As the initial panic selling calms down, and the worst case scenario of a default seems to have passed, markets will increasingly focus on the stand-alone fundamentals, and the proper pricing of credit risks.
Julia Wang, Global Market Strategist, Asia, J.P. Morgan Private Bank
Anne Zhang, Co-Head of Asset Class Strategy, FICC, Asia, J.P. Morgan Private Bank
Raymond Cheng, Co-Head of Asset Class Strategy, Equities, Asia, J.P. Morgan Private Bank
Yuxuan Tang, Global Market Strategist, Asia, J.P. Morgan Private Bank
Chinese assets have seen multiple challenges in recent weeks. Lately, Huarong has become a focal point. Investors focused on the company’s status as a large State-Owned-Enterprise (SOE) that is undergoing a corporate restructuring, and wondered what the implications will be for other SOEs and the broader market.
First, some background…
Huarong Asset Management Company is a centrally-owned SOE (for reference, the majority of SOEs are owned by local governments) that was established in the late 90s. Today, Huarong is a conglomerate with businesses in banking, trusts, asset management, and leasing as well as securities broking.
In the four years to 2018, its assets grew almost five-fold to more than RMB1.7trn, which would have placed it among China’s 20 biggest banks. Most of its USD23bn 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 Xiaomin 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 struggling to gradually digest its own bad debt.
Fast forward to March 31, 2021 Huarong postponed the publication of its annual results, leading to media speculations that it is undergoing a regulator-led restructuring. In recent days, media have reported that a regulatory takeover is likely. On April 26, the company announced it will delay announcing 2020 results past the April 30 deadline.
Markets are coming to the view 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.
Recent examples of how the government handles financial institution restructuring suggest they take a case-by-case approach. Given Huarong is very unique in its scale and complexity, the government will try to walk a fine line. In other words, nothing is really off the table for now. And as discussions with regulators are not yet finalized, we may not really hear any concrete plans for some time.
From a macro perspective…
In the short term, regulatory monitoring will likely help to avert a liquidity squeeze in the onshore market. Given over half of Huarong’s debt is in the form of bank lending (and its 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 sufficient liquidity. In fact, the event played right into the beginning of a mini-easing cycle in 2019 (see chart below). Whether similar events will play out this time is debatable but 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. The continued clean-up of 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. Its bonds are rated Baa1/BBB+/A- by Moody’s/S&P/Fitch, based on ‘deemed government support’ (with negative outlook following recent headlines).2
This type of rating uplift has long been applied to all China SOEs. 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. It could also impact the High-Yield market, given Huarong is a big financier of the projects of HY issuers. Since Chinese credits account for 50% of Asia credits, it could even lead to a sentiment shift in the broader Asia credit market.
In short, a credit event could cause a significant ripple effect on broader offshore credit. And given it’s an SOE owned by the central government, a disorderly fallout could potentially dent international investors’ confidence in investing in Chinese assets.
From an equity market perspective…
While less likely, a protracted or mishandled Huarong situation would limit the re-rating potential of China equities. There are several worries.
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.
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?
We are wary that the Huarong situation, if dragging on for too long, would dampen sentiment towards China equities, especially listed SOEs. This is despite the fact that, Huarong is probably more of a one-off incident given its linkages to financial corruption, and that there are in fact some major SOEs that have shown notable improvement over the years.
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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