China’s efforts to connect the world’s third-biggest bond market with the international financial system are hitting dual headwinds -- a climb in global borrowing costs, and the country’s own campaign to reduce financial leverage.
The dynamics have contributed to defaults by 12 bond issuers in 2018 through June 4, after 18 for the whole of 2017, according to Fitch Ratings. Firms from JPMorgan Chase & Co. to Fidelity International are warning to prepare for more. But with about 8.2 trillion yuan ($1.3 trillion) of domestic corporate and local-government securities due to mature in the coming 12 months, it’s an open question whether China is prepared to let chips fall where they may.
Authorities started shifting away from the old model of implicit guarantees for practically all debt securities in 2014, allowing defaults for the first time. The idea: tap market discipline to punish inefficient companies and encourage a more productive capital allocation. Given the massive size of the market -- now more than $11 trillion, with a further half trillion or so in dollar bonds -- it was always going to be a delicate transition. Where would the lines be drawn on who goes bust? A global-standard credit-ratings industry could hardly be engineered overnight.
Great Wall of Maturities
A total of 8.2 trillion yuan of bonds are set to mature next 12 months.
And with China’s door at its most open yet to overseas investors, the global spotlight is shining like never before on these securities.
Of the defaults so far in 2018, 11 have come from privately owned companies, while one was a state-owned enterprise, Fitch records show. Some investors have been girding for the first-ever delinquency from a local government financing vehicle; LGFVs played a major part in China’s record run-up in debt in the wake of the global financial crisis.
Discerning between companies with explicit guarantees from the government and those with only assumed backing is further complicated by the relative inexperience of many covering it.
"You don’t have the slate of experienced analysts -- you have people with three to five years of experience," said Jamie Grant, head of Asia fixed income at First State Investments in Hong Kong. "There are good credit analysts, but they haven’t been through the Asian credit cycle."
Structural issues with the market have also encompassed concerns about adequate back-office staff to vet trading.
As for those ratings, though, overseas investors -- who have become increasingly active in the onshore market -- are encountering a system that bears only loose resemblance to the grading structure found elsewhere. Among domestic corporate issuers in China, almost 30 percent have the highest AAA rating, according to data compiled by Bloomberg. That compares with 2.2 percent for bonds in the U.S. covered by the three big global ratings agencies.
Officials have signaled recognition of the discrepancy, last year moving to allow foreign-owned ratings companies to set up their own units in China. Fitch has sold its minority stake in one joint venture. S&P Global Ratings has said it will establish a local subsidiary, while Moody’s Investors Service has yet to announce a formal plan to dive into the domestic Chinese market.
Regulators have also moved on other fronts, including opening the door wider to foreign investors. After allowing qualified institutional investors access in the 2000s, a broader channel opened in July 2017 with the establishment of a "bond connect" with Hong Kong.
Foreign investors say there’s still plenty more architecture to work on, such as expanding access to onshore derivatives, which would let them better hedge interest-rate and currency risks. That would help level the playing field, said Perrott at UBS Asset Management.
With China overhauling its financial overseers earlier this year, prospects may be the best yet for coordinated reforms by the central bank, banking and securities regulators to increase transparency in the country’s debt markets.
"Removing some of these hurdles, so that if you’re a foreign investor you’re dealing with a system that you’re familiar with, then hopefully that will increase the interest," said David Yim, head of debt capital markets in Hong Kong for greater China at Standard Chartered Plc.. "It’s going in the right direction, as more and more investors sign up and start trading and buying onshore bonds."