The Huarong Message

Chinese equities kicked off the new week with what may as well have been the best session of 2021. The CSI 300 rose nearly 2.5%.

That’s notable because at least part of the optimism was tied to comments from the China Banking and Insurance Regulatory Commission, which late last week attempted to reassure the market amid what it’s fair to call acute concerns over China Huarong Asset Management. Huarong, which is saddled with more than $40 billion in local and offshore debt, is the latest obsession for the financial media, which spends every, single day in search of the next calamity.

Huarong is important. But more so as a conduit for Beijing’s moral hazard messaging than for any systemic risk it might pose. I mentioned this to a reader, over email, on Sunday evening. It seems exceptionally unlikely (to me anyway) that Beijing is eager to add “credit crisis at state-linked bad debt manager” to a list of problems that currently includes international ire over what’s been formally declared genocide in Xinjiang, rumors that Xi may have designs on giving Taiwan the Hong Kong treatment and, relatedly, deteriorating relations with Washington.

It’s obviously true that Beijing is keen to dispel the notion that all state-linked enterprises are immune from financial distress and enjoy an unconditional (if tacit) guarantee. I mentioned this last week, but according to Fitch, nearly three quarters of onshore defaults in 2021 are tied to SOEs. The figure for all of 2020 was more than half. In 2019, it was a mere 9%.

But telegraphing a high-level rethink around the scope of implicit guarantees for SOEs is something different from sitting idly by as a catastrophe unfolds.

Reports that Beijing was considering transferring the Finance Ministry’s stake in Huarong to Huijin (which operates within the sovereign wealth fund and is overseen directly by the State Council) seemed to suggest that bankruptcy or any kind of credit event that might be unduly destabilizing is viewed with trepidation by the Party.

When you think about the risk associated with Huarong, it’s important to remind yourself that the fate of obligations held by overseas investors isn’t in the hands of some mercurial, jealous cabal of market gods. Rather, it’s in the hands of the Party. Last week, Bloomberg wrote that the “burning questions” for investors are,

Will the Chinese government stand behind $23.2 billion that Lai borrowed on overseas markets — or will international bond investors have to swallow losses? Are key state-owned enterprises like Huarong still too big to fail, as global finance has long assumed – or will these companies be allowed to stumble, just like anyone else?

The implication is that this isn’t really a market matter at all. It’s a political matter. The reference to Lai was, of course, to Huarong’s former chairman, Lai Xiaomin, who was executed earlier this year “on a cold Friday morning in Tianjin.”

Lai was charged with bribery in connection with some $278 million in purportedly illicit payments over a decade, a time period during which he also served as a senior banking regulator. The international media called the sentence “unusually harsh,” even as some locals suggested the punishment would be greeted favorably by many lower- and middle-income Chinese.

“China employs the death penalty widely…. but its use for crimes like embezzlement, bribery and corruption has dropped in recent years amid public disapproval,” the Times wrote in January, on the way to quoting Joshua Rosenzweig, deputy regional director for East and Southeast Asia at Amnesty International, who said “a lot of the messages that the Chinese authorities try to send with these judgments, you are meant to fill in the blanks and come to your own conclusions.”

Irrespective of how corrupt Lai was, some outside observers viewed his execution with alarm — a kind of Superbad liquor aisle incident (“You f—in’ killed her!”). Human Rights Watch, for example, called it “a major step backwards” for China. “Imposing the death sentence on Lai for financial crimes, such as bribe taking, is outrageous and clearly violates China’s commitments to respect international human rights standards,” the group’s deputy director for Asia told the BBC.

Having already killed the man who presided over Huarong’s financial adventures outside its original mandate, is Xi likely to execute the company itself?

I don’t know, but I doubt it. And analysts do too. While ambiguity may linger around a possible restructuring, Standard Chartered’s Shankar Narayanaswamy now suggests being overweight Huarong’s bonds, on the assumption that debt service payments will be made. Should a restructuring occur in the offshore unit, recovery values on an NPV basis are “likely to be above current prices.” Plus, half of Huarong International’s book is linked to the parent, where any kind of serious credit event is “highly unlikely.” For its part, Nomura said “the narrative has improved substantially,” even as the outlook for Huarong International is cloudy. CLSA said a “study of past resolutions of troubled financial institutions shows the main [resolution] methods… are regulatory takeover and direct recapatalization.” That’s especially true for systemically important institutions.

What does all this mean for everyday people? Well, nothing, if by “everyday people” you mean folks who aren’t market participants or are otherwise uninterested in the daily to-and-fro. For investors, it’s just another reminder that people don’t bet on market outcomes anymore. They bet on likely policy outcomes. In many cases, that means running through the political calculus.

This story will evolve precisely according to communications from Beijing. If Chinese officials really wanted to, they could end the speculation with a single, unequivocal statement of support. The prolonged radio silence last week suggested they wanted to use this as an opportunity to send a message — or two, or three. Bloomberg’s Sofia Horta e Costa summed up those messages on Monday:

To SOEs: This is what can happen if you don’t put the state above profit (or reckless desire). To international bondholders: Don’t expect the state to bail out firms that were irresponsible. More broadly: Moral hazard is real… After last week’s panic in credit markets, it seems the central government now views its lesson to markets as effective, and the company’s bonds are rebounding.

Ultimately, the chances of Xi allowing a catastrophic credit event at a time when the world is laser-focused on everything from Taiwan to Xinjiang to trade to the origins of COVID, seem low. I seriously doubt the Party wants to add “credit crisis” to an ever-expanding list of problems.

It’s obviously true they’re more wary of moral hazard now than ever before. But it seems far-fetched to believe that Xi is going to knowingly countenance a financial catastrophe.