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Bond investors in China can no longer rely on Beijing for routine bailouts if investments run into trouble. That’s why investors need to appraise a borrower’s ‘strategic’ importance as part of any rigorous credit analysis. Edmund Goh, Investment Manager, Fixed Income – Asia, discusses what’s ‘strategic’ and what isn’t, as well as how the risk of default, and other reforms, have changed bond market dynamics.
To what extent can investors in Chinese bonds rely on the backing of the state? Understanding the relationship between borrowers and the government is one of the most important things an investor must master before venturing into China’s US$10 trillion local-currency bond markets.
Most issuers in the China Interbank Bond Market and Exchange Bond Market can claim some sort of government link, however tenuous that may be. But since 2016, China has made it clear that not all borrowers are created equal, and hence not all state-linked companies can be considered ‘strategic’.
This has forced bond investors to scrutinise these relationships. Issuers deemed important to national interests continue to enjoy valuable government guarantees. Meanwhile, others have been allowed to default on their debt, leading to investor losses.
These relationships can be opaque and may change over time as economic priorities shift. But one thing about China’s one-party political system is that policymakers, unlike their counterparts in the west, tend to think long-term. Industries and organisations that play a central role in nation building receive financial and policy support; commercial enterprises operated by local governments will not.
For active investors willing to do their own credit analysis, there is significant scope to add value.
So in practice, what is considered ‘strategic’? Investors must ask themselves two questions: ‘Does the borrower matter to anyone important?’ and, if so, ‘how much?’
High profile organisations set up by China’s State Council to execute national policy provide the safest of safety nets for bond investors. For example, China Investment Corporation, the country’s sovereign wealth fund, and the Ministry of Railways, one of the biggest issuers of bonds onshore, are considered as important as the Ministry of Finance.
Then there are the ‘policy’ banks (e.g. China Development Bank), which play a role in government-directed spending and are prolific issuers of onshore bonds that are actively traded. Important commercial banks, including Bank of China and Industrial and Commercial Bank of China, also have a critical role in financing national development. A default by any of these lenders is unthinkable because of the damage to national pride as well as the systemic risks posed.
Companies under the auspices of the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) are also covered. These are some 100 state-sanctioned monopolies that operate the national grid and develop oil fields, amongst other things.
Where government support becomes less clear, and will only be applied on a case-by-case basis, is at the local government level. Local government is a broad term that covers everything from the provinces to smaller administrative units. Municipal bonds and debt linked to so-called Local Government Financing Vehicles (LGFV) fall into this category.
Finally, firms labelled as ‘market competitive’ – government-linked companies engaged in commercial activities such as property development and consumer manufacturing – will need to make their own way in the world.
We are expecting the first ever default by a LGFV this year. These are shell companies set up for the sole purpose of borrowing money. They acquired notoriety a few years ago because they became associated with a big expansion of Chinese debt following the global financial crisis.
Borrowed money was often used to fund costly white elephants – underutilised railroads, new towns that failed to attract residents. Unsurprisingly, many of the underlying borrowers are now in financial difficulty.
The risks in the 7 trillion yuan (US$1.1 trillion) LGFV bond market are clear. Earlier this year, Tianjin Municipal Development Company (TMDC) failed to repay two loans worth a combined 500 million yuan. These loans are guaranteed by parent company Tianjin Municipal Development Group (TMDG). While TMDC doesn’t have any outstanding bonds, TMDG has some 251 million yuan of bond obligations via another, separate guarantee. The risk of contagion is obvious.
China’s authorities have worked hard to address the issue of moral hazard in the bond markets. Before 2016, domestic investors simply assumed that all bonds enjoyed government guarantees – explicit and implied. This belief encouraged excessive risk taking, distorting asset pricing and making credit analysis redundant. Perpetually socialising the cost of failure penalised issuers who acted responsibly.
Allowing bonds to default may have been the most important development, but policymakers also created a new municipal bond market that explicitly established credit risk as local government risk. Previously, when local governments bent the rules to sell bonds via LGFVs, it was anyone’s guess whether those bonds were guaranteed by a higher authority.
Regulators forced local governments to reclassify their debt into categories based on contingent risks and compelled them to cut ties to entities that do not provide an obvious public service. This obliged issuers to take ownership of the debt they had issued. Meanwhile, local government officials tempted to flout those rules were warned they would be punished, even after they moved onto new jobs.
In default, investors in Chinese bonds can expect very low recovery rates. For example, holders of paper issued by Dongbei Special Steel Group received only 22 cents on the dollar after the firm defaulted in 2016.
Elsewhere in China, there was a wider push to ensure that all investors, not just those in the bond markets, have a greater appreciation of the risk of losses. This included prohibiting banks from bailing out investment products that failed to hit investment targets, as well as rules to ensure asset managers disclose risks associated with new products with greater transparency.
Has any of this worked? Since last year, there’s evidence of greater credit differentiation between domestically-rated AAA, AA+ and AA paper, so that pricing more accurately reflects risk. Even for borrowers with the same credit rating, there is some appreciation of variations in implicit quality, which is sometimes reflected in prices. Those sectors or provinces that are deemed strategically more important, or set to benefit more from new policies, tend to trade at tighter spreads.
These are all big improvements from before. However, we still have a long way to go before we get proper bottom-up credit analysis and credit risk differentiation based on individual names. For active investors willing to do their own credit analysis, this means there is significant scope to add value. But they need to be aware that the inefficiencies they identify may persist for some time.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
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