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«The market underestimated China's deleveraging campaign»

Christopher Lee: «The immediate concern for the authorities is the high leverage in the system which means that a lot of companies depend on cheap credit to survive. The priority for the government now is to control the debt growth and reduce financial risks.»

For many companies in China it became more difficult to get funding on the bond market. The risk premium for corporate bonds with lower ratings is on the highest level in the last two years. More credit defaults mean that investor demand shifts to debt issued by state-owned enterprises. Christopher K. Lee, China Country Specialist with rating agency Standard & Poor’s, sees liquidity tightening which affects in particular weak borrowers.

Mr Lee, defaults in the Chinese bond market are on the rise. Is this a surprise for you? - We have expected in our outlook for 2018 that defaults in China will rise this year from a very low base. Also we expect that Local Government Financing Vehicles, LGFVs, will likely default because of the tightening of liquidity in the market and toughening policy to control the debt of local government.

Did market participants share these expectations? - I don’t think that at the end of last year there was a common expectation in the market that defaults will rise as investors expected good liquidity conditions to continue and a benign operating environment with strong company profits. The rise in defaults over the last few weeks was surprising for the market, especially the default of listed companies. Listed companies tend to have stronger balance sheets and better access to funding than privately held companies.

What would the default of a local government bond mean? - A default of a bond of a local government funding vehicle would be a major event. It would reprice a lot of local government funding vehicle bonds more significantly even though spreads for weaker borrowers have widened in recent months. This would mean that the funding costs for such issuers would increase significantly. Until now we heard of defaults of trust products which are bilateral agreements between a LGFV as the borrower and a trust company as the lender. But we have not seen yet a default of a public bond.

What kind of issuers have defaulted already? - So far we have seen private companies defaulting. These are the group of companies most vulnerable to the tightening of liquidity. The big banks which are state-owned have a preference to allocate capital to SOEs, state-owned enterprises. In the early stage of the liquidity tightening due to the deleveraging campaign we expect that private companies are in the first wave of defaults. Now, the liquidity tightening will also affect weak borrowers across the board. The weak borrowers are those that have excess capacity and are highly leveraged.

Why did the market not expect a rise in defaults? - The market has underestimated the effect of the deleveraging campaign. Investors had expected the government to intervene to support companies when the going gets tough. Certainly the government has provided liquidity to ensure that enough companies can get financing, but as state-owned borrowers have been preferred private companies were starved in terms of credit. The funding channels for quasi-sovereign borrowers is still wide open.

But was not one goal of economic reforms to stop the preferential treatment of state-owned enterprises? - The long-term goal is still to reform the financial system, to open up and improve the depth of the capital market as well as to internationalize the Renminbi. But the immediate concern for the authorities is the high leverage in the system which means that a lot of companies depend on cheap credit to survive. The priority for the government now is to control the debt growth and reduce financial risks. This was announced already in July last year in the National Finance Work Conference. There is still a high degree of excess capacity in the economy that the government needs to remove.

What is the current policy towards local government funding? - Local government debt is a concern as it is growing at a very rapid rate. The central government is concerned about debt which is hidden in funding vehicles and companies owned by the local governments. These entities rely on back channels using shadow banking instruments like trust products, and entrusted loans. These back channels is not transparent to the central government, investors and the public. At the same time, the central government opens up the front channels to allow local governments to borrow in a transparent manner by issuing bonds and taking up regular bank loans. It also increases for local governments the bond issuance quota and also allocates more of the quota to special purpose bonds, for example bonds for land development and toll road building.

What is the outlook for property developers as the housing market cools down and many have debt denominated in foreign exchange? - One issue with property developers in China is that they do very little hedging as it is too costly. Until now that was not a big problem as the Renminbi is strong despite the weakening of many Emerging Market currencies. My expectation is that the currency will remain stable and the foreign-currency debt will remain manageable. But the financing conditions for property developers like for other private companies is quite difficult.

Could there be an increase in defaults of property developers then? - There a lot of small and medium sized property developers which are highly leveraged and could come under stress. They expanded aggressively over the last few years as the times were good by buying land and taking on debt. We are back in the cycle where some small and medium size developers could default. But this is not a systemic problem as they have only regional exposure and rely more on the local banks for funding.

But then local banks could find themselves under pressure? - The local banks are the ones who are most heavily squeezed by the deleveraging campaign. They depend on the wholesale funding market where costs became much higher. At the same time these banks need to unwind the shadow banking and wealth management trust products. There are squeezed on both sides: their funding position as well as their ability to extend credit has weakened.

Could an influx of foreign investors to the Chinese bond market provide more liquidity and funding? - My personal view is that foreign investors will play a more important role in the Chinese bond market. But in the beginning, foreign market participants are more comfortable buying quality government and bank bonds, not corporate bonds. They will buy rather the interest rate than credit products. Foreign investors are not sure about the credit quality and corporate governance of many companies. They will likely build up resources in China to assess the credit quality in order to become more comfortable with corporate bonds. Currently we are in early days, the share of foreign investor is still very small – less than 3 per cent.