Financial Turbulence in the CPR – China’s First Ever Corporate Bond Default

by Anthony Guida

Rising debt levels, unhealthy excess capacity and a rickety financial system are some of the many descriptions offered by journalists of China’s current economic conditions following Premier Li Kequiang’s speech during the annual National People’s Congress session, where he stated that “China is braced for a wave of industrial bankruptcies as its slowing economy forces companies with sky-high debt to the walls”. Politicians are now faced with the task of containing disproportionate credit expansion that is responsible for the People’s Republic first corporate default. In 2013 government liabilities accounted for 30% of China’s GDP (¥17.9trln) and shadow-banking represented an industry of $6 trillion, during Li’s intervention his announcement of a regulated regional borrowing mechanism shows the government concern for borrowers to be subject to greater market discipline in which more selective lending and discrimination in terms of credit risk will tame China’s wild lending behavior.

“China is braced for a wave of industrial bankruptcies as its slowing economy forces companies with sky-high debt to the walls.” —Premier Li Kequiang

The Chaori Incident Aftermath

On March 7th, 2014 solar power maker Shanghai Chaori Solar Energy Science & Technology became the first Chinese firm ever to default on its onshore corporate bonds. After having announced the company’s inability to repay a $14 million interest fee on a $161.5 million bond issued in 2012, the government decision to deny bail manifests China’s new attitude toward banking accountability and emits an aura of caution amongst speculators and investors. Investors have confidently splurged in corporate bonds of Chinese firms on the belief that state banks would repay their debts. This attitude was well summarized by Leland Miller, president of China Beige Book who told BBC reporters earlier this March: “There’s never been a corporate bond default, so investors have been conditioned that there is no such thing as risk in China.”

As a result, cheap financing and local government support has lowered the market entry barrier to many industries, which has caused unsustainable over-capacity. Following the last financial crisis, the number of Chinese companies with debt doubling their equity has risen steeply. According to Bloomberg, since 2007 the number of publically traded companies with a debt-to-equity ratio exceeding 200% has risen to 256 from 163 (57%). As of now research tallies the total debt of these companies at $1.98 trillion (risen from $607 billion in 2007), 63% of these companies’ debt-to-equity ratio now exceeds 400%. The majority of them are involved in household appliance manufacturing, materials, renewable energy and software companies.

Q1 GDP growth dropped to 7.4% this month, making it the weakest advance since 1990. Growing concerns about China’s financial health have prompted mainland banks to cut lending by 20% to industries with surplus capacity. 

The price-to-book ratio is used to compare a stock market value to its book value (the value of an asset as listed on a balance sheet) and is a good indicator for a company’s growth potential and health. If a company trades for less than its book value (P/B ratio <1), then either the market believes that the asset value is overstated, or a company is earning poorly (or even negatively) on its assets. In January a survey conducted by South China Morning Post revealed that 10 Chinese banks listed in Hong Kong had a price-book ratio of 0.98. In other words, their balance sheets included a high proportion of non-performing loans, a perturbing recording given the importance banks play in China’s growth strategy.

According to a SCMP survey, the amount of inert loans is not 0.97% as banks claim but 13%; assuming that Chinese banks are able to realize 30 fen on the Yuan (similar to what was recovered during South-east Asia’s financial crisis during the 1990’s), the amount of zombie bonds today would total ¥7.4 trillion (14.2% of GDP), 13 times the ¥564 billion declared in September.

Reaction of Banks and the Effect on Manufacturing

As of March 2014 China’s manufacturing industry had weakened for five consecutive months, straining the government-set growth target of 7.5%. The median estimate of Q1 GDP growth dropped to 7.4% this month, making it the weakest advance since 1990. Growing concerns about China’s financial health have prompted mainland banks to cut lending by 20% to industries with surplus capacity. The Chaori default has prompted the state to protect its economy in the long term by inquiring into lending accountabilities; for the first time the China Banking and Regulatory Commission (CBRC) has asked banks to include loans linked to debt financing and derivative products in their annual report of outstanding loans, underscoring the regulator’s concern regarding financial risks posed by heavily indebted sectors in particular steel, cement, aluminum, flat glass and shipbuilding. Particularly under the CBRC’s radar are commodity imports namely steel and copper – the price of which has collapsed – partly in response to growing debt concerns. The immediate response has affected commodity traders in steel and iron ore, as producers received letters from banks stating that their credit limit compared to 2013 would be reduced by 20%.

Although banks have begun to reduce loans to struggling sectors, the CBRC has not set an official reduction lending target. However, the State Council announced that credit extensions to these sectors must be cut and that no new project approvals will be passed until 2017. The government has taken advantage of this restructuring of uncompetitive producers to raise environmental standards of polluting industries adding more upward pressure to operational costs.

Compared to 2012, manufacturing deals have fallen by $490 million, yet over the first half of 2013 Chinese M&A activity has risen to $35.3 billion (majority composed of CNOOC’s acquisition of Canadian Nexen worth $15.1 billion). Outbound deals are increasing with Chinese investors mainly focused on energy, resources, and consumer based assets. Chinese bidders have increased their exposure in the U.S (14 acquisitions worth $11.4 billion) and in Western Europe, where the number of acquisitions has increased though the amount of investment has declined. The main reasons behind such behavior are appetite for natural resources and the globalization of Chinese SOE’s however financial market volatility, U.S economic growth and quantitative easing must also be taken into account as negative macro-economic drivers for near-term M&A strategy.

The Asian Century

Increased domestic competition, labor shortages, investment discrimination and other upward pressure costs are undermining investment security. Currently half of the world economy is represented by the United States and Europe whereas only 25% by Asia. By 2050 the situation is expected to be reversed. For this transition to come to fulfillment the financial sector is expected to be equal parts import and manufacturing. Asian financial markets are underdeveloped, heavily regulated, and have capital controls and other constraints. In the last years, a massive accumulation of foreign currency reserves has restrained markets and private savings. According to Warren Hogan, ANZ chief economist, only by allowing a country’s exchange rate to be determined by the supply and demand of a currency in relation to other currencies in the foreign exchange market (floating exchange rate) will the private sector grow, thereby generating significant opportunities for financial institutions, market growths and two-way capital flows.

Currently half of the world economy is represented by the United States and Europe whereas only 25% by Asia. By 2050 the situation is expected to be reversed.

The bulk of foreign reserves are addressed to government bonds and U.S treasuries; if the private sector becomes the recipient of these reserves, money will be distributed more equally, flowing into different classes of assets, reports Hogan in a Financial Times interview. With this being said, there are large discrepancies in the source of Chinese capital. State owned enterprises and coastal region municipalities are largely responsible for the bulk of investments whilst inland cities and SME’s export little or no capital. For China to develop into a high income consumer-led economy a fiscal reform must ensue to create a high performance financial system where markets are responsible for allocating capital. As less money deposits into treasuries and more goes towards equities, foreign direct investments originating from Asia (in particularly China) will increase as the cost of capital for emerging economies declines.

Chinese Presence in Commodity Markets

Due to China’s hefty presence in world commodity markets, the price of oil and base metals can be subject to short-term shocks caused by the world largest consumer economy. Chinese policy regarding strategic reserves, trade and the environment is capable of having a large impact on commodity prices, which in turn can cause inflation, affecting other emerging economies. China consumes 20% of non-renewable energy sources, 23% of major agricultural goods and 40% of base metals. The transition to lower GDP growth as compared to previous years doesn’t necessarily imply less consumption, yet commodities linked to rising income will outperform those involved in construction/consumer led growth.

China’s share in global commodity markets. United Nations Comtrade database and ABN AMRO Group Economics.

China Investment Corporation (CIC), the world’s 5th largest sovereign wealth fund ($575.2 billion), has reconfigured its action plan in an attempt to capitalize on recovering U.S and EU economies whilst unloading behemoth energy and commodity holdings. CIC’s recent activities involve shedding $1.5 billion worth of shares in international companies spanning U.S electrical power companies, Hong Kong based green energy companies, and a $37 billion involvement in Canadian oil-sands projects. China’s M&A in oil, gas and mining activities for 2013 accounted for $44 billion, up 14% since 2012.

China’s pollution problem stemming from coal consumption, of which it is the largest producer, consumer, and importer (50% of world consumption) has created demand for more gas imports via pipeline and LNG.

China, which became the largest global energy consumer in 201, is expected to surpass the U.S. as the largest net oil importer by 2014, in primis due to rising oil consumption accounting for 1/3 of global consumption growth in 2013. Idem with natural gas: China’s pollution problem stemming from coal consumption, of which it is the largest producer, consumer, and importer (50% of world consumption) has created demand for more gas imports via pipeline and LNG.

Understanding the 12th Year Plan 

China has set a 7.5% target for economic growth in 2014 (to which trade committed partners and commodity prices have responded favorably) spurring a wave of critics who say the prioritization of growth will surmount the effectiveness of reforms. Their argument claims that if your ultimate priority is growth then your effectiveness in restructuring the economy will be distorted. Li Keqiang’s predecessor Wen Jiabao, in 2011 described the Chinese economy as strong on the surface, yet “unstable, unbalanced, uncoordinated and unsustainable”. The main goal for China’s 12th Year Plan (2011-2015) is to capitalize on its 1.3 billion potential customers: to shift away from exportled growth to increased internal private consumption, the best defense against weak global demand. Due to a dynamic expansion in GDP, FDI inflows, of which China, as a developing country, remains the largest recipient, are no longer the principle contributor to China’s trade surpluses, industrial output or tax revenues.

Framework of 12th five-year plan. S. Roach, Morgan Stanley. “China’s 12th year plan: Strategy vs. Tactics.” April, 2011.

A strong emphasis will be put on employment and on generating local purchasing power. By 2015 China’s goal is to have created 45 million urban jobs. To do this, it must recycle rural labor surpluses into the urban workforce which accounts for already 46% of total employment. From 1980-2009 the rural share of the population fell by 27% and urban populous intensity doubled (the migration tallies between 15-20 million people per annum). China’s tertiary sector generates 35% more jobs per unit of GDP than its secondary sector; transitioning towards service-led growth will accelerate labor intensive development and aid income generation. Service bound FDI has outpaced manufacturing FDI showing that China’s middle class is growing. According to a 2010 report published by the IMF, the average savings rate for urban household has risen to 30% by 2009. But what does this mean for business?

The government must now change its essence by transforming the nation’s agenda from exclusive GDP growth to the incorporation of private sector growth which will normalize and allow capital distributions to be set by markets.

By 2015, non-fossil fuel energy is planned to account for 11.4% of total primary consumption whilst targeting a 15% reduction in energy consumption and 17% in C02 emissions per unit of GDP. The manufacturing industry will be negatively affected by these changes: Stephen Roach from Morgan Stanley Asia predicts that by 2015 the industry will have declined to about 37% of GDP, the lowest since 1991 before China’s modern industrial revolution. The new leadership plans to accelerate the consolidation of industries by removing inefficient businesses and encouraging more outbound investment. Small regional suppliers of pharmaceuticals, chemicals and food retailers are expected to be replaced by national distributors to eliminate oversupply capacities and prevent reductions in the quality of goods, idem for the petrochemical and manufacturing industries. The key to achieving economies of scale is establishing creative partnerships. Sectors previously dominated by state owned enterprises such as oil and gas, transportation and aviation will gradually become more receptive towards private involvement. Efforts to increase incomes and wages will boost private spending but they force companies to integrate higher labor costs into BAU scenarios (minimum wage increase 13% per year). The new plan focuses on developing Strategic Emerging Industries (alternative-fuel cars, high-end equipment manufacturing, energy conservation, biotechnology etc.) and to increase their percentage in GDP from 3% to 15% by 2020. To aid this growth, R&D spending will have doubled in 2015, reenforcing the niche for educated human capital.

Oil and gas company SINOPEC earlier this year announced to sell up to 30% of its retail oil business to boost the company’s downstream value. The exploration of unconventional natural gas resources, new nuclear power plants and renewable energy stations are sectorial examples where foreign participation is strongly encouraged. With regards to the Chinese shale gas agenda (China hosts the largest shale gas reserves), multiple foreign companies including French TOTAL and Dutch SHELL have been invited to partner with Chinese NOC’s to overcome technological hurdles that prevent gas from reaching markets.

Conclusion

Chaori’s inability to repay its debts has attracted a wide range of comments, some more informal than others. According to Barclay’s analysts, the impact on overall bond and financial markets is expected to be minimal; however, others predict this to be the first of many corporate bond defaults. In the long term, development of bond markets will benefit as investor behavior in China will ensure that returns reflect risks. China’s 12th Year Plan acts upon years of unparalleled economic progress. The government must now change its essence by transforming the nation’s agenda from exclusive GDP growth to the incorporation of private sector growth which will normalize and allow capital distributions to be set by markets; in return, prosperity will flourish and a production-led economy will set stable ground from which 1.3 billion residents will become China’s main asset.

Anthony Guida is an MA student in the ENERPO program at European University at St. Petersburg.

Sources

A. Pira, Ecco come il default di Chaori può aiutare la Cina, 10/03/2014, <http://www.linkiesta.it/chaori-cina-fallimento-sviluppi&gt;

T. Holland, Chinese bank valuation imply a bad loan ration of 13 per cent, 22/01/2014 <http://www.scmp.com/business/article/1410657/chinese-bank-valuations-imply-bad-loan-ratio-13-cent&gt;

J. Noble, China woes yet to scare off bond investors, 24/03/2014 <http://www.ft.com/intl/cms/s/0/5d76df06-b33a-11e3-b891-00144feabdc0.html?ftcamp=published_links%2Frss%2Fmarkets%2Ffeed%2F%2Fproduct&siteedition=intl&gt;

Reuters, China banks cut loans to bloated industries like steel, cement, 15/03/2014, < http://www.scmp.com/business/banking-finance/article/1448928/chinese-banks-cut-loans-bloated-industries-steel-cement&gt;

J. Chen, China gets 1st onshore bond default as Chaori doesn’t pay, 7/03/2014, < http://www.bloomberg.com/news/2014-03-07/chaori-solar-fails-to-make-interest-payments-on-bond-wsj-says.html&gt;

K. Gittleson, Chaori solar landmark in Chinese bond default, 7/03/2014, <http://www.bbc.com/news/business-26464901&gt;

M. Schuman, Why there is good news in the bad news on China’s economy, 13/03/2014, <http://time.com/22924/why-there-is-good-news-in-the-bad-news-on-chinas-economy/&gt;

P. Inman, China Li Keqiang warns investors to prepare for wave of bankruptcies, 13/03/2014 < http://www.theguardian.com/world/2014/mar/13/china-li-keqiang-wans-investors-bankruptcies&gt;

S.Roach, China’s 12th year plan: strategy vs. tactics, April, 2011, Morgan Stanley Asia <http://www.law.yale.edu/documents/pdf/cbl/China_12th_Five_Year_Plan.pdf&gt;

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