Who’s Afraid Of The ‘Dandong’? ‘The Real Market Is Coming Out’ In China

Folks are defaulting in China.

Specifically, Dandong Port Group Co. missed a payment on some of its local currency bonds on Monday. Apparently, Dandong sold CNY1 billion of five-year notes three years ago at 5.86% with an option for investors to sell them back to the company early.

Unsurprisingly, everyone exercised that option and Dandong says they weren’t able to pay back the entire principal. They did pay CNY58.6 million in interest earlier this week, according to a statement.

Obviously, this is notable in the context of China’s massive corporate debt burden and Beijing’s ongoing effort to deleverage the economy. Here are some reasons why you shouldn’t be concerned (we’ll give you the “good” news first), as delineated by Bloomberg’s Anchalee Worrachate who admits up front that “default is never going to be good news” in a country where the debt-to-GDP ratio is 259%:

• The default rate hasn’t increased from last year. Twenty onshore bonds have defaulted this year, compared with 21 in the same period last year, according to Bloomberg data.
• The economy, while slowing, is still growing at a decent pace. Defaults are driven partly by the official deleveraging campaign, making it more expensive to borrow.
• China has in recent months stepped up cash injections in times of liquidity tightness. It seems the government probably knows what needs doing.
• Credible risk assessment is an important ingredient of any efficient bond market. China is working to deepen its local bond market, and allowing companies to default will help to speed that up.

So you can take comfort in that if you like, but this default is interesting to the extent it appears to have geopolitical implications.

Dandong manages the largest Chinese port trading with North Korea. Here’s SCMP:

Relations between Beijing and Pyongyang have soured, with China under pressure from countries including the United States to do more to rein in North Korea’s nuclear weapons ambitions. The port of Dandong has been particularly hard hit by Beijing’s move to ban imports of coal, textiles and seafood — and cut off oil shipments to the isolated regime — in line with UN Security Council sanctions.

Until the bans, one thriving business at the port was imports of anthracite — a type of coal that burns with little flame and smoke — from North Korea. The country became China’s biggest source of anthracite in 2013, beating Vietnam, and the following year the coal became China’s No 1 import from North Korea.

Business had slowed after Beijing stopped North Korean boats transporting coal from docking at the Dandong port at the end of 2015. China then halted all coal imports from North Korea in August.

The port group was founded in 2005 by four Hong Kong-based companies. It is indirectly controlled by local firm China Rilin Construction Group. Rilin chairman Wang Wenliang was one of 45 members expelled from the National People’s Congress, China’s legislature, in a vote-buying scandal last year.

It said in a half-year bond report released in August that the bond was “normal” but did not rule out the possibility of being unable to repay it as the company’s overall debt level remained high.

Some 76 per cent of the company was financed by debt by the end of June, according to the report. Of its total debt of 37.1 billion yuan, close to half would be due within one year.

“As the port’s economic situation weakens, throughput has also fallen,” the report said. “At the same time, our logistics business has declined, eroding our revenue.”

And there’s more to the “Wang” story (when was there ever a “Wang” story that was only surface deep?). Here’s WSJ:

The company’s controlling shareholder, Wang Wenliang, was replaced as Dandong Port’s legal representative this August, although he remains in control of Dandong Port through two corporate entities, one of which is based in Hong Kong, according to company filings.

A fixture on lists of China’s wealthiest people, Mr. Wang has surfaced in separate scandals in China and the U.S. in recent years. He was one of several dozen deputies from Liaoning province expelled from China’s legislative body last year in a vote-buying scandal.

In the U.S., his political funding and other donations have also been scrutinized. His construction business Rilin Enterprises, for instance, gave $1 million to $5 million to the Clinton Foundation since its founding, according to records published by the organization co-founded by the former candidate Hillary Clinton. A spokeswoman for Mr. Wang put his total donations to the foundation around $2 million.

But backstory aside, you have to think about this in the context of rising yields in China and also in the context of the Party Congress now being in the rearview. “The real market is slowly coming out, after the congress,” Shen Meng, director at Beijing-based investment bank Chanson & Co. told the Journal, adding that “Dandong Group’s problems reflect the lackluster state of the whole Chinese economy and the northeast region.”

As we noted on Monday, one worry here is that rising sovereign yields will finally spill over into corporate bonds, which have thus far remained relatively resilient:

Average yields on AA- rated corporates rose 16bps in October, the largest increase since May. Here’s some color from a recent Goldman note:

At the current juncture, we maintain the view that the domestic bond default rate likely has bottomed in 2017, and that we will see more defaults in the coming years, as maintaining growth stability will likely be less important post the Party Congress. We believe the pick up in default rates will be gradual. Two things can derail that — either (1) global growth slows down, leading to less of a tailwind from exports, putting downward pressure on China growth and having a negative effect on corporate credit profiles, or (2) policymakers switch to more proactive stances towards SOE and local government financing reforms, thereby allowing more defaults to occur from state-related entities.

Whatever the case, this isn’t the best news and it’s something you want to keep a close eye on, especially in light of Zhou Xiaochuan’s recent dire-sounding warnings about corporate debt levels and worse, “Minsky” moments.