Finance sector reforms put the squeeze on China's zombie firms

March 06, 2019 16:08
Real estate sector is expected o remain a key driver of China's economy. Photo: Reuters

At a time when the Chinese economy is slowing and trade tensions remain with the United States, the rise in corporate bond defaults can be interpreted as a further signal to exercise extreme caution when investing in Chinese companies.

While both domestic and offshore bond defaults did pick up in 2018 , we would argue that it points to a Chinese economy that is becoming more market-oriented, with a government less inclined to bail out failing companies that have been kept on life support for too long. Financial sector reforms, particularly the reining in of shadow banking activities, have made it much more difficult for over-indebted companies to refinance existing bond obligations. In our view, this can only be a positive development, when you consider the percentage of high yield bonds rated B+ or lower surged to 53 percent of all issuance in 2017 – a potentially destabilizing factor for China’s economy.

Against this background, when choosing where to invest, we place great stock on companies that offer good levels of transparency and proper corporate governance. It avoids the risk of ‘nasty’ surprises further down the line.

For this reason, there are some sectors we tend to avoid: it is, for instance, very difficult to know what Chinese asset managers hold on their balance sheets. Financial statements are published at best every six months, sometimes less frequently. In other words, you don’t know what’s under the hood. I’m also cautious on Chinese industrial firms, especially ones where the state is a majority shareholder, and has the power to impose political priorities over economic ones.

While bonds issued by such companies often have investment-grade status because there is implicit backing from the state, they may not properly reflect the health of the business. A similar situation arises with local government financing vehicles – entities created to fund major infrastructure projects. There around 2,000 of them, many of which are rated investment-grade because of government support ; there are however real question marks as to whether the Chinese authorities could bail out all of them were the economy to find itself suddenly under extreme pressure. In this light, investment-grade status does not seem like a guarantee at all.

Of the sectors we do favor, real estate is high on our list. As we hold the view that the Chinese authorities have enough fiscal and monetary tools at their disposal to manage a natural slowdown in the economy’s cycle, so real estate developers remain attractive; they are, and are likely to remain, a key driver of growth, and it is noticeable that the sector has always received support in times when the economy has slowed.

That is not to say we are being reckless. Our focus is only on the very largest developers that have a proven track record, strong financials and have a diversified portfolio of properties. Smaller real estate companies are likely to struggle with financing under the tighter lending conditions now in place, making it harder for them to build and grow their land banks while making them vulnerable to sector consolidation. Furthermore, we make it our business to visit China on a regular basis and meet the developers in which we are invested; it allows us to get a better understanding of their sales momentum, and whether they are on target to meet their objectives.

There is always the possibility that government measures to stimulate the economy fail to do their job and China experiences a ‘hard landing’ with growth grinding to a halt. While it is not our view, it is vital to hold companies that have true investment-grade status – ones that don’t rely on government support for their rating, that are champions in their sector and have an edge on their competitors. China’s technology sector has a number of companies with this type of profile. These are the companies, in our view, that will outperform whatever the market conditions.

When considering the outlook for China, it is impossible not to address the country’s current conflict with the US over trade. On this point, we are relatively optimistic that the two trading giants can come to an agreement and the markets certainly seem to think so. Since November, the renminbi has been strengthening against the US dollar in part on rising expectations that March 1 will not see Donald Trump increasing tariffs from 15 percent to 25 percent on US$200 billion worth of Chinese goods. The US president has announced the extension of tariff deadline, suggesting negotiations between the two parties has been constructive, even if a little tricky.

While we will continue to remain vigilant on the rate of corporate bond defaults, we believe Chinese companies with good corporate governance, healthy balance sheets and operating in sectors where they hold a competitive edge, should continue to attract credit investors even as the pace of economic growth in China continues to slow.

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Fund Manager, Fixed Income at Jupiter Asset Management