China’s Xi Seen Making Bonds Healthier Amid Manageable Defaults

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President Xi Jinping’s bid to reform China’s corporate debt market is winning support among investors who see more defaults as a reflection of health, not sickness.

Vital signs show fitness mid year, even after landmark bond failures by a state-owned firm and developer. Investors increased purchases of all Chinese company notes 50 percent compared with 2014 to the equivalent of $947 billion in the first half. Yields have dropped 72 basis points since Dec. 31 on Chinese international securities and 54 basis points for domestic debentures following central bank rate cuts, Bank of America Merrill Lynch indexes show.

“Rising defaults don’t signal bigger financial stress,” said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong. “It’s China’s financial reform strategy. It’s encouraging because it shows they are allowing proper pricing.”

President Xi has allowed more defaults, relaxed rules for the sale of asset-backed securities and loosened property financing controls as he gives markets a larger role in the economy. The steady reforms and stability with bonds contrasts with the stock market, where volatility has surged after the worst rout since 1992.

Tackling Debt

While the nation’s benchmark equities index shed 29 percent in the three weeks through Friday, onshore corporate bonds returned 0.5 percent.

Xi faces pressure to keep debt markets calm after total government, corporate and household obligations ballooned to 282 percent of the economy as of mid-2014, according to McKinsey & Co. Despite the weakest economy since 1990, he has reined in informal lending known as shadow banking and avoided large-scale fiscal spending like the 4 trillion yuan ($644 billion) the nation unleashed during the global financial crisis.

“The government may allow more bond defaults to help financial resources to be allocated more efficiently,” said Li Ning, deputy general manager of the fixed income department of Western Securities Co. in Beijing. “That may help address China’s debt problem.”

Real Estate

The government has dealt with shadow banking in part by opening the domestic bond market for private-sector companies, said Florian Schmidt, the head of debt capital markets at SC Lowy Financial (HK) Ltd.

“Alternative funding routes to what has been very expensive credit should play their part in reducing the debt problem, at least in the private sector,” Schmidt said.

The central bank has cut the benchmark lending rate four times since November. Authorities have let more developers sell onshore yuan bonds, after Kaisa Group Holdings Ltd. became the nation’s first builder to default on dollar notes in April.

“I think we’ve seen the worst of the Chinese property sector,” said Gordon Ip, Hong Kong-based senior fund manager at Value Partners Ltd.

The nation last week vowed more participation by foreign companies in the local capital market and to let international ratings companies grade local government securities.

“The question is, are you getting sufficiently compensated for the bear case scenario where this policy easing doesn’t work?” said Gaurav Singhal, a credit analyst at Nomura Holdings Inc. in Hong Kong.

High-leverage, overcapacity sectors such as coal and steel need attention, according to China Chengxin International Credit Rating Co., Moody’s Investors Service’s local joint venture.

“Their bond default risks are rising,” said Zhang Yingjie, a Beijing-based deputy general manager in the research department of the credit assessor.

Shandong Iron & Steel Group Co. is among industrial companies facing bond payments this month. The metal maker must repay 2 billion yuan of 5.2 percent notes July 26.

Xi is steering China toward more reliance on consumption and services rather than smokestack industries.

Reforms to the growth model and financial system mean corporate debt’s size relative to the economy will gradually drop, said Zhao Yang, the chief China economist at Nomura Holdings Inc. in Hong Kong. “The government might allow more debt defaults to increase risk exposure and reduce moral hazard.”

— With assistance by Lianting Tu, and Judy Chen

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