As the initial panic selling calms down, and the worst case scenario of a default seems to have passed, markets will move on to focus on the stand-alone fundamentals, and the proper pricing of credit risks.
Raymond Cheng, Co-Head of Asset Class Strategy, Equities, Asia, J.P. Morgan Private Bank
Julia Wang, Global Market Strategist, Asia, J.P. Morgan Private Bank
Yuxuan Tang, Global Market Strategist, Asia, J.P. Morgan Private Bank
Anne Zhang, Co-Head of Asset Class Strategy, FICC, Asia, J.P. Morgan Private Bank
Chinese assets have seen multiple challenges in recent weeks. While economic activity and the pace of policy normalization has been largely in line with our expectations, market sentiment was hit by a number of events. Lately, the Huarong bond incident became a focal point. Investors focused on the company’s status as a State-Owned-Enterprise (SOE) that is undergoing a corporate restructuring, and wondered what the implications will be for other SOEs and the broader market. In today’s note we share some key views.
First, some background…
Huarong Asset Management Company is a SOE that was established in the late 90s to take on the bad debt of the Industrial and Commercial bank of China (ICBC), which paved the way for the latter’s listing on the stock market in 2006. Since then, Huarong had grown into a financial conglomerate with an estimated RMB1.7tr in assets.
In recent years, its main business has been in commercial acquisition and the resolution of bad debt, around half of which is focused on the property market. It is majority-owned by the Ministry of Finance (~61.4 %, including indirect holdings via other vehicles). Huarong started issuing USD-denominated bonds in 2014, and was listed on the Hong Kong stock exchange in 2015.
As of today, the group has USD23bn offshore USD-denominated bonds outstanding, which is about 1/5 of its total debt. Most of the offshore debt is issued by a Special-Purpose-Vehicle (SPV) of Huarong’s international subsidiary, with a keepwell agreement1 from the parent company.
In 2018, former Chairman of the company Lai Xioamin was investigated in China’s largest ever financial corruption case, and he was subsequently executed earlier this year.
In the last few years, the company has been trying to gradually digest its own bad debt, but it’s been tough. Fast forward to 31st March 2021 when Huarong postponed the publication of its annual result and its stock halted trading due to a ‘significant transaction’. Onshore media then reported that a regulator-led restructuring was being discussed. The speculation put Huarong’s offshore bonds on a rollercoaster, amidst various media speculation on how the international subsidiary will be treated in the restructuring. The downward spiral was temporarily arrested in recent days by media reports that a regulatory takeover is likely.
Recent news flows from the central government are increasingly calming down the market, conveying that an outright default may be avoided. At the same time, most investors understand that regulators have increasingly tilted towards more market-driven resolutions for SOEs in trouble, so a debt restructuring cannot be ruled out for Huarong.
But in practice, what a market-driven resolution means is still unclear. In fact, recent examples of how the government handles financial institution restructuring suggest they take a case-by-case approach.
So given Huarong is very unique in its scale and complexity, the government will try to walk a fine line between disincentivizing moral hazards and limiting the damage to international investors’ confidence. In other words, it seems that nothing is really off the table. Furthermore, discussions with regulators are likely not yet finalized, it’s possible that we may not really hear any concrete plans for some time.
From a macro perspective…
In the short term, we believe careful regulatory monitoring will likely help to avert a liquidity squeeze in the onshore market. Given over half of the debt is in the form of bank lending (and the bonds are also held by financial institutions), the regulators will likely be able to have a meaningful influence in getting the various creditors to wait out the discussions. Even if we end up seeing something along the lines of a market-oriented outcome, it will still likely be a negotiated result that involves many different parties. The People’s Bank of China (PBoC) will likely keep a careful watch on liquidity.
For reference, when Baoshang bank was taken over by the PBoC in 2019, the bank was given liquidity support both at the local level and the central regulatory level. In fact, the event played right into the beginning of a mini-easing cycle in 2019, which was packaged together with reform and lowering of the Loan Prime Rate, which is the policy rate (Chart 1).
Whether similar events will play out this time is debatable given interbank liquidity conditions have already eased quite a bit in April. The policy stance should be biased toward easing not tightening.
From a long term perspective, a gradual breakdown of the SOE ‘implicit guarantee’, and more credit differentiation is a positive outcome for the overall economy. While it’s bad for companies that rely on the rating uplift, it’s good for companies that have improving fundamentals, which actually drive growth. And don’t forget that from a long term perspective, the continued clean-up by legacy bad debt will help growth by making more credit available for companies that can put it to good use.
From a credit market perspective…
Huarong’s presence in the Asia credit market is sizable. It is the seventh largest issuer in the $1.2 trillion JPMorgan Asia Credit Index (JACI) with USD18 billion in bonds outstanding, which accounts for 11% of Chinese financial bonds, or 3% of overall Chinese credits in the index. Given its significant weighting, it could cause a significant ripple effect on broader Chinese offshore credits should there be a credit event.
In addition, since the company is majority-owned by the central government, a disorderly fallout could potentially dent international investors’ confidence in investing in Chinese assets, at a time when attracting foreign investment has been one of the top strategic priorities of the government.
Huarong bonds are rated Baa1/BBB+/A- by Moody’s/S&P/Fitch, noting that they benefit from ‘deemed government support’. All three international credit rating agencies had put it on stable outlook (which only turned negative following the recent headlines), anchoring the view that Chinese SOEs enjoy various levels of implicit government support given their systematic importance.2
This methodology has long applied in the rating of all China SOEs, which issue roughly half of Chinese offshore credits. Therefore, a wholesale change will widely impact financing costs of these entities, as well as their eligibility to be invested in by global funds tracking IG benchmarks.
A SOE repricing could also shake the whole Chinese high yield (HY) market, not only from a generic HY versus IG perspective, but also due to the fundamental impact on funding costs, as Huarong used to be an important financier of the projects of HY issuers. And since Chinese credits account for 50% of Asia credits, it could even lead to a sentiment shift in the broader Asia credit market.
Given these effects, it is not surprising that Huarong’s ups and downs have led to big swings in Chinese credit markets and sentiment over the past month. But as the initial panic selling calms down, and the worst case scenario of a default seems out, markets will move on to focus more on the stand-alone fundamentals, and the proper pricing of credit risks.
From an equity market perspective…
While less likely, a protracted unresolved, or mishandled Huarong situation would limit the much-needed re-rating potential of China equities after the recent notable correction, given this triggers many questions unanswered, including and not limited to the following:
First, how should the market look at listed SOE entities as equity investment opportunities? SOEs account for 31% of MSCI China market cap, and in the event that the Chinese authorities let a major SOE go bankrupt, listed SOEs would bear a higher risk premium going forward, implying lower valuation multiples for China equities.
Second, would funding costs soar for SOEs given that a keep-well agreement does not imply a full government backup or guarantee?
And lastly, would large-cap SOE banks’ valuation be under greater pressure given that 39% of their loan books come from SOE debt? This would become a self-fulfilling prophecy, furthering the market skepticism about SOE banks’ book value.
In short, we are wary that the Huarong incident, if dragging on for too long, would dampen sentiment towards China equities, especially listed SOEs. This is unfortunate, as Huarong should be viewed as more of a one-off incident given its lousy operational track record. There are in fact some major SOEs that have shown notable improvement over the years and have gone unnoticed.
1 A keepwell agreement is a unique kind of credit support that is common in China’s offshore credit market. It is a show of willingness from the onshore parent to keep the offshore subsidiary well in financial conditions for debt service, and is a simpler and faster alternative to a legally binding cross-border guarantee, which is very cumbersome to secure.
2 Central SOEs broadly enjoy two to three notch rating uplifts from their standalone fundamentals based on implicit support from the state. In certain cases, ratings were boosted into higher rungs of IG ratings closer tied to the A1 sovereign rating, which may imply even five to six notches of rating uplift. Such a top-down approach may be justified by the issuers’ policy mandates to develop key infrastructure projects or social wellness mandates ahead of profitability and credit metrics, but they are harder to quantify.
The J.P. Morgan Asia Credit Index (JACI) provides an investable and liquid benchmark by providing exposure to Asia-ex Japan region US-dollar bonds, including sovereigns, quasi-sovereigns and corporate entities. It follows a traditional market capitalization technique.
All market and economic data as of April 26, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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