A corporate bond default should hardly be a headline dominating-event unless the default in question is of a particularly large concern, or is tightly coupled (as in could, Lehman-style, trigger more distress) or is a precursor of things to come. The sudden spell of worry in China over the RMB 89.8 million ($14.6 million) interest payment default by the comparative small fry Shanghai Chaori Solar has managed to focus attention on the fact that something has to give when authorities tighten credit after companies go on a leverage splurge. And in the case of Shanghai Chaori Solar, it managed to go from AA at the time of its bond issue to CCC before its default, an impressively fast two year decline.
The belief among Chinese enthusiasts has been that the banking system is so tightly controlled by the authorities that nothing all that bad can happen. But the reaction in the domestic credit markets says that faith is being tested. The authorities are not rescuing Shanghai Chaori Solar (unlike the expected default of an investment trust in late December, which again put domestic markets in a bit of a tizzy). The new issue bond market is effectively shut down, with four borrowers who had hoped to come to market suspending offerings. Walter Kurtz also notes that liquidity in the secondary bond market is also down, another sign of investor and dealer concern, and that banks are cutting back lending rather than stepping into the breach. So this is at least a credit squeeze, and may be the start of a full bore credit contraction.
The China bears for years have pointed to China’s remarkable (or reckless) credit growth, with more and more companies looking like classic Minsky Ponzi units, dependent on new credit to meet existing obligations. A real determination by the authorities to tighten will put the entire Ponzi sector under pressure, and investors (and one expects the authorities too) don’t have a great handle on where the dead, or perhaps more accurately, zombie bodies lie. A new Bloomberg story, Zombies Spreading Shows Chaori Default Just Start, gives an overview. The troubling background is the degree to which credit has exploded since the crisis, with total debt of public non-financial companies rising from $607 billion at the close of 2007 to just shy of $2 trillion at the end of last year. And some are highly geared, with debt to equity ratios of over 200%. Key extracts from the article:
Publicly traded non-financial companies with debt-to-equity ratios exceeding 200 percent have jumped 57 percent to 256 from 163 in 2007, according to data compiled by Bloomberg on 4,111 corporates.
This is still only 6% of the total, so the sharp reaction in the market suggests that the risks by dollar value may be greater than these figures suggest (as in the zombies are larger on average than most public company borrowers). And it is quite probable that many of the public companies have issued equity only, so you’d need to look at the zombie debtor outstandings relative to total corporate bond market outstandings to have an apples to apples reading.
The change in official attitudes, and not the default per se, appears to be the driver of the newfound caution. Bloomberg again:
The government is signaling greater willingness to let borrowers be subjected to market discipline, according to Christopher Lee, head of corporate ratings for Greater China at Standard & Poor’s.
“We expect more discrimination in terms of credit risk and more selective lending,” Hong Kong-based Lee said by phone yesterday. The Chinese government will allow any further defaults “in a selective and controlled basis as opposed to the Big Bang approach, which is not their style,” he added…
While any Chaori default likely won’t prompt an immediate liquidity crunch in China, it may lead to a chain reaction, Hong Kong-based strategists David Cui, Tracy Tian and Katherine Tai at Bank of America wrote in a March 5 note. It took a year for the U.S. financial crisis to escalate, they said.
FYI, the Bank of America report compared the default to Bear Stearns, which is peculiar, in that: 1. Bear Stearns was rescued and the officials were convinced the market tsuris was over and 2. Bear was not the start of the credit crisis; the first acute phase was the implosion of the asset-backed commercial paper market in August-September 2007.
The general tone of expert commentary is decidedly negative, even when they agree that longer-term, allowing companies to default is salutary. A sampling from Bloomberg:
“We’ve had trust defaults, we’ve had corporate defaults and we’ve had the currency weakening so there’s a whole bunch of indicators that say it’s getting worse in China,” said Tim Jagger, a Singapore-based fixed-income manager at Aviva Investors Asia Pte., U.K. insurer Aviva Plc’s Asian asset management unit. “Until you get some bigger picture direction to the contrary, it’s very difficult to construct a buy case at these levels.”
More corporate bonds onshore may default this year, said Li Ning, an analyst in Shanghai at Haitong Securities Co.
And Walter Kurtz noted:
These developments are quite negative for China’s economy. Confidence in the nation’s credit markets – both bank lending and corporate bonds – has taken a hit. It remains unclear however just how pervasive these problems could become – some think this is just the tip of the iceberg.
The much more serious problem is that if China does have a lot of bad loans, it can’t readily repeat the playbook it used when it was last in this fix, in 2002-2003. We noted in a 2011 post:
One of the striking features of China’s continuing growth as an economic power is its extreme (as in unprecedented in the modern era) dependence on exports and investments as drivers of growth. Even more troubling is that as expansion continues, consumption keeps falling as a percentage of GDP.
As countries become more affluent, consumption tends to rise in relationship to GDP. And the ample evidence of colossally unproductive infrastructure projects in China (grossly underoccupied malls, office and residential buildings, even cities) raises further doubts about the sustainability of the Chinese economic model.
The post crisis loan growth in China, in tandem with visible signs that a meaningful proportion of it has little future economic value, has stoked worries that Chinese banks will soon be struggling with non-performing loans. China bulls scoff at this view, contending that China’s 2002-2004 episode of non-performing loans was cleaned up with little fuss (I never bought that story and recall how Ernst and Young was basically bullied by the Chinese government into withdrawing a 2006 report that NPLs at Chinese banks were a stunning 46% of total assets of its four largest banks. Note estimates of the NPLs as a percent of total loans from that crisis vary widely, even excluding Ernst, from 20% to 40%).
The latest post by Michael Pettis links the two phenomena, the fall in Chinese consumption and the cleanup of its last banking crisis. If his analysis is correct, this bodes ill for any correction in global imbalances. China needs to increase its consumption in relationship to GDP to rebalance its economy, but a banking system bailout along the lines of the last one will push them in exactly the opposite direction.
We suggest you read Pettis in full, but here are the critical part of his case:
Throughout modern history, and in nearly every economic system, whether we are talking about China, the US, France, Brazil or any other country, there has really only been one meaningful way to resolve banking crises…The household sector…always pays to clean up the banks.
There are many ways to make them pay… If the regulators are given a longer amount of time during which to clean up the banks, they can use other, less obvious and so less politically unpopular, ways to do the same thing, for example by managing interest rates. In the US and Europe it is fairly standard for the central bank to engineer a steep yield curve by forcing down short-term rates. Since banks borrow short from their depositors and lend long to their customers, the banks are effectively guaranteed a spread, at the expense of course of depositors. Over many years, the depositors end up recapitalizing the banks, usually without realizing it.
Yves here. Notice that QE was the opposite of that traditional steep yield curve formula, which Greenspan used very effectively in the wake of the S&L crisis. Oops. Back to Pettis:
There are two additional ways used in countries, like China, with highly controlled financial systems. One is to mandate a wide spread between the lending and deposit rates. In China that spread has been an extremely high 3.0-3.5 percentage points. The other, and more effective, way is to force down the lending and deposit rates sharply in order to minimize the loan burden and to spur investment. This is exactly what China did in the past decade…..
By most standards, even ignoring the borrower’s credit risk, the lending rate in China during the past decade is likely to have been anywhere from 4 to 6 percentage points too low. Over five or ten years, or more, this is an awful lot of debt forgiveness…
The combination of implicit debt forgiveness and the wide spread between the lending and deposit rate has been a very large transfer of wealth from household depositors to banks and borrowers. This transfer is, effectively, a large hidden tax on household income, and it is this transfer that cleaned up the last banking mess.
It is not at all surprising, then, that over the past decade growth in China’s gross domestic product, powered by very cheap lending rates, has substantially exceeded the growth in household income, which was held back by this large hidden tax. It is also not at all surprising that household consumption has declined over the decade as a share of gross national product from a very low 45 percent at the beginning of the decade to an astonishingly low 36 percent last year.
China’s consumption share continued to fall after this post was written. The perhaps inchoate concern is that China may have reached the limits of a once-successful economic paradigm. And as we’ve stressed, no major economy has made a smooth transition from being export and investment driven to being consumption driven. China has made that task even harder by doubling down on its current strategy. They’ve managed to hold off a day of reckoning far longer than the skeptics predicted, but the bears may be about to be proven right.