more pronounced, foreign investors should eventually become more comfortable with investing their capital across a broader array of Chinese corporate risk, which is what Beijing wants.

In addition, as S&P notes, more failures to pay bonds will pave a firmer path for investor rights amid corporate bond defaults and expectations for repayments.

In a note issued on Tuesday (December 1), the credit rating agency noted that the country’s Enterprise Bankruptcy Law has “only this year become important to international investors”, courtesy of “landmark defaults involving US dollar bonds, and growing recognition in the country that court action may be preferable to out-of-court negotiations that drag on for years”.

The rating agency said that it sees these cases to be good for China's credit markets: “They raise transparency, facilitate resolutions, and make outcomes more predictable”.

Ultimately, these tried and tested processes should offer international investors confidence that a defined judicial process exists for when Chinese borrowers cannot pay their debt back. And that knowledge will give international fund managers and asset owners more confidence to allocate their money into local deals.