Chaori Solar, which is based in Shanghai and listed in Shenzhen, is missing a coupon payment this month, marking the first domestic bond default in China’s modern economy. How big a deal is this?
It is a big deal in the sense that Beijing is allowing defaults on coupon payments. It comes after some trust companies got into trouble earlier. Huaxia Trust in early 2013 and China Credit Trust and Jilin Trust more recently have defaulted on part of their interest coupon payments.
It is a big deal as it shows that Beijing is finally exiting from the “implicit guarantee” policy, which has created serious incentive problems and moral hazard in China’s capital markets and distorted credit pricing.
It is a big deal because exiting “implicit guarantee” is structural positive for financial reform in China.
Some investors are wondering if there is going to be any systemic fallout. No, systemic risk stemming from the Chaori coupon default will be unlikely because 1) it is not a default on principal (which will come due in 2017), 2) it is not a large company with systemic impact, and 3) Beijing is not exiting “implicit guarantee” swiftly and suddenly.
If there is any unexpected negative shock arising from this event, Beijing will still likely come in with a bailout, as it did in January to prevent a default on principal by the China Credit Trust product. This should help prevent a confidence crisis from causing contagion in the system.
Is this the start of waves of default in China? Yes, but don’t panic.
The risk of default is rising as a confident leadership under President Xi is moving to exit “implicit guarantee”. The point is that allowing defaults to happen is a necessary step to reform China’s financial system by allowing the market to estimate and price the probability of default. With no default in the domestic bond market under the “implicit guarantee” policy, China’s credit risk has been seriously mispriced.
We should expect more defaults coming from the small players in the industries that are suffering from inefficiency and excess capacity. In a nutshell, this event marks a shift in China economic and policy paradigm towards market discipline.
So the implication from this credit event is really short-term pain for long-term gain. Beijing’s reform strategy is to engineer an orderly clean-up of the bad debts in the system. It is unlikely to allow any large players, including local governments, SOEs, banks and large private firms which have systemic effect, to default in the short term. Debt and wealth management products exposed to industries with excess capacity, such as coal, steel and solar, are facing increased default risk amid slowing economic growth and tighter liquidity environment.
Then, what is the market impact of the Chaori event? Overall, the market’s reaction has been calm. A-shares fell slightly on the day when the Chaori news broke but then recovered the next day. Interbank rates have not shown any stress at all. If anything, they have kept falling since the news due to fund injection by the People’s Bank of China. The central bank’s two liquidity management tools – Short-term Liquidity Operation (SLO) and Standing Lending Facility (SLF) – should act as a backstop to prevent any financial seizure.
However, this credit event (together the other recent ones) will certainly increase risk aversion and drive up low-grade bond yields. Overall, small defaults may even lower interest rates and yields on high quality debt, such as bonds issued by the central government, policy banks and SOEs, as investors run for safety. Hence, the spread between high-yield (risky) and high-grade (safe) bonds is expected to rise.
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