Reality Check: Looking Behind the Headlines of the Recent China Defaults

Over the past several weeks, a handful of Chinese state-owned enterprises (SOEs) defaulted on their onshore debt commitments, sending shockwaves through China’s onshore debt markets. Despite the volatility, we do not believe the situation presents a systemic risk to the broader Asian high yield bond market. Here, we recap what happened and explain why we believe the correction was based on market fears instead of a real surge in credit events.

The defaults that triggered it all

The situation started with the default of Brilliance Auto, an SOE also known as the Huachen Automotive Group, in late October. Market fears picked up steam when Yongcheng Coal & Electricity Holding Group Co. defaulted on November 10. Rumors that the enterprise had transferred valuable assets ahead of the default left bondholders concerned about recovery value. Finally, Tsinghua Unigroup, a large chipmaker partially owned by Tsinghua University under China’s Ministry of Education, defaulted on small-sized bonds valued at CNY 1.3 billion on November 18.

As a result, liquidity dropped for weaker SOEs, particularly in economically weaker provinces. Funding costs rose for AA+ credit, considered speculative grade in China’s onshore bond market. Spreads widened in the three-year AA+ segment of the market, which generally contains the weakest SOEs. The largest movements were concentrated in the defaulted bonds and bonds of entities with a perceived weak government link or headline-driven nature, representing less than 0.5% of the entire market. Spreads in the five-year AA+ segment were relatively stable as it is a much smaller part of the market and investors in this longer-maturity segment tend to be stickier.

China’s onshore bond market experienced a large shift in the number of defaults in 2018. The number of defaults soared from 34 in 2017 to 125 in 2018, and has stayed above 100 each year since then. Because defaults on this scale are a relatively new phenomenon in this market, market participants are still gaining an understanding of the legal framework and steps involved with defaults and debt restructuring. As a result, defaults in segments of the bond market that are perceived as different from historical defaults tend to cause market panic.

After observing the market reaction, the Chinese government took swift, decisive action to contain the market impact. The State Council Financial Stability Development Committee, chaired by Vice Premier Liu He, met about two weeks after the Yongcheng Coal event on November 21 to regulate bond market development and help maintain bond market stability. The government also implemented a fraud probe of Yongcheng Coal, and expanded the inquiry to include banks, rating agencies and accounting firms. Furthermore, Yongcheng Coal has now agreed to pay back 50% of the bond proceeds and return the rest within 270 days. We believe this action signals to the market that the Chinese authorities will step in to regulate fraudulent activities.