Chinese Bond Default Rattles Markets; Harbinger of More Credit Woes?

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.

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  1. j gibbs

    Anyone investing in China deserves what he gets. More money has been lost chasing yield than at the point of a gun.

    1. NotSoSure

      Let’s be fair, lots of people have made money investing in China (in fact a cousin of mine, a foreigner has been making money from the Chinese house appreciation). I am not a China bull, but this seems yet again overrated. It does not matter what market it is, it’s currently dominated by either the government or/and their thugs. Until someone disturbs that balance, you can’t have a crisis anywhere anymore.

      1. MyLessThanPrimeBeef

        That’s always the question, when will the balance be disturbed.

        Will people lose their made-money?

        1. NotSoSure

          And you and I know it could be a long time. The book Red Capitalism states that even bad debts from 2 decades ago are still in the book and yet so far nothing going. Heck I bet Japan still has bad debts from the 80s and yeah it’s been slow going but no crash, etc has materialized.

          Again, I am no longer afraid of any corporate bankruptcy, etc. Behind the scenes, I am sure people are getting paid left and right to suck it up. From Chinese history, what’s more certain is that eventually some injustice will be committed that will be intolerable to most people and then the real fireworks will start.

          1. MyLessThanPrimeBeef

            It’s true it could be a long time.

            And then, imbalance as you said, like, from recent history, the Boshin War or the Xinhai Revolution.

    1. Yves Smith Post author

      I put a search string from Pettis into Google and you are right, it’s not on the Web any more. It’s a shame, because that was an important piece. It might be findable in a wayback machine but I rely on Richard Smith to do that, I’m not skilled in their use.

      Aargh, this is increasingly a problem with the Internet. Stuff disappears. For instance, the FT archives material for only 5 years.

      Some of my bad habits as an early blogger, in 2007 and 2008, when I would post very long extracts of articles, are now proving useful, in that I have material in my archives that no longer exists elsewhere.

  2. Paul Niemi

    I have watched factories close in the US and production move to China, like a land rush — wheels falling off the wagons as the corporations couldn’t get there fast enough. But it is unreal. I walk through Walmart, look at the prices of the Chinese goods, and I can’t believe they can make that stuff for that price, let alone sell it for that price. Cheap labor alone doesn’t explain it. Sure, the toasters are cheap, but the prices are cheaper, and I know it can’t go on. For me the height of the ridiculousness was learning that some grocery store chains are now selling chicken that was exported to China to be cut and wrapped and then re-imported to the US for sale in the stores. Huh? It’s unreal, because it is unreal. Chinese companies are borrowing money to start production, borrowing more to continue production, rolling over debts that are due, and the pile of debt is never going to be paid back because it can’t be. This can occur because of a government that can order bankers to lend, and the bankers must salute and write the loans. To hell with the consequences, because it is somebody else’s problem. If anyone thinks that is a superior system to ours, just watch what will happen. I have commented here before about the danger of offshore investments in China and was called a liberal internationalist, whatever that is. Nevertheless, I believe China is now where the US was, economically, right in the days leading up to Black Tuesday, October, 1929. They have had their Roaring 20s, a boom led by credit expansion and the magic thinking of great expectations. All the signs are there, including rich Chinese secretly depositing as much money as they can outside the country and desperately knocking on the doors of places like Canada to get in to get away. When the Chinese credit bubble pops, it is going to be dangerous, and they know it. Now, I think the question is how many foreigners, invested in the juggernaut, will lose their shirts too. I’m reminded how the European upper crust invested fortunes in the US in the 1920s, mortgaging their piles of rocks to play the US stock market, then encountering genteel poverty in the 1930s. Our so-called plutocrats have their fingers in this pie up to the elbows, as well as ordinary savers invested in foreign growth funds. I’m watching the price of copper, as an indicator that the blowup is coming. It has to fall, since no one is building houses, and the Chinese will have to sell everything not nailed down when there is no money. As an aside, I walked through a Kmart a few days ago. The huge barn full of Chinese goods had half a dozen customers, one buying only a Butterfinger, and big signs saying “Checks cashed, $3.” Yes, something has to give in China, and it will.

    1. F. Beard

      Yes, something has to give in China, and it will. Paul Niemi

      Nope. China can simply ban further credit creation and do a Steve Keen “A Modern Debt Jubilee” and instantly China will be OK, both debtors and non-debtors.

      You money worshippers are a scream. You think real economies must suffer because of an insane, unjust money system? Think again. It’s only fiat that is needed to change unjust debt to just equity. I think China may be wise enough to show that it has used bankerism for its own purposes.

      [Note: To stop commenting here, I’d have to stop reading here since the comments are sometimes a target-rich environment I can hardly resist. And the truth is worth more than my vanity, at least in egregious cases.]

      1. Paul Niemi

        I have a different definition of fiat that does not include the dollar. The dollar is not backed by gold, but it is backed by debt. In other words, for every dollar there exists someone’s promise to pay back a loan. Undermining of the currency happens when lending standards are relaxed, and bad loans are made. A true fiat is printed money without matching debts, in my mind. Now I don’t think you are really serious about China declaring a debt jubilee. It would be years before they could even get toilet paper again.

        1. F. Beard

          It would be years before they could even get toilet paper again.

          A ban on new credit creation would be hugely deflationary by itself as existing credit was repaid with no new credit to replace it. Agreed? So that huge deflation could be countered with a distribution of new fiat equally to the entire population METERED to just counter that deflation.

          So then, just where does toilet paper come in? Hmm?

          1. Paul Niemi

            If you are serious, you could try this experiment: take a pen and paper and write $500 on it, then see if your landlord will accept that for a rent payment. Probably not. The idea that any nation can solve their problems by running the printing presses, which you seem to be implying is a solution for this case, can not be taken at face value.

            1. F. Beard

              The metered distribution would keep the money supply CONSTANT (it would cease after all deposits are 100% backed by reserves less reserves borrowed from the central bank).

              So please tell me how one can have price inflation with a CONSTANT money supply? (Feel free to use p = mv/q.)

            2. F. Beard

              Also, you neglect to mention the temporary ban on credit creation. Is that literally unthinkable to you? Please note that honest, 100% reserve backed lending (the only kind the banks trust among themselves) would still be allowed.

            3. F. Beard

              If you are serious, you could try this experiment: take a pen and paper and write $500 on it, then see if your landlord will accept that for a rent payment.

              Here’s a counter experiment: Create a perfect copy of a $100 bill and see how many people refuse to take it.

              You’re not dealing with an amateur here so cease with the insulting thought experiments.

              1. allcoppedout

                You have that right Beard, The view of my dad’s WW2 generation was that the US did exactly this after the war.

                Perhaps the Chinese politiburo will revert to communism, give away the ghost cities to the people and repatriate various billions from offshore real estate and accounts in the British Virgin Islands?

                1. F. Beard

                  And/or allow all that offshore Chinese money to only be repatriated for Chinese produced consumer goods, not real assets.

              2. Paul Niemi

                First, promise to pay implies that people expect real work will be done for which the money may be redeemed, and faith implies that people believe in the creditworthiness of the borrowers who back a currency. Merely having a constant nominal money supply does not impute faith in the currency, as people may require other means or currencies with which to conduct their affairs which are redeemable. A jubilee would destroy faith not only in the currency but in the institutions people rely on to protect their liberty and property. Second, a ban on credit creation would bring commerce to a halt. Third, it’s not an insulting thought experiment but a question you might find on any first-year economics exam. Fourth, I am not a “scream” nor a “moneyworshipper,” so I have treated you well by comparison.

                1. F. Beard

                  Merely having a constant nominal money supply does not impute faith in the currency, as people may require other means or currencies with which to conduct their affairs which are redeemable.

                  No faith is required since:

                  1) The banks would be required to accept the new fiat to extinguish debts and to fully back their deposits instead of embezzle them.

                  2) Fiat is the only means of extinguishing tax liabilities including state and local taxes.

                  3) The inertia of using fiat as a unit of account and a means of exchange would ensure its continued usuage.

                  Second, a ban on credit creation would bring commerce to a halt. Paul Niemi

                  Wrong since loans backed 100% by reserves would still be permitted and the metered bailout would provide just the right amount of new reserves for that 100% reserve lending to keep lending constant. If not then the rate and final amount of the distribution could be increased to bring real interest rates down.

                  Moreover, shares in Equity (common stock) is an ethical form of endogenous money creation that requires no government privileges

                  Fourth, I am not a “scream” nor a “moneyworshipper,” so I have treated you well by comparison.

                  Make that illicit-credit worshipper then. Or illicit-debt worshipper because what part of government-backed credit creation, not for the general welfare but for private interests does not strike you as theft under color of law? As violation of Equal Protection Under the Law in favor of the rich since the rich are the most so-called creditworthy?

                  Now you illicit-credit-lovers have created a mess so why don’t you at least have the humility to step aside if you can’t clean it up short of a Great Depression and possibly WW III? Hmm?

      2. OMF

        You money worshippers are a scream. You think real economies must suffer because of an insane, unjust money system? Think again. It’s only fiat that is needed to change unjust debt to just equity. I think China may be wise enough to show that it has used bankerism for its own purposes.

        There are other consequences for running too hard, too fast, without allowing natural balacing forces to take effect. Every few months, there’s always a story about scams and scandels in China, mostly dealing with shady businessmen cutting corners and regulations to make a quick buck in an enviornment which not only promotes but sustains this behaviour. The latest was the recent “gutter oil” scandal.

        But attached to almost every such report is an interview with or comment from an ordinary Chinese worker or citizen, who quietly gives his quiet but nontheless disapproving assesment of the situation. It’s the kind of reaction you see a lot in Ireland as well. People don’t like to see swindlers, louches and criminals running wild, not facing consequences, and even being rewarded for hurting everyone else. And this is the behaviour that modern monetary policies are promoting.

        I have no doubt that if the bankers and technocrats continue to avoid consequnces and reward failure as a result, that people will grow more and more discontented, particularly as the resulting burdens are increasingly foisted on them. If something cannot go on forever, then it will stop.

    2. monday1929

      You might enjoy reading Jim Chanos on China. Be aware that copper (and steel) as a leading indicator may lead you a bit astray because of its use in obtaining shadow financing- both may collapse more or less together. Newly upturned war cycles may further support copper.
      I would appreciate if anyone can explain the logic of this financing- buying copper and then using it as collateral for loans- how would one borrow more than the copper cost to begin with?

      1. Paul Niemi

        By lying about how much copper you have. By using it as collateral more than once. It is a wink and a nod and fill out the form.

        1. monday1929

          Ah, warehouse receipts notarized in bulk by “Linda Green”- the Chinese have learned from us.

    3. j gibbs

      Paul Niemi, this is the most intelligent analysis of China I have read anywhere. I agree with you, and for that reason if for no other, you are probably missing something. Me too.

      1. Paul Niemi

        Thank you for your kind remarks, for which I am most grateful. It won’t be long, I guess, before we know what piece of the puzzle we are missing. Nevertheless, I think I am on the right track. F. Beard, above, was so perturbed by the thought as to forget to quote scripture.

        1. F. Beard

          Forget? No. But pearls before swine comes to mind. And I don’t need to quote Scripture but merely read it carefully to have a source of wisdom that is mostly missing here.

          And your analysis was the very conventional “bankers have gotten us (e.g. the Chinese) into a mess we can’t get out of without massive suffering” and you reek a bit of gold-buggery with your talk of redeemability.

          But we’ll see if Chinese wisdom is up to the craftiness of the Devil’s money system.

          1. Paul Niemi

            I’m not giving you an out. You accepted my analysis, then took a sharp left turn to a solution that could have been authored by Vladimir Lenin himself. Except for metering out “fiat” he did all the rest that you suggest in Russia, 1918 to 1921. The result was famine. I have met people who went so far to the right they went under and popped up on the left, but I know I have heard the rhetoric you use verbs like “ban” and “require” to describe before. It reminds me of the crap spouted by that old crank Lyndon LaRouche. So the question is, do you consider yourself a modern Trotskyite? Call me all the names you want, from your little perch, but the perspective I present is my own, and it is genuine. I don’t adhere to the pampered, preppy language of neo-this and neo-that and liberal-the-other. I have also read the Bible myself, cover to cover, and I have enough respect for the scripture to not drag it into political debates. If you and I meet in agreement on issues of the day, then that is wonderful; but if we don’t, then it can’t be helped.

            1. F. Beard

              Lenin? My understanding is that the Commies used credit creation themselves while I would eliminate it or at least remove all government privileges for it and remove penalties from the use of common stock as endogenous money so that business would have an incentive to share wealth and power rather than steal them.

              I have also read the Bible myself, cover to cover, and I have enough respect for the scripture to not drag it into political debates.

              The Bible has a LOT to say about social justice. Your above remark it thus a subtle attack on Scripture as irrelevant or “too holy” to be useful. Nice try but you do know it won’t fool God?

          2. F. Beard

            I’m not giving you an out.

            I’m not the one trapped into defending needless suffering with tired bromides and stale straw-men attacks. Your bluff has been called and you’re the one squirming or at least should be.

            So what is Godwin’s Law called when Lenin instead of Hitler is invoked?

    4. participant-observer-observed

      ” This can occur because of a government that can order bankers to lend, and the bankers must salute and write the loans. To hell with the consequences, because it is somebody else’s problem. ”

      Maybe a form of Chinese MMT in action? Chinese gov’t policy is typically not reckless nor short-sighted, although its objectives are always worth questioning. (Massive famines are still in cultural racial memory.) Corruption and apathy of individuals is always there too.

      At the individual/personal level, cultural philosophical differences also exist with respect to capital. Guang Xi culture differs from Western mentality in that money is for circulating and mediating relationships, not for parking and earning standing still.

      Xie Xie to Yves for keeping an eye on Asia!

    5. Schofield

      The weird effect of China’s use of Lerner’s Functional Finance is that it promoted market capitalism so “efficiently” that the resulting competition effectively quadrupled real wages in industrialized areas as prices dropped. The writing off and roll-over over of non-performing loan portfolios by the central bank should according to Western economic experts have resulted in excessively high abnormal inflation. They forgot the high population resource China has that can be harnessed to Western developed technology and division of labor routines. They also never figured out that a sovereign government is a special kind of bank that only needs anything approaching 100% reflux of its loans if abnormal inflation threatens.

  3. Chauncey Gardiner

    Yves, thank you for this post. Developments in China are woefully under-analyzed and underreported IMO. Huge impact on the global economy, and particularly for our friends in Australia and Canada.

    I have noticed big jumps in the Baltic Dry Index this week, but it’s too soon to tell what this might be signaling given recent events elsewhere in the world. Also noticed China’s monetary authorities have suppressed Overnight SHIBOR below 2 percent from 4.3 % a month ago, while holding 3-month and longer SHIBOR maturities at 5 percent or above.

  4. nowhere

    Wait a minute – the rating services dropped those bonds from AA to CCC BEFORE they defaulted? Which rating service would that be? The ones I’m familiar with in North America seem to make a specialty of keeping a AAA on pure garbage until it’s actually in the process of defaulting and occasionally threatening a downgrade when they don’t like the politics of an organization.

  5. susan the other

    Sorry I missed this post and comment yesterday. Stuff is hitting the fan all over the place. One advantage to inter-connected finance, that is economic dependency, is that if something happens in China it happens to the rest of the world. And vice versa. That is, until countries pursue their own sustainability. So much for Larry Summers’ advocacy of bubbles. Maybe he should switch and talk about waves just to be surreptitious. China is clearly putting the brakes on. Today I read that their exports are crashing and it has been implied that the reason is pollution! Cool. So very soon now everybody’s exports are gonna crash too. And Oh Yes… China just condemned the US and backed Russia in the Ukraine flap.

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