Bad Chinese

By now, you’re probably aware that China is in a tough spot.

As I’m fond of saying, Beijing is trying to do the impossible: they’re trying to deleverage and releverage at the same time.

In a nutshell, China has to maintain the illusion that the economy is growing at a clip somewhere near 6.5% while figuring out a way to simultaneously curb bond market speculation, pop real estate bubbles, and cut deflationary excess capacity.

All of this is set against the backdrop of a decidedly difficult currency devaluation that needs to be fast enough and deep enough to prop up the export-driven economy, but slow enough and shallow enough to avoid exacerbating capital flight.

Throw Donald Trump and Peter Navarro into the mix and the Politburo has a truly Herculean task on its hands.

One of the consequences of curbing excess capacity is defaults. Indeed, allowing SOEs to fail is part and parcel of a wider effort to show the world that China is moving towards a more market-oriented economy. But this is a slow process. Chinese banks are sitting atop an untold amount of bad debt and their exposure to overcapacity sectors is effectively impossible to estimate given the rampant use of off balance sheet vehicles to extend credit to borrowers that have lost access to traditional channels.

You’ll recall that the PBoC began to tighten money market rates in late November in order to purge excessive leverage. Unfortunately for China, that tightening coincided with rising US bond yields and an ill-timed spate of fraud revelations on entrusted bond deals. The stage was thus set for a sell-off in the country’s government bond market. In mid-December, yields on Chinese 10Y govies soared the most on record and trading in some futures contracts was suspended. Ultimately, Beijing was forced to drop its preference for longer tenor liquidity ops in the interest of getting the market back on its feet.

The point is, there’s a whole lot going on here and none of it bodes well for default rates. Unless China quickly flip flops and begins to express a preference for growth versus a preference for financial stability (which doesn’t appear likely given this month’s repo rate hike), you can expect default rates to rise going forward.

With all of that in mind, consider the following color out Sunday evening from BofAML.

Via BofAML

Onshore corporate default more than tripled in value from CNY12bn in 2015 to CNY40bn last year. Despite an increase in credit events over the last two years, the default rate for China (0.6% as a percentage of total corporate issuers for 2016) is still far less than that of other regions. We expect the trend to continue with increasing defaults in quantity and diversity, which we think will improve market differentiation of credit quality. Sectors with overcapacity will likely continue to be under pressure and state owned enterprise (SOE) supply side reform may result in further SOE defaults, while local government financing vehicles (LGFVs) will be at lower risk, in our view.

Looking at the monthly default trend last year, we saw two major waves of defaults: the first one was from February to May, and the second one was from November to December. The first wave was concentrated in sectors with overcapacity, such as metals/mining, which were under operating pressure; the second wave was also influenced by tight liquidity in the onshore market as the rates sell-off caused larger than-expected market reactions. The number of defaults, corporate bond yield and primary market new issuance cancellations were highly correlated, which suggests to us that the rise in defaults influenced market sentiment, which triggered a sell-off, drove up the corporate bond yield and impacted primary market issuance. AAA/AA enterprise bond spreads to government rose 45bp/37bp during the first wave and 76bp/79bp in second period from trough to peak, respectively. The rise in corporate bond yield/spreads likely discouraged corporates from issuing bonds given higher issuing costs and tighter market liquidity with weak market sentiment.

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Looking at bond defaults by deal type during 2016, we see an increased proportion of public bond defaults vs 2014 and 2015, when the majority of defaults came from private placement. Issuers endeavor to prevent their public bonds from defaulting, as this has a greater impact on their brand names and also causes increased volatility in the market. But as defaults became more frequent and market driven, we saw more public bonds defaults and weaker local and even central SOE defaults in 2016. The first SOE default happened in 2015, followed by two central SOE and seven local SOE defaults in 2016, as governments have become more willing to let weaker sectors in SOEs default as SOE reform forms the basis for successful deleveraging.

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