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article imageOp-Ed: China’s bond defaults looking grim

By Paul Wallis     May 9, 2019 in World
Beijing - Bonds are big business in China, and when this market starts looking shaky, nobody feels safe. Defaults have started piling up, 3.4 times the defaults in 2018. The Chinese credit market is looking very nervous.
One of the big issues is the notorious but convenient “shadow banking” system. This is a far less regulated banking system, which China has been trying to bring under control with varying levels of success. The shadow banking system lends vast amounts of money, and China has been trying to bring it under control.
However - China also encourages credit by banks for a more transparent credit system. This could well be an own goal, ironically, in that paying bank loans means borrowers have to look for funds to make repayments. That inevitably means funding from other sources, notably shadow banking loans or fixed term bonds taken out from unregulated lenders to cover other loans, are under pressure. Reduced access to shadow banking is basically a funding squeeze, but also necessary in China’s rampant financial markets where demand for money is always high and transparency can be non-existent.
The shadow banking system is considered by experts to be responsible for the movement of large amounts of money. It’s hard to estimate the real scope of the problem, due to the lack of regulation. China seems to be quietly but persistently cracking down, and the bond issues may be the major symptom of the effects of the crackdown.
Nothing in China is ever simple
At a time when China has been making billionaires like confetti, the depth of exposure of banks, companies and individuals is almost impossible to assess. The shadow banking system does serve a useful function, but it’s also the exact opposite of a transparent system, hence the worry when defaults suddenly spike like this.
(Before we go any further – This is not an exclusively Chinese issue. Banks, finance companies, lenders and borrowers around the world use an informal lending system for short and longer term funding. The problem is that these borrowings can easily cascade into a major sequence of defaults, and even crash banks, in worst case scenarios. The subprimes disaster was a good example of what happens when a system crashes.)
The biggest, most visible and most troubling of the defaults is by a company called Neoglory, a jewellery company which has missed 7 billion yuan (just under $1billion US). Neoglory seems to be stuck with this situation, and unlike other default issues, isn’t getting support from the regulators or local authorities.
That’s the classic default scenario which is bothering global markets, and there are several major corporate entities now defaulting. How deep a hole have Chinese borrowers dug for themselves? Can the defaults create a major lending issue? Nobody’s too sure, because while what’s known doesn’t look good, getting a clear picture in such a huge market is almost impossible.
It’s a reasonable assumption that Beijing isn’t at all happy about this situation. At the official level, the euphemisms are flying high, but the official silence is unusual. Beijing usually makes very blunt statements when it intends to regulate severely.
It’s unlikely that regulators will tolerate a rather nasty-looking smear on the financial sector for long. Major defaults are unlikely to go unpunished, and regulator demands for rectification are usually followed by either prosecutions or jail terms.
The trouble is that nothing in China is ever simple. Networks of borrowers and lenders, both mainstream and in the shadow banking system, can be huge. If one person is in trouble, a lot of others are likely to be in trouble soon. You can see why the Chinese market is always wary of credit issues.
The current numbers for defaults are around $40 billion US. That’s chicken feed in the Chinese economy, but it’s enough to indicate a possible systemic problem that’s much bigger. If it is bigger, China’s credit policies could get a lot tougher, and that could spell major issues in the financial markets:
• Capital could be pulled out of foreign markets. Catch up payments could demand a lot of cash up front, meaning major upheavals in financial markets around the world as the Chinese money goes home to pay debts.
• Security guarantees could be enforced, changing the financial status of Chinese borrowers.
• Big bankruptcies in this sector could cause market crashes and corrections. Markets are highly risk averse, and people simply bailing out their money before a big hit could start some major market declines.
• Lenders could face serious losses, reducing the amount of capital available for loans. That includes loans outside China, another imponderable for its effects on global markets.
What does this say about the Chinese bonds and wider financial market?
It’s hard to tell. There's a lot of stats, but the overall situation is almost totally opaque. Nobody's saying much. That the Chinese government will use any means necessary to deal with the problems is obvious. The response could be absolutely brutal. Any threat to the financial sector can expect severe consequences. How much damage will be done before it does step in is another matter, and the clock is definitely ticking. A lot of money could be lost before the alarm goes off.
A much more positive note
We may be about to see what China will do about it already. Interestingly, China has just started the trading of mature defaulted bonds on state-owned platforms. This looks like good debt to asset management, and it’s also being used to “prevent malicious escape from debt”. Selling these defaulted bonds does make good sense as a working option for managing the debts and reassuring the market.
This opinion article was written by an independent writer. The opinions and views expressed herein are those of the author and are not necessarily intended to reflect those of DigitalJournal.com
More about Chinese bonds, China shadow banking, China bond defaults 2019, Chinese financial markets, Neoglory
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