Faltering Bonds Condense Risk as Builder Collapses: China Credit

China’s faltering bond market is forcing banks to pick up the slack, spoiling Premier Li Keqiang’s efforts to spread financial risks as defaults extend from solar companies to real-estate developers.

New notes issued minus maturing securities fell 64 percent to 133 billion yuan ($21.5 billion) in the first two months of 2014, while new yuan loans made up about 69 percent of total credit in February, the most in seven months, according to central bank data. The yield on five-year company securities rated AA- rose 128 basis points in the past year to 7.71 percent yesterday, compared with an average 5.6 percent on high-yield U.S. debt, according to a Bank of America Merrill Lynch Index.

Developers’ bonds slumped yesterday after government officials familiar with the matter said Zhejiang Xingrun Real Estate Co. collapsed with 3.5 billion yuan of debt due, two weeks after Shanghai Chaori Energy Science & Technology Co. became the first onshore bond issuer to default. Over-reliance on state bank loans concentrates risks in the financial industry and puts funding out of the reach of smaller firms, according to Citigroup Inc.

“Bank lending will have to pick up the slack,” said May Yan, a banking analyst at Barclays Plc in Hong Kong. “The intention is to grow the bond market much faster but, if there are more defaults, investors probably won’t be as enthusiastic and there will be less interest in high-risk notes.”

Expansion Slows

China’s bond market expansion is slowing after a decade in which issuance climbed 80-fold. Overall sales outside of auctions slipped 10 percent to 3.77 trillion yuan last year, after climbing 56 percent in 2012 and 48 percent in 2011. In the corporate bond market, in which securities houses underwrite debt of smaller companies, offerings have slumped 49 percent this year.

The increasing reliance on state bank lending runs contrary to policy makers’ pledges in November to expand direct financing such as bond and stock sales while encouraging investment in small- and medium-sized enterprises. 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 state-directed lending caused defaults to balloon.

Slower growth is adding to concern more firms may miss debt payments. February data showed the steepest slide in exports since 2009 and the slowest inflation in 13 months, while industrial output and retail sales growth cooled more than estimated in the first two months of the year. This year’s economic growth target of 7.5 percent, which Li last week said was “flexible,” would mean the slowest expansion since 1990.

Swaps, Bonds

Contracts insuring China’s debt against default rose 11 basis points in 2014 to 91 in New York yesterday and reached a five-month high of 105 on Jan. 24, according to CMA prices. The yuan plunged 2.3 percent this year to 6.1965 per dollar in Shanghai today, China Foreign Exchange Trade System prices show. It touched 6.2040, the weakest since April 2013.

Investors have sought refuge in safer debt. The yield on 10-year corporate securities rated AAA has dropped 32 basis points this year to 5.99 percent yesterday, while that on similar-maturity government debt has slipped four basis points to 4.51 percent.

While regulators lifted a 14-month ban on initial public offerings this year, a 4.5 percent drop in the Shanghai Composite Index has cut their appeal. Stocks and bonds issued by some real estate companies extended a slump yesterday after Zhejiang Xingrun’s collapse stoked concern defaults are starting to mount. Government officials familiar with the matter said on March 17 that the closely-held developer doesn’t have enough cash to repay its debt.

Default Warning

The PBOC said it didn’t participate in an “emergency meeting” yesterday on Zhejiang Xingrun’s collapse and that it isn’t involved in dealing with risks from the failure. There will be more defaults among China’s small builders because of oversupply, slower growth and polarization in favor of larger, better-funded firms, Fitch Ratings analysts Andy Chang and Kalai Pillay wrote in a note dated yesterday.

The yield on the 8.75 percent notes due 2018 sold by Evergrande Real Estate Group Ltd., the nation’s fourth-largest developer by market value, jumped 107 basis points this week to

11.27 percent today, the highest on record, DBS prices show.

Reliance on Banks

Bank credit was 128 percent of China’s gross domestic product as of the first quarter of 2013, while fixed-income securities were 41 percent and stocks accounted for 44 percent at the end of 2012, according to a Brookings Institute report. That compared with 48 percent, 240 percent and 118 percent in the U.S., respectively.

“The problem is that, in China, economic entities are too reliant on the banks, and bank credit is only available to mostly big- or medium-sized enterprises,” said Ding Shuang, an economist at Citigroup Inc. in Hong Kong. Developing direct financing will “diversify risks and improve access to smaller businesses.”

Restrictions on lending forced smaller companies to turn to China’s $6 trillion shadow-banking industry, which includes trust companies and wealth management products issued by banks. A near-default of a trust product in January and tighter government regulations have made the sector wary of funding smaller companies. New trust loans were 78.4 billion yuan in February, the least since October and down from 182.5 billion yuan a year earlier.

A 3 billion yuan China Credit Trust Co. product that lent money to a failed coal miner was bailed out in January. Jilin Province Trust Co., which missed five interest payments on a similar security, declined to comment on the sixth installment that was due last week.

Bank Loans

“As default risks in corporate bonds rise and equities perform poorly, bank loans could be an alternative when the shadow banking sector isn’t willing to roll over their debt,” said Kewei Yang, head of Asia-Pacific interest-rate strategy at Morgan Stanley in Hong Kong.

Premier Li has renewed a focus on smaller enterprises as he seeks to rebalance the economy away from export manufacturers and polluting state-owned industries. Such firms contribute almost 60 percent of gross domestic product and 75 percent of new jobs, according to the China Association of Small and Medium Enterprises.

Non-performing loans climbed by 28.5 billion yuan in the last quarter of 2013 to 592.1 billion yuan, the highest since September 2008, according to the China Banking Regulatory Commission. The four biggest lenders sank to the lowest valuations on record in Hong Kong trading last week, despite being the most profitable in the world.

Implicit Guarantees

Last year’s top three corporate issuers were all state-owned firms, whose offerings may not reflect market conditions because they enjoy an unspoken guarantee from the government. China Railway Corp. alone accounted for 13 percent of total sales in 2013.

This isn’t the right time to expand direct financing because credit risks remain mispriced, according to Xu Gao, a Beijing-based economist at Everbright Securities Co.

“Fund allocations in the bond market don’t follow market forces as there’s still a lot of government intervention in the form of implicit guarantees,” said Xu. “As long as the economy doesn’t slow too much, bad loans won’t be a problem.”

The faith in implicit guarantees took a beating this month when Chaori Solar became the first onshore bond issuer to default. The solar panel maker’s 1 billion yuan of March 2017 bonds have been halted from trading since July, preceding its default on March 7 when it failed to make a full coupon payment of 89.8 million yuan.

Pulled Sales

At least four companies pulled domestic bond sales because of the Chaori default. Suining Chuanzhong Economic Technology Development Co. said on March 5 that it will delay a planned 1 billion yuan offering because of “serious fluctuations in the bond market” after Chaori said the previous day that it may not be able to make the payment.

Xining Special Steel Group canceled a planned 470 million yuan sale, citing “recent market changes,” while Qunsheng Group Co. scrapped a 500 million yuan bond offering because of a lack of demand. Defaults may be unavoidable in some cases, Premier Li Keqiang said last week.

“Risks in banks may be exposed if the economy slows, especially with manufacturers’ profitability falling,” said Rainy Yuan, a Shanghai-based analyst at Masterlink Securities Corp. “We hope the portion of direct financing, which are equities and bonds, can increase, but not off-balance-sheet lending.”