Crumbling Credibility
A series of bond defaults by State-owned enterprises spread anxiety and distrust in the corporate bond market, signaling a need for more objective and dynamic ratings and stricter supervision
Recent bond defaults by top-rated State-owned enterprises have taken the China bond market by surprise. Brilliance Auto, a State-owned automaker and parent of BMW'S joint venture partner in China owned by the northeastern Liaoning provincial government, defaulted on a 1 billion yuan (US$153.2M) three-year bond due in October, even though in August it pledged to repay the bond on time. In November, Yongcheng Coal and Electricity Holding Group Co. Ltd, a State-owned coal mining company in central Henan Province, announced that it had defaulted on a 1 billion yuan (US$153.2M) commercial paper, an unsecured short-term debt instrument issued by corporations. Shortly after, Tsinghua Unigroup, a chipmaker backed by Tsinghua University in Beijing, also defaulted on a three-year bond totaling 1.3 billion yuan (US$199.2M).
The series of bond defaults by State-owned enterprises (SOE) that boast high credit ratings, which usually indicate a strong ability to repay debts, shocked the bond market in China where investors take governmentbacked enterprises for granted as a safe haven. It also set off chain reactions including the sell-off of bonds issued by coal companies and local SOES and the postponement of many other credit bonds (bonds issued based on a company's credibility). Chinese financial regulators are investigating these companies and the linked financial institutions and credit rating agencies.
Defaults are normal in a bond market even though it was rare for SOES in China until recent years, analysts noted, but what makes it abnormal is the transference of liquid assets of some companies before the defaults occurred. Brilliance Auto reportedly transferred its stake in Hong Kong-listed Brilliance China Automotive Holdings Ltd. to a subsidiary in September. Yongcheng Coal defaulted several weeks after issuing a midterm note and a week after transferring its stake in Zhongyuan Bank located in Henan (interpreted by many as quality assets) to two other local State-owned enterprises, which it later explained was for fundraising.
“These defaults will have greatly impacted the credit rating system and even cause turmoil in the corporate bond market as the companies in question are all [top] AAArated,” Wu Xiaoqiu, former vice president of the Renmin University of China and now director of the Finance and Securities Institute at the Beijing-based university, said in an interview with Newschina. The credit rating is crucial for companies, which are rated based on the ability to pay lenders. Wu believes that it is important to clarify whether the sudden spate of defaults is a natural result of market operations and strengthen information disclosure supervision.
Newschina: This is not the first time SOES have defaulted on bonds. Why has the market reacted so violently this time?
Wu Xiaoqiu: Bonds are risky assets and defaults are normal. In economic downturns, companies that perform poorly or have high financing costs but liquidity shortfalls [lack of cash to make repayments] are all at risk of bond defaults. But this series of defaults is so concerning because we saw abnormalities. For example, the credit ratings of these enterprises in question were all top-notch, and they had good cash flow and asset quality [covered by credit ratings as a core indicator to measure a company's ability to pay off debts]. But some companies transferred many of their high-quality assets [such as stocks and bonds] before the defaults, which are signs of trying to maliciously escape debts.
NC: Some worry that defaults by highrated enterprises might make credit bonds decrease in value as collateral, which is commonly used for financing, or cause liquidity
problems, making it harder for market participants to buy and sell, which will further impact the overall financial market.
WX: The worry makes sense because these enterprises are Aaa-rated and backed by local governments. Besides, these companies were not in bad financial shape, as they revealed previously. That's why they had the credibility to raise finance by issuing bonds. This round of defaults will first of all shock the credit rating system in China. If top-rated enterprises' bonds can't be trusted, then don't even mention those rated lower. Meanwhile, the defaults will jeopardize the credibility of local governments' financing platforms [mainly referring to municipal investment companies for city construction] and local SOES. It will also place the overall market on high alert or even lead to turmoil.
NC: But still, some hold that the crisis will help break investors' faith in SOES and in ‘rigid payment,' a situation in which investors can always count on principal redemptions and interest payment. What's your view on that?
WX: SOES are essentially limited liability companies [in which the owners or shareholders are not personally liable for the company's debts or liabilities]. Local governments finance but do not promise to guarantee a company with government credibility. It's on the right path to break the implicit government guarantees [that is believed to have caused distortions in the corporate bond market] for bonds issued by SOES, which is important to improve the bond market overall.
But breaking the faith in rigid payment ought to be a natural result of marketization, not a consequence of non-market activities. Otherwise, the market will be suspicious of malicious evasion of debts. The market is very sensitive and smart, and it will be able to discern if it's a case of escaping debts or a normal default.
As a matter of fact, the crisis this time is not about breaking rigid payment, a process that started several years ago [in 2014]. The problem is that these companies' financial conditions suddenly worsened and jumped into default, thus making people suspicious that non-market factors might be behind it.
NC: Why have there been so many defaults by SOES in recent years?
WX: That's partly due to economic downturns. Another reason is some local SOES, taking for granted that the government will bail them out, easily accumulate debts by borrowing more money or issuing more bonds than they are capable of paying off. Enterprises need to consider when they invest in projects if they will be profitable, how long before they see returns and whether they have enough cash flow when their bonds mature. It demands great financial management skills that many companies currently lack.
NC: What concerns bondholders most is debt evasion after a default. How could it affect the market?
WX: Malicious debt evasion is illegal, immoral and destructive to the market. It refers to a company's decision to deliberately transfer the risk [when sensing a possible default], which makes a default that otherwise might have been avoided a high probability event. Such behavior has great impact on the credibility of the whole corporate bond market and on investor confidence. In particular, it
undermines the credibility of local SOES and investment expectations for their bonds.
NC: What is core to pushing forward marketization and legalization of the bond market?
WX: The most important thing is real information disclosure. Companies should respect the facts and avoid making sudden structural adjustments or asset transfers to evade debts. Those who violate the rules should be punished. A company's financial condition does not change abruptly, so it is important to disclose information, particularly to bondholders, or let them see the risks via price fluctuations of bonds.
NC: Credit ratings for companies are the cornerstone of the corporate bond market. What can be done to foster an environment with objective and independent credit ratings?
WX: Credit ratings are the prerequisite for bond markets where the risks are omnipresent and the interest rate, offer price and trading price of bonds are all risk-based. Without timely, dynamic, unbiased and objective credit rating agencies and systems at the helm, the pricing will fail to reflect the true situation of the market, and it can lead to problems like defaults at any time. The thing is, we don't have a dynamic credit rating system yet. The current rating system has major shortcomings.
Besides, bond issuers must fulfill their obligations to disclose due information following market rules and regulations. In particular, malicious risk transfer should be prohibited. It will require improvements to the law. Meanwhile, stricter supervision should be put in place for bond issuance, bond trading and the disclosure of information.
Last but not least, strict and fair law enforcement is needed to make sure that any company [State- or privately-owned] will be punished for misconduct. Of course, investors also need to be very sensitive to risks. But if there are problems with information disclosure and credit ratings, investors have no way to know the risks.