Halloween, on October 31, is traditionally the day for spooky behaviour. China’s bond market received its own scare a day earlier.
On October 30, mainland coal company Hidili Industry International Development said it would not be able to repay its outstanding US dollar bond issue after defaulting on Rmb6 billion ($947 million) of local loans.
The unwelcome news put the frighteners on international investors who hold the bonds. And it came just nine days after state-owned steel maker Sinosteel failed to make an interest payment on Rmb2 billion ($315.52 million) of its 2017 bonds.
However, for securitisation and distressed debt investors, the growing stresses in the market provide evidence of the potentially lucrative opportunities now emerging in China.
China has accumulated debt at an astonishing speed in recent years. Encouraged by the government, banks (almost all state-owned) have routinely expanded their lending lines by a net 15% a year. As a result, the country’s total debt-to-GDP ratio surged from around 150% in 2008 to reach 282% in mid-2014, according to a McKinsey report in February.
But as China's economic growth begins to wane, the fallout from that credit binge is now beginning to be felt.
Beijing is officially targeting GDP growth of around 7% this year, versus 7.7% in 2013 and 7.4% in 2014. Many economists think the government overestimates its growth by a percentage point or more.
In other words, Chinese companies have never been more indebted at a time when the economy is expanding at it slowest pace in 30 years.
Inevitably, that will lead to some companies failing.
As the cases of Hidili and Sinosteel underline, coal mining, steel making, and shipbuilding companies are seen by analysts as particularly susceptible.
Yet the rate of corporate failure is likely to be far slower than it would be in Europe or the US because Chinese banks often rollover loans to companies that would otherwise be unable to repay them.
Instead, the banks will need to run up more new lending lines as their levels of effectively insolvent assets grow. The risk is these non-performing assets eventually create the very financial hard landing the government is so desperate to avoid.
Bad debt buyers
It should be pointed out that the divestment of bank assets is not a given, at least in the short-term.
On August 29, the government scrapped the 75% loan-to-deposit ratio that local banks had previously had to follow. That frees them to push overall debt levels in the country even higher. The lenders may well reason that they have more balance sheet available now and therefore do not need to consider a serious divestment of assets.
Yet ultimately the banks may not be given much choice. On October 27, Agricultural Bank of China revealed that its third quarter profits had barely grown by 1% year-on-year, while its overall non-performing loans ratio topped 2%.
China’s government is likely to want to head off any serious questions being asked about the health of its financial system. That may well include ensuring the loan-to-deposit and NPL ratios of its banks don’t become disconcertedly high.
One solution that has served it well in the past is to strip bad assets out of the leading banks and put them into the hands of the country's bad debt specialists. That way, the banks can continue to have enough liquidity to conduct more lending.
The most obvious beneficiaries from such a line of action would be the country’s asset management companies: Huarong, Great Wall, Cinda, and China Orient. These were tasked with cleaning up the balance sheets of China's big four banks ahead of their public listings in the mid-2000s.
Both the AMCs and their investors seem confident that their skill sets will be needed in the coming months and years, to judge by their recent capital-raising forays.
Huarong conducted a HK$17.8 billion ($2.3 billion) initial public offering a week ago and Great China sold a second $1 billion bond issue in June. That comes after China Orient's $1 billion bond in August 2014, a month after Huarong sold a $1.5 billion bond, which in turn followed China Cinda's inaugural $1.5 billion deal in May.
As the examples of Sinosteel and Hidili reveal, the country’s banks (and thereafter the AMCs) will not be the only holders of troubled debts. Bondholders will be left vulnerable to deteriorating balance sheets as well. Many Chinese companies have tapped local and international bond markets for debt. More defaults are likely to follow.
While that prospect may upset regular investors, it offers distressed debt specialists a rising number of opportunities to get exposure to assets in the world’s second-largest economy at knock-down prices.
Chinese banks may yet also offload more assets via securitisations.
The country’s auto-loan securitisation market has witnessed increased issuance in the past several years, while Bank of Communications conducted a credit card asset-backed security deal only last week.
Plus there are signs that the authorities are paving the way for further such deals. In early October the National Association of Financial Market Institutional Investors (Nafmii), a regulatory subsidiary of the People’s Bank of China, published disclosure guidelines for consumer loan asset-backed securities from commercial banks and consumer finance companies.
The guidelines are the fourth such set of guidelines to be issued by Nafmii and indicate the government’s growing awareness that its financial institutions may require more tools to strip risk from their balance sheets. It is likely that the Chinese authorities will make more rulings to ease the path to other forms of asset securitisation.
Of course, as the global financial crisis of 2008 revealed, securitisations do not offer investors a guarantee of asset protection, no matter how well collateralised. And the country’s banks are unlikely to want to securitise their best assets. Aspiring investors would be wise to be cautious.
Yet for those with a stomach for risk, the country’s growing debt challenge could throw up some frighteningly intriguing opportunities.