Moral hazards linger in Chinese bonds
A LACK OF concern for moral hazard in
some corners of China’s debt markets
has undoubtedly kept the printing
press running over recent years. In
fact, the ability of companies and local
governments to avoid default and
repeatedly raise funds has led many
commentators to liken the onshore
lNANCIALûSYSTEMûTOûAûGIGANTICûPONZIû
scheme.
But is the will to eliminate — or
at least water down — moral hazard
about to make an appearance in China?
China’s shadow banking industry
has enjoyed rampant growth for years,
ANDûTHEûBIGGESTûBENElCIARIESûHAVEûBEENû
LOCALûGOVERNMENTûlNANCINGûVEHICLESû
(LGFVs), which have been able to raise
more debt regardless of the tougher issuance standards in
the conventional market.
LGFV issuance via special purpose vehicles grew at about
an 25% annual rate in 2015, dialling down only slightly
in 2016 to around 20%. It’s estimated that there is around
US$600bn-equivalent of LGFV bonds outstanding.
There is a plan to swap the LGFV debt mountain into
lower-yielding municipal bonds, in an exercise designed to
reduce the interest burden on the products. Some of that
exercise has been carried out, with short-term debt shifted
into longer-duration munis.
Still, LGFV issuance has continued at the behest of local
GOVERNMENTûOFlCIALSûDESPERATEûTOûKEEPûUPûTHEIRûOWNûGROWTHû
rates. And an increasing amount has made its way offshore,
where buyers include been the clients of private banks in
Asia, principally in Hong Kong and Singapore, who have
BEENûOFFEREDûLEVERAGEûBYûTHEIRûRELATIONSHIPûOFlCERSûINûORDERû
to book the paper.THE FIRST LGFV default has yet to occur, but it seems that
moment might not be too far off.
According to Fitch, the Chinese authorities will allow
some of the lower-rated LGFVs to fail, while standing ready
to prevent a systemic collapse through bailouts, should
they be required. A kind of moral hazard with Chinese
characteristics.
The exercise of allowing idiosyncratic default will require
DEFTûlNESSING ûANDû#HINAûISûONEûOFûTHEûFEWûCOUNTRIESûWITHûAû
chance of pulling it off.
Still, in the context of rising interest rates – the People’s
Bank of China last week raised rates in the face of a 25bp
tightening of the US Federal Funds rate – the strain of
servicing the LGFV debt will become increasingly onerouswith each successive Fed tightening.
Two more rate increases are expected this year, according
to the market priming of neophyte Fed chair Jerome Powell.
The futures market is pricing in three.
The smart money thinking is that it is offshore LGFV debt
THATûWILLûBEûSACRIlCEDûONûTHEûALTARûOFûMORALûHAZARD ûWHILEû
onshore investors will be taken care of should debt service
failure loom.THAT GLARING DICHOTOMY – between the offshore and the
onshore – has hung like a sword of Damocles over China’s
debt markets for years, but that hasn’t stopped the punters
from queueing up for more and more of the stuff, often via
the largesse of private banks or prime brokers and their
leverage facilities.
The most salient lesson of the dangers of owning offshore
Chinese debt came in 2009 with the restructuring of Asia
Aluminum, which saw offshore debt holders get hosed to
THEûBENElTûOFûONSHOREûDEBTûOWNERS
Offshore holders of the payment in kind paper issued by
AA got 1.5 cents on the dollar while their onshore brethren
in the form of Chinese banks faced no haircut on the
secured loans they held with the company.
That kind of outcome has turned
numerous international asset
managers off the prospect of investing
in China, full-stop. Many complain
about the “black box” nature of
Chinese investments, running from
accounting standards, to corporate
governance, to the pervasive grip
of the Chinese authorities over the
lNANCIALûSYSTEM
Indeed, as a trade war with the
US looms on the horizon, the fear is
that China might turn to the capital
markets in retaliation.
For years fearmongers have warned
of the potential dumping of the
PBOC’s Treasury bond holdings, but
US investors are also worried of the
application of selective default.
Sure, those fears look overdone for now, but it might
become a much more realistic scenario in the event of a
brutal trade war and an escalation of the rhetoric from both
sides.
For the moment there has been no investor pushback
on China assets, whether they be Panda bonds, US IPOs or
Hillhouse Capital Management’s US$10bn China-focused
fund. When it comes to local government debt, however,
offshore investors would do well to be wary.People
&Markets
As a trade
war with the
US looms on
the horizon,
the fear is
that China
might turn
to the capital
markets in
retaliation.A trade war could
threaten offshore
creditors to China’s
local governments, says
JONATHAN ROGERSCOMMENT