Moral hazards linger in Chinese bonds

IFR Asia 1033 - March 24, 2018
5 min read
Asia

A lack of concern for moral hazard in some corners of China’s debt markets has undoubtedly kept the printing press running over recent years. In fact, the ability of companies and local governments to avoid default and repeatedly raise funds has led many commentators to liken the onshore financial system to a gigantic ponzi scheme.

But is the will to eliminate — or at least water down — moral hazard about to make an appearance in China?

China’s shadow banking industry has enjoyed rampant growth for years, and the biggest beneficiaries have been local government financing vehicles (LGFVs), which have been able to raise more debt regardless of the tougher issuance standards in the conventional market.

LGFV issuance via special purpose vehicles grew at about an 25% annual rate in 2015, dialling down only slightly in 2016 to around 20%. It’s estimated that there is around US$600bn-equivalent of LGFV bonds outstanding.

There is a plan to swap the LGFV debt mountain into lower-yielding municipal bonds, in an exercise designed to reduce the interest burden on the products. Some of that exercise has been carried out, with short-term debt shifted into longer-duration munis.

Still, LGFV issuance has continued at the behest of local government officials desperate to keep up their own growth rates. And an increasing amount has made its way offshore, where buyers include been the clients of private banks in Asia, principally in Hong Kong and Singapore, who have been offered leverage by their relationship officers in order to book the paper.

THE FIRST LGFV default has yet to occur, but it seems that moment might not be too far off.

According to Fitch, the Chinese authorities will allow some of the lower-rated LGFVs to fail, while standing ready to prevent a systemic collapse through bailouts, should they be required. A kind of moral hazard with Chinese characteristics.

The exercise of allowing idiosyncratic default will require deft finessing, and China is one of the few countries with a chance of pulling it off.

Still, in the context of rising interest rates - the People’s Bank of China last week raised rates in the face of a 25bp tightening of the US Federal Funds rate - the strain of servicing the LGFV debt will become increasingly onerous with each successive Fed tightening.

Two more rate increases are expected this year, according to the market priming of neophyte Fed chair Jerome Powell. The futures market is pricing in three.

The smart money thinking is that it is offshore LGFV debt that will be sacrificed on the altar of moral hazard, while onshore investors will be taken care of should debt service failure loom.

THAT GLARING DICHOTOMY – between the offshore and the onshore – has hung like a sword of Damocles over China’s debt markets for years, but that hasn’t stopped the punters from queueing up for more and more of the stuff, often via the largesse of private banks or prime brokers and their leverage facilities.

The most salient lesson of the dangers of owning offshore Chinese debt came in 2009 with the restructuring of Asia Aluminum, which saw offshore debt holders get hosed to the benefit of onshore debt owners.

Offshore holders of the payment in kind paper issued by AA got 1.5 cents on the dollar while their onshore brethren in the form of Chinese banks faced no haircut on the secured loans they held with the company.

That kind of outcome has turned numerous international asset managers off the prospect of investing in China, full-stop. Many complain about the “black box” nature of Chinese investments, running from accounting standards, to corporate governance, to the pervasive grip of the Chinese authorities over the financial system.

Indeed, as a trade war with the US looms on the horizon, the fear is that China might turn to the capital markets in retaliation.

For years fearmongers have warned of the potential dumping of the PBOC’s Treasury bond holdings, but US investors are also worried of the application of selective default.

Sure, those fears look overdone for now, but it might become a much more realistic scenario in the event of a brutal trade war and an escalation of the rhetoric from both sides.

For the moment there has been no investor pushback on China assets, whether they be Panda bonds, US IPOs or Hillhouse Capital Management’s US$10bn China-focused fund. When it comes to local government debt, however, offshore investors would do well to be wary.

Jonathan Rogers_ifraweb
Jonathan Rogers