China Bond Risk Exceeds Ireland as Defaults Unavoidable

Chinese Flag
People wait for the daily flag-lowering ceremony at Tiananmen Square in Beijing. China’s leaders are wrestling with the fallout from a credit boom that began with a 2008 stimulus package, funded with off-balance-sheet financing arranged by local governments and banks. Photographer: Tomohiro Ohsumi/Bloomberg

China’s default risk has risen beyond that of Ireland, having been on par with France and Japan a year ago, as Premier Li Keqiang said financial leverage is making the economy’s outlook more complex.

Five-year contracts protecting against non-payment on government debt climbed to 99 from 63 a year earlier, almost double the 49 for Japan and 51 for France, CMA credit-default swap data show. That compares with 88 for lower-rated Ireland, which exited a bailout in December. The yuan has lost 1.3 percent in the past month, the most in Asia, while the Shanghai Stock Exchange Composite Index has declined 5.2 percent.

This year’s 7.5 percent economic expansion target is “flexible” and some financial product defaults may be unavoidable, Premier Li told a press conference at the National People’s Congress yesterday. A report showed industrial production growth slowed, making it harder for companies to repay debt. Shanghai Chaori Solar Energy Science & Technology Co. became the first onshore bond issuer to default last week.

“China’s major default risks stem from the explosive credit growth into infrastructure, real estate and mining projects that failed to deliver returns,” said Wee-Khoon Chong, Singapore-based head of rates strategy Asia ex-Japan at Nomura Holdings Inc. “We expect more defaults in corporate or local government notes this year, but we do not expect them to lead to a systemic disruption of the financial system.”

Less Transparent

China’s leaders are wrestling with the fallout from a credit boom that began with a 2008 stimulus package, funded with off-balance-sheet financing arranged by local governments and banks. While those efforts avoided putting strain on state banks and the central government, they are less transparent.

Regional authorities, which aren’t allowed to sell debt directly, set up thousands of financing vehicles to raise funds to build subways, highways and sewage works. Their liabilities rose to 17.9 trillion yuan ($2.9 trillion) as of June 2013 from 10.7 trillion yuan at the end of 2010, according to National Audit Office data.

China’s $6 trillion shadow-banking industry, which includes trust companies and wealth management products issued by banks, was rated the nation’s biggest challenge in a Bloomberg News survey of 29 economists before the annual meeting of lawmakers started March 5.

In January, a near-default was averted when a 3 billion yuan China Credit Trust Co. product that lent money to a collapsed coal miner was bailed out. Jilin Province Trust Co., which missed five interest payments on a similar security, declined to comment on the sixth installment that was due this week.

Stumbling Block

“We don’t want to let today’s stepping stone become tomorrow’s stumbling block,” Premier Li said yesterday while stating that the government will increase oversight of financing vehicles to ensure there are no regional or systemic risks. “I’m afraid that sometimes certain individual cases of such defaults are hardly avoidable.”

LGFVs need to repay about 82.5 billion yuan of paper due in the three months ending April 30, or 37 percent of this year’s total of 224.84 billion yuan, according to data from China Chengxin International Credit Rating Co., Moody’s Investors Service’s joint venture in China.

This is contributing to a jump in China’s credit-default swaps, which rose 25 basis points this year to a five-month high of 105 on Jan. 24, according to CMA prices. The rate is up 19 basis points this quarter and is poised for the first three-month advance since June 2013.

Bailout Concern

“Growing concern over looming defaults led to a surge in demand for CDS as investors seek to insure themselves against a credit-default event,” said Saktiandi Supaat, head of foreign-exchange research at Malayan Banking Bhd. in Singapore. “Plans to rein in shadow financing imply that the government can no longer be counted on for a bailout, hence raising the possibility of more defaults.”

Curbing the shadow-banking industry would help reduce the risk of financial turmoil while slowing growth. China Banking Regulatory Commission Chairman Shang Fulin said March 11 that it will curb lending to industries with overcapacity, adding that certain risks are building in the banking system. Former central bank adviser Li Daokui said this month that the government will take steps to support economic expansion that he projects will ebb next quarter to below the year’s 7.5 percent target.

Cleaning House

The focus on cleaning house has prompted some rating companies to retain a steady outlook for the world’s second-largest economy. China is ranked Aa3 by Moody’s Investors Service, its fourth-highest investment grade and on par with Japan and six levels higher than Ireland.

“The first onshore default and slowdown in the economy are already folded into our analysis,” Ivan Chung, vice president at Moody’s in Hong Kong, said in an interview in Singapore yesterday. “‘We don’t trade CDS, so we can’t comment on whether this level is appropriate or not. But obviously market sentiment is changing.”

The company is keeping a stable forecast for China’s sovereign rating.

As the economy slows, the yield on the government’s 10-year bonds has declined five basis points this year to 4.5 percent, according to data compiled by Bloomberg. A report yesterday showed industrial production growth eased to 8.6 percent in January and February, the weakest start to a year since 2009.

Widening Spread

Steve Wang, head of fixed-income research in Hong Kong at BOCI Securities Ltd., said solar companies and industries with excess capacity such as steel and mining may suffer defaults. Haitong Securities Co. said in a research note last week that debentures sold by Baoding Tianwei Baobian Electric Co. and Sinovel Wind Group Co. are among onshore bonds with the highest credit risk.

The 2018 notes of Baoding Tianwei, which also makes solar-cell parts, fell 17.81 basis points in the past year to 82.19 as of March 10, according to exchange data. The bonds were suspended on the Shanghai Exchange this week after the manufacturer said losses widened to 5.23 billion yuan in 2013 from 1.55 billion yuan in 2012. The company will pay bond interest for due July 2014 on time, according to a statement to the stock exchange today.

Chaori’s 1 billion yuan of March 2017 bonds have been halted from trading on the exchange since July, preceding its default on March 7 when it failed to make a full coupon payment of 89.8 million yuan. A bondholders’ meeting is planned for March 26 and investors are considering a lawsuit.

The solar industry is “pretty risky,” and Chaori’s default “has definitely caused some impact in terms of widening bond spreads,” BOCI Securities’ Wang said.


The government has spent more than $650 billion bailing out banks by carving out bad loans and injecting capital since the late 1990s, after years of government-directed lending caused default risk to balloon.

The spread on five-year AA- notes over similar-maturity government notes reached 363 basis points on March 7, the widest since Feb. 25, according to Chinabond indexes. The gap was down to 359 basis points yesterday from 418 basis points on Feb. 7, which was the highest since 2012.

Traders are paying more for China debt protection “even if credit rating agencies do not view the sovereign risk picture as having changed,” said Sacha Tihanyi, senior currency strategist at Scotiabank in Hong Kong. “Major concerns include the risk of further bailouts or defaults in the wealth management and trust product sector, as well as the risk that the recent bond default is the first in a string of many to come in the next couple of years.”

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