China defaults – positive signs and a warning to the world

The default of the AAA-rated local State Owned Enterprise (SOE) Yongcheng Coal shocked the Chinese credit market in early November. This is not a private enterprise but one backed by the second largest economy in the world. It is not surprising then that this triggered a sell-off in a series of weak local SOE bonds, and a resultant credit spread widening.

This event has also triggered a modest liquidity squeeze due to the concentrated redemptions of onshore funds. The mini-panic settled down in late-November on the back of Yongcheng Coal’s solution of repaying 50% of the principal and rolling over the repayment of the remaining amount outstanding to 9 months later.

This deal came after the central government regulators’ warning to local government and the creditors. In addition, on 30 November, the People’s Bank of China (PBOC) injected 200 billion Yuan into the market through a one-year Medium-term Lending Facility for financial institutions. The intention of this is to provide liquidity and to prevent systemic financial risk.

Although this round of sell-off has subsided, investors will restructure their credit selection processes and become more cautious on the local SOEs bond selection. Greater emphasis will be placed on the repayment capability of the companies themselves and the belief that the local government guarantee may break down permanently.

There can be little doubt that credit defaults are coming. We are witnessing a self-imposed stress test in the Chinese credit markets. However, in the long term, we see this as a very positive event for the China bond market – and a healthy process - that will fit well with the credit market reforms that China is conducting. As the PBoC’s Governor Yi Gang said this month, any government bailout should be exited gradually and orderly without triggering any systemic risk. We believe that the credit market will be healthier and more mature when the repricing process is complete, and when the spread is able to properly reflect the credit risk.

Investors may think that what has been happening in China is a curious development particular to China – we are not convinced.

When it comes to cyclical economic health China is in poll position. This is why the spate of credit defaults in China should alert investors to the risk of latent problems in all economies, not just China, from the pandemic shock and years of excess leverage. Few would contest the prediction that there will be widespread bankruptcies in Europe, US, the UK, and Japan in the coming quarters, after the pandemic is arrested, and after the world comes out of its ‘medically-induced coma.’ So, in addition to our expectation of the US bond yields to steepen in H1 2021 (with the 10Y yield rising to at least 1.50%), credit spreads will also likely widen in the US and Europe. Further, pressures on the peripheral sovereign bonds in Europe may return, forcing a reaction from the ECB.

We suggest that investors don’t read the news about China’s credit defaults as a mere curiosity of a country far away. Instead, this is very valuable information for the rest of the world in the months ahead.

What happened in Japan 20 years ago has turned out not to be a curiosity but a leading indicator of what has happened to much of the developed world. What is happening in China is potentially a blueprint for what we might see in many other parts of the world in the coming period.

There is a delay only because China came out of the pandemic induced shutdown first, and this lead-lag in timing should be taken as a precious source of information.

This communication is intended for professional investors.
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