Default of a Chinese Bond: Isolated event or the beginning of something bigger?

Default of one small solar company or one medium sized steel mill does not foretell an immediate collapse of the Chinese bond market. But it is a very clear warning of its direction

It finally happened. A Chinese domestic bond has defaulted. It was the first default since the Chinese central bank (PBOC) started regulating the market in 1997. The unlucky company was Shanghai Chaori Solar Energy Science and Technology (Chaori). The major question though is this a sign of healthy maturing market or the beginning of a major problem?


If you had to choose allow a bond to default, Chaori was certainly a prime candidate. First it is small. It has only 1,500 employees. Second it is a private company, not a large state owned firm. Third, it is in the struggling solar industry with substantial over capacity. Fourth, its issues were well known. Some sort of default was expected. Trading in the bonds was suspended last June. At that time they were trading at only 50% of their face value. The total issue is $160 million and the missed payment was only $15 million.


China’s premier Li Kequiang warned that Chaori was not the last. He said on 12th March last week that future defaults of financial products are “unavoidable”. He pointed out that allowing defaults was a natural part of the financial deregulation process. There is also the issue of moral hazard, which the authorities are trying to address. In essence if you don’t allow companies to default, the markets assumes that they will never take place. With the certainty that companies cannot go under, investors will continue to pour money into risky assets.


But that is not the only problem. The other part is that local governments simply cannot afford to bail companies out. They have their own problems. There are 388 financing arms of municipal authorities. They owe Rmb 9.7 trillion ($1.6 trillion) as of the middle of last year. Only 53% have enough cash to cover estimated debt and interest payments this year without refinancing.


Statistics published this week show a weakening economy. The numbers for industrial production, retail sales and urban fixed asset investment all badly missed forecasts. Industrial output slowed from 9.7% in December to just 8.6% the lowest reading since August 2009. Prices for iron ore and copper markets, usually barometers of the Chinese economy, have been dropping to new lows.


Much worse are the statistics for the real estate. Beijing’s new home sales for the month of February dropped 61% compared to the same period last year. Price acceleration in China’s biggest cities showed the first slowdown in a year.  Some hard up developers are beginning to discount prices by up to 40%.  Although the official news agency has denied it, banks are growing cautious about lending to developers especially those in smaller cities.  


The slowdown in real estate could be devastating. With the exception of a few experiments, there are no real estate taxes in China. Local governments depend on land sales for revenue. Revenue desperately needed to pay off debts. Income from land sales was Rmb 4.1 trillion ($.067 trillion) 33% of national income. The cost of land used to be only 20% of the cost of housing. To feed local coffers it has grown to 60%.  So as the real estate sector slows, so will the desire to bail out the bond market.


The problem with defaults is that you cannot have just one. The circumstances that lead to the first one have affected other companies as well. So as Li Kequiang warned, there will be other defaults. The muted reaction to the Chaori is supposed to be a positive, but it may encourage other defaults and there are a bunch of companies in line. Baoding Tianwei Baobian Electric is a company owned by central government. Its bond was just suspended from trading. Haixin Steel, a privately owned medium-sized mill in the heart of China’s coal country failed to repay loans that came due last week.


But this is China, so a default can have different ramifications. Haixin steel is part of a web of triangle debt. These are methods of providing financing between suppliers, manufacturers and customers. Each business provides the next business in the supply chain with credit. For example a coal company would sell the steel mill coal on credit. The steel mill would then sell its products onto a real estate developer also on credit. Then the companies would guarantee each other’s debt.


A recent example of how the collapse of one company can have a much broader impact occurred in 2012 near the eastern city of Hangzhou. When a single property developer collapsed, local governments and banks had to provide bridge loans to 62 different companies to keep them afloat.


The situation is made infinitely worse by the lack of information. The Chinese government’s need to restrict information creates its own set of problems. No one really knows how many of these agreements there are or with whom. So if one company goes under, no one is sure how many more it will take with it. Insolvent local governments won’t be able to provide the usual help. Without the government guarantees, investors may dump everything, the good along with the bad.


But it doesn’t end there. Most of the debt is held long term by the banks. Secondary trading is very thin. So there is virtually no market and no price discovery mechanism. Without liquidity markets can fall a long way.


Is this China’s Bear Stearns moment? Perhaps but what must be remembered about the collapse of Bear Stearns was that it had a very limited impact. Bear Stearns was once a highly respected investment bank in the US. It collapsed on 31 March 2008. It was subsequently bailed out by a loan from the Federal Reserve and a quick sale to another investment bank, JP Morgan. The important point about Bear Stearns is that the market totally ignored the lesson. A month after the collapse the market rose 4% before it continued its way down.


So the default of one small solar company or one medium sized steel mill does not foretell an immediate collapse of the Chinese bond market. But it is a very clear warning of its direction. It isn’t up.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)


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Sensex, Nifty may decline mid-week: Weekly closing report

Nifty will be in a downtrend if closes below 6,400


The Indian market broke the three weeks of positive closing. The BSE 30-share Sensex closed the week that ended on 14th March, at 21,809.80 (down 110 points or 0.50%), while the NSE’s 50-share Nifty closed at 6,504.20 (down 22 points or 0.34%) for the week.


On Monday, the uptrend on the benchmark paused on weak global data. The Nifty closed at its all time high of 6,537 (up 11 points or 0.16%). China’s exports in February fell 18.1% from a year earlier while the imports rose 10.1%, yielding a trade deficit of $23 billion ($25.4 billion) for the month versus a surplus of $32 billion in January and the inflation rate was 2% for February. On the other hand, Japan's economy expanded less than estimated in the fourth quarter and the current-account deficit widened to a record in January 2014.


On Tuesday, the market snapped the five days of upmove by closing in the negative. Nifty closed at 6,512 (down 25 points or 0.39%). The Indian government unveiled the trade data for February 2014. India's trade deficit narrowed to $8.13 billion in February 2014, from $14.12 billion in February 2013. Total imports declined 17.09% year-on-year in February 2014. Merchandise exports fell 3.67% year-on-year. The trade deficit for the 11-month period April 2013 to February 2014 narrowed to $128.08 billion, from $179.92 billion during the period from April 2012 to February 2013.


Against the negative closing of the US indices on Tuesday and the Asian indices on Wednesday, benchmarks back home managed to stay in the positive. Nifty closed at 6,517 (up 5 points or 0.08%) on Wednesday. In US, the Labor Department said that employers posted 3.9 million job openings in January, up 1.5% from December; however, the increase fell short of what the market was expecting.


The indices were pulled lower on Thursday on the negative performance of the software stocks. Infosys warned that its March quarter earnings will come at the lower end of guidance. However, the improved economic data (index of industrial production and inflation based on the consumer price index) helped reduce the weakness. Nifty closed at 6,493 (down 24 points or 0.37%).


Back home, the inflation based on the wholesale price index (WPI) eased to 4.68% in February 2014, lower-than-expected nine-month low. On the other hand, the weak economic data from China on Thursday made at least four investment banks lowering forecasts for China's 2014 economic expansion which affected market sentiments. Nifty closed at 6,504 (up 11 points or 0.17%).


The economy can grow an annual 5.2% in the quarter to end-March on higher farm output growth, the chairman of the Prime Minister's Economic Advisory Council said on Friday. C Rangarajan also said he foresees the economic growth to pick up to 5.5% to 6% in the fiscal year that begins on 1 April 2014.


For the week, among the other indices on the NSE, the top two performers were Realty (2%) and Infrastructure (1%) while the worst two performers were IT (6%) and Metal (4%).


Among the Nifty stocks, the top five stocks for the week were IDFC (9%); BPCL (6%); Kotak Mahindra Bank (6%); Hero MotoCorp (6%) and IndusInd Bank (5%) while the top five losers were Infosys (9%); Sesa Sterlite (8%); Tata Steel (8%); Hindalco Industries (8%) and Ranbaxy Laboratories (7%).


Of the 1,411 companies on the NSE, 578 companies closed in the green, 792 companies closed in the red while 41 companies closed flat.


Out of the 27 main sectors tracked by Moneylife, top five and the bottom five sectors for this week were:


ML Top sector


ML Worst sector




Software & IT Services


Real Estate






Non-Ferrous Metals




Farm & Farm Inputs








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