The defaults represent idiosyncratic credit events, rather than a sign of systematic and aggressive tightening. We believe China’s economic growth outlook is unlikely to be affected and remain positive on Chinese assets.
On the 10th of November, a local government-owned State Owned Enterprise (SOE), Yongmei, defaulted on its short-dated bonds. Coming on the heels of another large SOE default (Brilliance Auto) just a few days prior, the events triggered a domino effect in the onshore credit market. ‘Relevant bonds’, namely other bonds issued or guaranteed by the same group, plunged in value and triggered a wave of redemption by investors. This then led to further tightening of collateral standards and weak liquidity for a wide range of bonds. Provinces like Shanxi and Hebei, which have many SOEs in the commodities or heavy industrial sectors, also saw their SOEs’ refinancing come under pressure.
The root cause of the market panic is the perception that both companies are evading their debt responsibilities by moving good assets to related parties before defaults occurred. In the case of Yongmei, the company refused to pay its debt obligations, despite having ample cash. This is a relatively new phenomenon, particularly when it involves SOEs, which are generally perceived to have the strongest ‘willingness’ to pay. Already, regulators have announced investigations into these companies and their related parties. Heavier penalties will likely deter other SOEs from taking their debt responsibilities so lightly. Given the need to prevent this contagion, we will also likely see some regulatory intervention.
While there are certain idiosyncratic drivers behind the defaults, the events highlight a more fundamental issue in the Chinese credit market. SOEs have long enjoyed low borrowing costs, even when many are highly leveraged and in financially challenged sectors. This is due to a widely-held assumption that local governments will go a long way to prevent SOEs from defaulting. Recent events have shaken that confidence. More importantly, there is the general worry that these events reflect a notably more hawkish policy stance on leverage, and is a sign of more broad-based policy tightening to come.
Our views are more sanguine. While the PBoC has sent some clear signals about moving back to a more ‘neutral’ monetary policy stance, we don’t expect an aggressive or systematic round of policy tightening in the next 12 months, for three reasons.
Firstly, the growth rebound should do much to reduce China’s debt burden. As shown on Chart 1, China’s overall leverage ratio (defined as the credit-to-GDP ratio) has already started to normalize on the back of the growth recovery so far this year. This should continue to improve in 2021, given our (and consensus) expectation for a more meaningful GDP rebound of around 8% growth from the previous year. If China maintains this year’s credit growth, its debt ratio would stabilize at 15 percentage points higher than pre-COVID levels. However, if Beijing dials back credit growth to 2019 levels (which is our base case), its leverage ratio will be only six percentage points higher than in 2019. Overall, compared with past cycles, the need to ‘de-leverage’ after the COVID-19 crisis appears to be a smaller challenge and can likely be achieved through fine-tuning rather than aggressive tightening, in our view.
Overall, we do not believe China is heading into an aggressive round of systematic policy tightening. The growth rebound will help to improve debt conditions, and there appears to be no need for proactive tightening given the lack of inflationary and external pressures. However, this does not mean we won’t see more defaults in certain sectors, particularly given that Beijing is pushing credit away from old industries and towards new industries. It is also forcing old industries to downsize. In addition, policymakers in China have been gradually removing implicit guarantees of government support. So even as macro policies are not necessarily tightening, such structural pressures on many SOEs will likely persist. But in the absence of systematic tightening, the stress will be more sectoral, and spillover will be manageable, in our view.
What does this all mean for investors?
From a macro perspective, we are not heading into an aggressive round of policy tightening. This means China should be able to maintain its relatively stable economic growth, as well as its interest rate lead over other parts of the world. This is supportive for Chinese assets. In particular, we favor the RMB and China Central Government Bonds (CGBs).
This also reinforces our view of a strong cyclical global recovery in 2021. The backdrop of a global recovery, a weak USD, and falling geopolitical risks, support our conviction in emerging markets, particularly exporters in Asia (Taiwan, South Korea, Singapore, and Japan) and commodity exporters (Brazil, Indonesia). We recommend a selective and active management approach to gaining exposure to this trend.
From a fixed income perspective, markets are likely to calm down after more regulatory intervention. We recommend staying clear of vulnerable sectors, such as coal, steel, metals and mining, as well as local governments with less fiscal room (Yunnan, Guizhou, Qinghai, etc). The willingness of companies in such sectors to pay their debt obligations is harder to quantify, and it is likely that a more transparent corporate structure would be needed to help mitigate this risk.
All market and economic data as of November 30, 2020 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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