China’s debt shakeout intensifies

Via Bloomie:

A string of defaults by Chinese state-owned companies has sent shockwaves across the world’s second-largest credit market.

But some bonds have fared much worse than others as investors clamber to avoid the next potential blowup. Among the most notable losers: notes issued by Pingdingshan Tianan Coal Mining Co., Jizhong Energy Group Co., Tianjin TEDA Investment Holding Co. and Yunnan Health & Culture Tourism Holding Group.

Two days after Yongcheng Coal & Electricity Holding Group Co.’s default on Nov. 10, Pingdingshan Tianan Coal held a meeting to assuage investor concerns following a bond slump. It later wired funds to meet early redemptions on a 500 million yuan ($76 million) bond.

But investors remain cautious about its liquidity. The company’s so-called “quick ratio,” which measures its abilities to use liquid assets to meet short-term debt obligations, fell to 0.6 at the end of September from 0.69 a year ago, according to Bloomberg data. A quick ratio of 1 or above is typically considered healthy.

It’s an ongoing issue as China’s extremely leveraged corporations show systemic stress. Also at Bloomie:

China’s corporate debt defaults are set to exceed 100 billion yuan for a third consecutive year, underscoring the pandemic’s disruption of a government campaign for greater fiscal stability.

It’s spilling over into shadow banking and local government bond markets:

As Caixin reports, Huaxin Trust Co. one of 68 companies licensed to conduct trust business in China and one of the largest “shadow banks” in the mainland , is trying to raise as much as 6.8 billion yuan ($1 billion) from strategic investors as it faces a growing liquidity squeeze that’s already forced it to skip repayments on dozens of investment products over the past few months.

The Dalian, Liaoning province-based institution announced last Tuesday that it is seeking one or more strategic investors to inject 3.4 billion yuan to 6.8 billion yuan into the firm, which would increase its registered capital to 10 billion yuan to 13.4 billion yuan.

But, as Caixin’s Timmy Shen writes, what drew the market’s attention was a condition stipulated by Huaxin that any investor would need to agree to “support the company’s liquidity before the completion of their investment to allow the firm to protect the interests of investors in its trust products.” And while this is tantamount to a pledge to backstop a bailout of the core shadow banking pillar, one veteran trust-industry source told Caixin that it can be difficult to persuade strategic investors to provide liquidity support before even making their investment, although investors can use this as leverage to get better terms.

But, it is deliberate. Indeed, it looks to me like an attempt to clean up the bond market such that international capital is more reassured about transparency, Via Sinocism:

Chinese authorities warn bond issuers they can’t ‘run away’ from their debts after defaults rock investor confidence | South China Morning Post

According to a statement published by state news agency Xinhua on Sunday, the Financial Stability and Development Committee agreed to adopt a zero-tolerance approach and will punish all kinds of “debt evasion” to protect investors. It also promised to investigate “fraudulent issuance, disclosure of false information, malicious transfer of assets and misappropriation of funds”.

The committee, chaired by Vice-Premier Liu He, also told local governments and regulators to “build up a good local finance ecosystem and credit environment”.

The statement – 刘鹤主持召开国务院金融稳定发展委员会第四十三次会议_国务院副总理刘鹤_中国政府网


Top Financial Regulator Pledges Zero Tolerance for Debt Dodgers – Caixin

The Financial Stability and Development Committee (FSDC) vowed to strictly investigate any bond issuer suspected of violations including fraudulent issuance, disclosure of false information, malicious transfer of assets, and misappropriation of bond issuance funds, according to a Saturday meeting chaired by Vice Premier Liu He. The FSDC is a cabinet-level body under the State Council that oversees various agencies supervising China’s financial sector…

The FSDC also called for closer cooperation between financial regulators, and pledged to strengthen prevention and warning systems to keep liquidity reasonably ample and guard against systemic risks.

Question: Why did it take the latest mess for them to focus on this?

Beijing warns of crackdown on misconduct after bond defaults | Financial Times $$

Some of the 180,000 workers at Yongcheng say they have not been paid for months, highlighting the pressures building on local officials across the country as they grapple with bond defaults by state-owned enterprises.

“I am preparing myself for mass lay-offs,” said a Yongcheng worker. “It is unlikely our firm can get over its difficulties without making sacrifices.” All of the current and former employers interviewed by the Financial Times asked not to be identified.

And so far it is working. Via GaveKal:

This has been a rough year for most people. But among investors, few can have suffered more than the China bears. The year started well for them.

By the end of 2019, the US trade war had morphed into a full-on tech war. Washington’s actions brought Chinese national champion Huawei to its knees. Then, the emergence of Covid-19 in Wuhan and the subsequent Chinese lockdown raised the prospect that an exogenous shock could finally lead to the big pay-day the China bears had long been waiting for, some of them for more than a decade.

Now, with less than six weeks of 2020 to go:

1) The renminbi is the world’s best performing major currency this year.

2) The MSCI China index is outperforming the MSCI World by 19%, and is also outperforming every major global equity market except Nasdaq (see the left-hand chart overleaf).

3) The Chinese government bond market is the only major bond market in the world to have outperformed US treasuries year-to-date (see the right-hand chart overleaf). Moreover, it has done so with much lower volatility than any other major bond market. This makes sense given that bond yields across the Western world are much lower than in China, and lower yields usually equate to a higher volatility of total returns.

So, with an outperforming currency, outperforming bonds, and an outperforming equity market, so far 2020 has turned out to be a good year for investors in China.

Given this outperformance, you might expect massive flows into Chinese assets. If nothing else, all the world’s quant models, momentum-driven programs and risk parity strategies should be flagging that Chinese assets have been delivering superior risk-adjusted returns. And foreign capital has indeed been pouring into China (see The Second Wave Of Bond Inflows).

Combine these inflows with China’s continued trade surplus of between US$40bn and US$60bn a month, and this amounts to a lot of money flowing into the Chinese mainland (see China’s Departure From Standard Operating Procedures).

This brings me to three interesting recent developments.
1) The suspension of the Ant Group IPO less than two days before the stock was due to begin trading (see Ant Stomped). The Ant deal had all the hallmarks of frothiness. At US$35bn, it was the biggest IPO in history, for a name that on day one was set to become the largest financial company in the world by market capitalization (the grey market was indicating an open at around US$450bn of market cap), thanks in part to more than US$2trn in orders and unprecedented retail participation.
2) The launch by Beijing of antitrust measures against China’s big tech companies (see The Internet is No Longer Exempt).
3) The RMB1bn missed debt payment by Yongcheng Coal & Electricity, a state-owned enterprise from Henan province (see Cracks Appear

In Local Support For Bonds), and the lashings of media attention subsequently devoted to its default.

As Mike Tyson used to say: “Everyone has a plan until I punch them in the face.” After the events of the last three weeks, foreign investors in Chinese assets probably feel as if they have taken three Tysonesque hits to the face in rapid succession. So, through our bleeding noses, how can we make sense of these consecutive blows? I can offer three possible explanations.

In this sense, Beijing’s recent actions could be seen as the Communist Party killing a whole flock of birds with just a handful of stones. First, Beijing deflates the growing internet stock bubble without having dramatically to tighten monetary policy, which would inflict “friendly fire” casualties.

Second, Beijing reminds China’s tech entrepreneurs of their place in the domestic pecking order. Third, Beijing reminds domestic investors that funding local governments and their enterprises comes with risks, which in turn prevents local potentates from getting too big for their britches because of all the money they can raise on the capital markets. Fourth, these measures may help stem, at least for a while, foreign inflows into

China’s equity and bond markets, so helping to prevent both the buildup of bubble-like conditions and an uncomfortably sharp rise in the renminbi.

This is not to say that Beijing deliberately pushed Yongcheng into bankruptcy. The company clearly got there all on its own. But once it did get there, Beijing had the choice either to sweep this one quietly under the rug, or to make a big deal out of the bankruptcy in a signal to investors that the days of policy easing are over. It seems Beijing chose the latter course.

And this serves as a salient reminder that in China the domestic information flow remains tightly controlled by the Communist Party’s propaganda department. So when the local media starts banging on about antitrust measures against Chinese internet companies, or spills oceans of ink on the default of a Henan coal company, it should be taken as a clear message to investors: you can no longer count on accommodative policies across the board.

In other words, the three consecutive blows over recent weeks are best interpreted as a deliberate policy choice. This means that the environment for Chinese tech stocks has soured, at least in the near term. So has the outlook for frothier Chinese credits. Beijing is now going out of its way to invite investors to differentiate between issuers, and to cool it on the risk-taking. But as it does, I find myself comforted in my long-standing bullishness on both the renminbi and Chinese government bonds, because long term investors can only welcome the tactical prevention of bubble-building. Three strikes and still in.

The injection of credit risk is an unmitigated positive for the Chinese economy long term. This is precisely the kind of reform it needs to drive more productive capital allocation though it will also be bearish for commodity consumption. So, I see this episode as the latest attempt by Chinese authorities to pursue structural adjustment away from its investment-addicted corporations:

The question is: can the financial system and political economy take it? Both have proven time and again since 2011 that the answer is “no” with renewed stimulus in 2012, 2015, 2019 and 2020. The slower growth that results from these reforms has always reached panic point sooner rather than later for both banks and governments.

I expect we’ll see the same this time so, again, it will be rising stress followed by aborted reforms and the steady decline into secular stagnation instead.

David Llewellyn-Smith
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