China Market Doesn't Flinch at Default

Despite the fact that the China bond market did not seem phased by the announcement of its first ever default, MoneyShow's Jim Jubak feels the default may become a big deal in the long-term.

Friday, China's onshore corporate bond market was hit with its first default—ever. Shanghai Chaori Solar Energy Science & Technology (CH:002506) was unable to pay an 89.8 million yuan coupon due Friday on a bond issue.

It's hard to make a case that the default of the Shenzhen-listed company rattled China's financial markets. The Shanghai-Shenzhen 300 index closed a scant 0.24% lower Friday.

I think the default is a big deal—in the long-term. It inches China's financial markets closer to pricing risk into stocks, bonds, investment trusts, and other financial products. With a very few exceptions, China's markets behave as if the government will bail out any company that gets in trouble and will make investors whole. An event like Friday's default suggests that might not always be the case. And the default will blaze new pathways as China continues to develop legal processes for dealing with default and bankruptcy.

So if this default is important in the long run, why didn't it have more effect on financial markets Friday? I think I understand the lack of a reaction. I also think it's worth considering the possibility that markets are wrong. And that we'll test that conclusion later in 2014.

There are three reasons, I think, for the lack of a market reaction Friday.

First, the markets see Chaori as a “three-strikes and you're out” story. The company only avoided default a year ago after a local government in Shanghai pulled strings to get its bank to defer claims on overdue bank loans. At the end of June, Chaori had failed to pay 1.5 billion yuan in loans to 12 banks on time. In November, the Bank of Tianjin said it was shopping for buyers for 52 million yuan in loans to the company. The bank had already extended the loans once.

Second, Chaori operates in a sector that the Beijing government has targeted for a “reduction” in suppliers. The government has made it clear that it would like to see some solar companies go out of business or merge so that the sector could start to make money again.

Third, and this is the most important, I think the markets see Chaori as a small operator without sufficient political connections. In this view, this default is more of a “show trial” than a real change in policy. By letting Chaori default, Beijing gets to make the point that investors shouldn't assume that the government will always ride to the rescue. But that doesn't mean (the markets seem to have thought on Friday) that Beijing wouldn't bailout a more politically-connected company. In China's politically cynical markets, Friday's default actually reinforces a perverse point—that if you want to avoid risk, the trick isn't to invest in solid balance sheets but in superior political pedigrees.

I think the logic here can get a bit circular—it's easy to assume that since Chaori was allowed to default without a bailout, it must not have any political clout. (And it's hard to follow the political DNA in China's often-opaque ownership and management family trees.) But I do think the history of Chaori, and its president and chairman Ni Kailu (together with his daughter, Ni owns 44% of the company), suggest a company with limited clout. For example, in January, the press was reporting a bailout through an ownership transfer from Ni to the state-owned Qinghai Muli Coal Development Group. That deal fell apart when somebody refused to approve the involvement of a state-owned company in the transfer. It also doesn't smack of clout to have to look for a rescue from a state-owned coal company. That sector is up to its eyebrows with its own financial problems. Or go back to the company's 2010 IPO on the Shenzhen market. That listing was originally scheduled for 2009, but regulators refused to approve it because they found the company's expansion strategy too risky. Chaori only got its listing after working to increase its capital base. To me, that doesn't sound like the kind of objection regulators make to companies with political clout. Object to listing a solar company because it's too risky? In China? The interest rates that Chaori was paying on its debt make me question the quality of its political connections too. The 1 billion yuan of five-year notes the company sold, in March 2012, carried a variable coupon rate that started at 8.98%. In a country where the price a company pays for money is determined by connections…that argues that Chaori is a very small fish.

For Friday, at least, China's markets were saying that this default is no big deal since the central government will still bail out any significant company—since significant companies all have political connections much better than those of a Chaori.

I think we'll get a lot of chances to test that conclusion in 2014. Total debt at publicly traded non-financial companies in China and Hong Kong stands at $1.98 trillion, currently up from $607 billion at the end of 2007, according to Bloomberg. Sixty three of those companies have debt to equity ratios above 400%. The list is dominated by companies in sectors with big over-capacity problems, such as solar steel and shipbuilding.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund see the fund's portfolio here.