A succession of defaults has rattled China’s $15tn bond market and is raising concerns about the country’s financial health following a sharp slowdown in economic growth this year. For foreign investors who have snapped up Chinese paper in 2020, the burning question is whether the liquidity crunch will spread. For more general observers, the risk is that bond market defaults may signal deeper structural weaknesses.
Such concerns are important. But from a policy perspective, the defaults are to be welcomed. They show that Beijing is seeking to impose a measure of financial discipline after a record debt splurge in the first two quarters. Such discipline is sorely needed: total debt to GDP was approaching 335 per cent at the end of June, up from 302 per cent at the end of last year, according to the Institute of International Finance.
Beijing’s main message appears fairly straightforward. It is warning state-owned enterprises and their local government backers that some of the easy credit that was deployed to combat the pandemic is being reined in as China’s economy recovers. It is also making clear that the type of sustained liquidity splurge that Beijing unleashed in the aftermath of the 2008 financial crisis will not be repeated.
Nevertheless, a course of bitter medicine also appears unlikely. The People’s Bank of China, the central bank, said in a report last week that “normal” monetary policy will be maintained, suggesting that Beijing is not about to administer a sharp tightening in policy.
Thus the recent bond defaults of Yongcheng Coal and Electricity Holding, Tsinghua Unigroup, and Huachen Automotive Group — all at least partly state-owned — should be seen as salutary lessons. Liu He, China’s top financial official, was serious when he warned of “zero tolerance” towards misconduct in financing deals or attempts by companies to evade their debts.
Implicit in Mr Liu’s remarks was that the focus of Beijing’s increased scrutiny is the frothy $4tn corporate bond market, rather than the market for Chinese government and policy bank bonds. This will come as a relief to foreign investors, who have almost completely eschewed the riskier corporate bond market as they increased their holdings of Chinese debt this year.
So far, Beijing’s strategy appears to be bearing fruit. Not only have the defaults pushed up the average coupon rate for new bonds from state-owned enterprises since October, they also seem to be changing a longstanding culture of complacency. A belief that the bonds of state-owned companies enjoy effective government guarantees has now crumbled, fund managers say.
But such progress, while welcome, represents only baby steps. Though China has the world’s second largest bond market after the US, governance standards are weak. One reason why foreign investors have been so reluctant to enter the corporate bond market — in spite of coupons often in excess of 5 per cent — is because they do not trust the statements issued by state-owned enterprises. With more than 70 per cent of all outstanding Chinese corporate and government debt rated at triple-A, it can be hard for investors to identify where the real weaknesses lie.
China’s step towards inculcating greater financial discipline is welcome. But Beijing should realise that governance standards for its big companies are, increasingly, set by its huge bond market. If it allows the bond market to be riven with fraud, pretence, evasion and wishful thinking, companies will remain prey to the same culture. China’s route to corporate efficiency and investor protection lies through an Augean overhaul of its capital markets.
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