Fear the China Put Nobody's Talking About
The mountain of maturing debt could be a lot higher than it looks.
For all the talk of China’s mountain of debt, defaults and deleveraging, there’s a chasm nobody is talking about.
Here’s an alarming and frequently cited statistic: Chinese industrial companies have at least $124 billion of debt maturing over the next two years. Actually, it’s worse. They have another $34 billion of bonds with put options – giving creditors the right to sell back their securities or get a higher coupon – that can be exercised within the next two years. Lenders could be asking for their money back much sooner than companies and investors expect.
Whether bondholders cash in is anyone’s guess. But they have an incentive to do so, given rising market rates. For borrowers, puts effectively bring forward the maturity date: In July-September this year, about $3 billion of such options can be exercised for the first time on debt that’s due two years later, in 2020.
Beijing isn't as ready as in the past to backstop all its companies, and credit risk is a dawning reality in China. The average spread on highly rated one-year corporates is almost a full percentage point higher than last year; the average defaulted bond is now almost 1 billion yuan ($156 million), twice the size three years ago.
Credit risk warnings, in the form of bond-trading suspensions or uncertainty around interest or principal payments – or even failure to file financial data – affected 454 issues in the second quarter, up from 311 one year earlier, according to Rhodium Group LLC analysts. It’s no surprise that cries for help have mostly come from industrial companies and real estate developers.
Such risk isn’t necessarily a bad thing, in isolation. Markets tend to adjust asset prices to reflect such dangers. Then there’s liquidity risk – essentially the ability to trade in and out of the market. That’s unlikely to increase rapidly, at least initially. But if credit risk rises too fast for the market to find a clearing price, liquidity risk can shoot up, too. With both measures heightened, in an extreme scenario, the market freezes.
Options will force credit differentiation, which investors in China have tended to ignore. As Rhodium’s Bart Carfagno and Allen Feng note, the rate at which “put options are exercised will likely mirror the divergence in credit conditions,” with more being exercised for weaker companies and fewer for the stronger ones. This will add to overall credit risk and liquidity risk. As they increase, the trap becomes self-fulfilling.
To be sure, the government could swoop in and back all the companies that investors think are on the brink or have guarantees, implicit or explicit. But there are no clear precedents to determine which would default and which might be rescued. Last year, investors exercised put options on Huasheng Jiangquan Group Co.’s 2019 bonds. The company bought back about 200 million yuan of the securities but couldn’t afford the rest, and defaulted despite links with other SOEs. Huasheng re-emerged last month, tapping markets again with a corporate guarantee.
Some defaults, like Sinosteel Corp. in 2015, have been fully recovered. Others, including Baoding Tianwei Group Co., also in 2015, are unresolved.
Judging by Beijing’s handling of market rates over the last year, a sudden pullback in the effort to deleverage China isn't an immediate option. Hemmed in by other risks in the financial system, government support will be more difficult to ascertain. For industrial companies saddled with inefficient capital structures and addicted to the state’s debt tap, adjustment may be difficult. They might not even be able to rely on higher profits, given rising interest and material costs.
The chasm is a frightening place, but investors should be sure to peer into it.
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Paul Sillitoe at email@example.com