Abstract: The credit debt default outbreak at the end of 2020 marks an important turning point for Chinese investors, because it started with a state-owned enterprise, which broke their long-standing belief in rigid redemption. The reason behind is the reduced willingness and ability of local governments to intervene and bailout indebted companies. Despite that the credit bond market could have a hard time adjusting, in the long run, strengthened fiscal disciplines and deepened reforms of local governments as well as decreased investor expectation for rigid redemption will promote the formation of a more equitable and efficient price discovery mechanism for the credit market.
In the last few months of 2020, the Chinese credit bond market saw interesting changes that had far-reaching implications for the Chinese economy. Simply put, a flutter of a butterfly's wing in Henan swept down businesses in Gansu and Qinghai.
There is no credit bond market without credit risks and defaults. However, the debt default in Henan this time, despite its small scale, has caught the entire credit bond market unprepared and dealt wide-reaching blows, taking a heavy toll on many of the poorly-qualified municipal bond issuers as well.
I. Rigid redemption has distorted the bond market
In recent years, market participants in China have been concerned with both a surging macro leverage rate and difficult and expensive financing. However, there seems to be a contradiction here.
The rise in macro leverage ratio means that the financing system has been providing debt financing for the real economy; a high and surging leverage ratio indicates large-scale debt financing that is growing rapidly. But why has this translated into difficult and expensive fundraising?
Lowering the leverage ratio would worsen the situation, but this is exactly what China has to do now while it strives to make financing easier and cheaper. The contradiction in between has given rise to what was mentioned at the start: a flutter of a butterfly's wing in Henan swept down businesses in northwestern China.
People see this phenomenon in different ways. As I understand it, the root cause behind is the implicit rigid redemption in the credit bond market that has been growing over the past decade or so with increasingly wider impacts.
Many credit bond investors have had this ingrained idea that city investment platforms, state-owned enterprises (SOEs) and central government-owned businesses will never fail because the government will always lend a hand. They also tend to believe that all businesses, state-owned or private, will not fail as long as they are big enough because the government will always help them out.
The investors believe so for a reason, which is easy to understand if we look at where credit debt defaults in the past ended up.
In China’s financing structure, the public sector and SOEs are taking up a higher proportion; meanwhile, investors increasingly believe that the government will not stand by should defaults happen. These have increasingly distorted the pricing mechanism for credit bonds. As a result, private businesses have to bear much higher financing costs than SOEs in the same industry with similar qualifications; meanwhile, the spread of the ownership premium has gradually trended up in recent years.
The credit bond market is way larger than the equity market in China. The distorted risk pricing of such a large market would have negative impacts on the efficiency of resource allocation and the quality of economic growth.
II. The government is intervening less in the bond market
The wave of defaults in the credit bond market in 2020 marks an important watershed and turning point for many investors, because it started with a SOE. This has broken their belief in rigid redemption.
As a matter of fact, the market did not expect Yongcheng Coal to default since the size of its debts was not big enough to significantly strain its cash flow. But it still ended up with defaults, which shook the investors’ confidence in SOEs’ rigid redemption.
What's more, this event has shocked all pricing mechanisms built upon investor confidence in rigid redemption, and led to a renewal in market pricing.
Defaults by SOEs and central government-owned businesses were rare before, but started to increase in 2020. Amid the pandemic’s blow, the central bank maintained an easy credit environment, the interest rate was low in the credit bond market, and funds were quite accessible. Under this circumstance, why did we have so many defaults by central government-owned businesses and local SOEs? It would make sense if these defaults had happened amid the deleveraging campaign back in 2018, but how do we explain their emergence now?
I think the reason lies in the reluctance of the government to intervene. On one hand, local governments are, undoubtedly, less capable to bail out indebted companies; on the other hand, against the backdrop of deepened SOE reforms, clearance of local government financing vehicles and crackdown on illegal local borrowings, they are also less willing to do so.
This have placed greater pressure on the credit bond market in the short run to adjust, but price signals indicate that ownership discrimination in the market is on the wane, with narrowing credit spread between private and state-owned businesses with similar qualifications. A more equitable bond market is taking shape, and this could bring more efficient resource allocation and high-quality economic development.
Some worry that the government will come back to the rescue in the near future if the credit debt market has an extremely hard time adjusting. We will have to wait and see, although I do not think it likely.
In summary, strengthened fiscal discipline and deepened reform have arrested the willingness and ability of local governments to intervene and distort the economy, dented market confidence in rigid redemption, and promoted the formation of a more equitable and efficient price discovery mechanism for the credit market.
