China’s First Onshore Bond Default: A New Precedent

While the default of Shanghai Chaori sets a new precedent for the bailout of mainland firms by the PRC, claims that the default may precipitate ‘China’s Lehman moment’ miss the big picture. Rather, the Chaori default is likely the first step towards the PRC’s adoption of a more selective bailout strategy.

Op-Ed CommentaryShawn Greene

Last Friday, the solar cell producer Shanghai Chaori Solar Energy Science & Technology became the first Chinese company in the PRC’s history to default on a domestic corporate bond after failing to make an RMB89.8 million (US$14.7 million) interest payment.

After establishing a strong precedent for keeping risky borrowers afloat via bailouts and debt extensions, the decision by the Chinese government to allow Chaori to default during the annual meeting of the National People’s Congress signals a fundamental shift in the PRC’s approach to mainland corporate debt.

With Haitong Securities estimating that RMB5.3 trillion (US$862 million) in trust products will come due this year (a large portion of China’s US$1.4 trillion corporate bond market), investors and financial analysts are understandably concerned by the PRC’s decision to signal the end of its unconditional bailout policy through Chaori’s default.

Before the firm’s default last week, Bank of America Merrill Lynch issued a research note warning that a default by Chaori could precipitate China’s ‘Bear Stearns moment’ (a reference to the 2008 failure that helped ignite the global financial crisis) and potentially trigger a chain reaction of capital flight and more defaults:

“If a default indeed occurs (especially on principal), we believe that the market will have reached the Bear Stearns stage (when the market started to seriously re-assess subprime debt risk). We doubt that the financial system in China will experience a liquidity crunch immediately because of this default but we think the chain reaction will probably start. In the U.S., it took about a year to reach the Lehman stage when the market panicked and the shadow banking sector froze. We assess that it may take less time in China as the market is less transparent.”

While BoA Merrill Lynch raises a valid point, their analysis fails to acknowledge the near-inevitability of Chaori’s landmark default, and the harsh reality that the PRC’s unconditional policy of keeping risky borrowers afloat could not continue indefinitely.

A key point to keep in mind is that Chaori’s default should be not be viewed as anything more than a test case for the time being.

After teetering on the brink of default for more than three years, Chaori is a perfect low-risk test case for a scaling back of the PRC’s bailout policy. The firm’s inability to pay more than five percent of its US$14.7 million interest last week comes after Chaori narrowly avoided a default in January 2013 – when the Shanghai municipality pressured local banks not to demand loan payments, thereby enabling the firm to pay interest on a five-year, one billion RMB bond.

This time around, however, the firm was hapless enough to allow its default to coincide with the annual meeting of the National People’s Congress – the first meeting of China’s legislature since Xi Jinping’s Third Plenum named the “decisive” (决定性) role of market forces in resource allocation as a core principle of the PRC’s economic reform strategy.

“Whenever a default becomes possible, there’s always either the government or a bank stepping in to coordinate a debt restructuring. There still isn’t a normal, market-oriented bond default system distorting the financial market’s risk allocation functions,” Liu Mingkang, former Chairman of the China Banking Regulator Commission, said to a session of the Chinese People’s Political Consultative Conference (CPPCC) in Beijing last Friday.

Mei Xingbao, an external supervisor at the Bank of China, echoed these sentiments on the CPPCC’s sidelines. “We need to be more accepting and allow defaults to happen. The debtor must be responsible for his own debt. He must tell the investors that there is risk involved in the product.”

If we accept the Chaori default as a test case for the adoption of a more “market-oriented” bond default system by the PRC, it is fair to say that the experiment has been a success thus far. Following the default, the CSI 300 Index closed just 0.24 percent lower, and the firm’s Vice President announced the company would begin selling its overseas plants to raise the money needed to repay the debt.

But what will the PRC’s new bond default system look like?

Despite BoA Merrill Lynch’s fatalistic assessment, it is unlikely that the PRC’s new approach will involve the government discontinuing the practice of providing bailouts and debt extensions outright. Rather, a selective approach to bond defaults is significantly more likely.

Since the 2007 financial crisis, the number of publicly traded non-financial Chinese companies with poor debt-to-equity ratios (ratios exceeding 200 percent) has increased by 57 percent, with China’s corporate bond market surging from only RMB800 million at the end of 2007 to RMB8.7 trillion in January 2014. While the PRC’s policy of implicitly guaranteeing corporate bonds has attracted a flood of investment in recent years, many investors have adopted a strategy of blindly chasing bonds with the highest coupons regardless of the issuer’s creditworthiness.

While this influx in investment ultimately helped fuel the nation’s rapid growth, to label the continuation of China’s bond default system “unsustainable” would be a gross understatement. With Chinese corporate debt on track to overtake America’s later this year, there isn’t enough money in the world – much less China – to bail everything out.

Although the PRC is in a significantly better position than Western governments to prevent a collapse of the nation’s financial system, China’s slowing economy has subtly reminded the nation’s leadership that a policy of unconditional bailouts cannot continue forever.

With this in mind, the PRC’s decision to allow Chaori’s default is likely the first step towards the adoption of a selective bailout approach to bond default. Although it will be impossible to know exactly what China’s new bond default system will look like until another mainland firm is pushed to the brink of default, it is safe to assume the government will favor a selective bailout strategy that will avert a ‘chain reaction’ of capital flight and defaults while carefully introducing the concept of risk into the nation’s bond market.

If the Middle Kingdom has learned anything from watching the West struggle to contain the fallout from the 2007 financial crisis, its new bond bailout system will take this selective middle path.

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