The darkest day for China’s S$16.6 trillion bond market? It may be a sign of brightness

In China, every year, at Mid-Autumn Festival – when the moon is at its fullest and brightest – families would gather to feast and celebrate the end of the harvest season.

But for many investors this year, the revelry was short-lived. There was no harvest for the taking.

On Sept 25, China’s financial markets awoke from the long Mid-Autumn Festival holiday to two missed bond payments from apparel and accessories conglomerate Neoglory Holdings Group Co totalling 2.74 billion yuan (S$540 million).

These were joined by more non-payments from three other bond issuers, making it the largest number of defaults investors have seen in a single day – with some dubbing it the “darkest day” for China’s US$12 trillion (S$16.6 trillion) bond market.

Many are bracing themselves for worse yet to come, given that lenders to companies continue to hold on to huge amounts of debts relative to their assets.

After all, the blood spilled so far this year has been staggering.

A total of 24 companies, mostly private, have defaulted on 48 bonds worth 56.7 billion yuan in 2018, according to data compiled by Reuters. This is more than double the 26 billion yuan worth of defaults on 30 bond issues seen in all of 2017.

It is no surprise that investors are panicking over what appears to be a credit risk problem that is boiling over. But is there real cause for worry?

Look beyond the recent string of bond defaults, and you will see that China actually has the credit situation under control.

Understanding the context is key. The China of the past has never failed to bail out companies in trouble. In fact, it only suffered its first corporate bond default recently, in 2014.

As a result, many Chinese companies took on debts much bigger than themselves, driven by complacency and the knowledge that the Chinese government would step in with a safety net if and when things turn sour. Investors believed so as well.

But today’s China is a very different one. In the past year or so, China has embarked on a massive clean-up of its financial system, including moves to tighten credit and rein in a corporate debt boom that the International Monetary Fund has warned is “dangerous”.

And few realise that credit defaults actually account for just a tiny share of the non-financial corporate bond market in China.

It has also been noted that the 108 billion yuan worth of papers that Chinese companies have defaulted on since 2014 account for not even 0.5 per cent of China's corporate bond market.

By allowing defaults in the bond market to take place, albeit in a controlled manner, the government is sending a very strong message out to corporates, investors, and credit ratings firms alike: Do your due diligence. And if you fail to do so, don’t expect a free pass out of trouble.

More importantly, to the wider financial community, China is showing that it is taking real steps to open up and move towards international market norms – at a time when an increasingly inward-looking United States is closing its doors to trade.

Sweeping change is already taking place.

In June, market index provider MSCI added more than 200 China A-shares (shares of companies based in mainland China that were historically only traded by mainland citizens) to its global and regional indices. The long-awaited move is marks a significant change, because it means foreign funds can now flow into China.

At the same time, foreign businesses, particularly those in once-restricted industries such as healthcare and automotive, are no longer required to team up with local partners in joint ventures in order to set up a presence in China.

Going back to the financial services industry, ratings giant S&P Global, for instance, has said it plans to start a new entity for its business in China. Such a move would spell good news for global investors in search of more reliable ratings, and boost China’s bonds market as a whole.

The government’s push for innovation is also ringing in early signs of success. In the retail scene, up-and-coming Beijing-based coffee start-up Luckin Coffee is posing a huge challenge to incumbent brand Starbucks, having sold five million cups in the four months since it began soft operations earlier this year.

It is said to have been part of a US$200 to US$300 million Series A funding round in June that values the company at more than US$1 billion.

Elsewhere, Shanghai-based e-commerce start-up Pinduoduo clocked another milestone in its meteoric rise when it went public on the Nasdaq in a US$1.6 billion initial public offering in July, while YouHaoDongXi (The Good Stuff) has raised US$70 million as a two-year-old company.

The turbulence that typically accompanies Chinese stock markets may continue, but one thing is clear: efforts to ensure there is stronger financial accountability and broader market access are well under way, which will strengthen the country’s economic foundation.

In addition, the current low market valuations should also spell a window of opportunity for the well-informed investor.

In taking new and giant leaps towards global market norms and opening its doors to the rest of the world, China is clearly taking change seriously. And it is high time that investors do the same too.

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