China’s Path to Free-Market Reforms: Default?

Default. A word no bond investor—and no issuer—wants to hear. In China, however, a default might just be music to global markets’ ears. You see, the country has never had an onshore corporate bond default—bailouts are the norm. But that tradition might end on Friday, and while it wouldn’t be great for the bondholders in question, it would signal the government is implementing market-based financial reforms—a key step in China’s ongoing development and one necessary for it to be a more global market force.

On Tuesday, Chinese solar company Shanghai Chaori Solar Energy Science and Technology announced it likely won’t make an 89.8 million yuan (roughly $14.6 million) interest payment due bondholders Friday. Historically, this would be the government’s cue to step in, order the state-run banks to front the cash, and guarantee the loans. Officials long considered financial rescues necessary to maintain a stable, orderly financial system, in turn necessary for political and social stability. This time, however, the government has kept mum, indicating they’ll allow the default to run its course. Bondholders held a protest outside a local government office in Shanghai to demand assistance, but so far, officials haven’t caved—per Chaori Solar’s board secretary, the government “is treating [the] debt crisis according to market rules.” If they hold firm, China will have its first-ever onshore corporate bond default.

The break with tradition shouldn’t surprise considering officials have long stated their intentions to transform China’s financial system from state-driven to market-based. Out with the government-mandated interest rates, capital controls, currency pegs and investment, and in with market-driven pricing and free-flowing capital—and in with a system where markets deal with default, failure and risk.

In a free market, bond yields are a function of risk—the higher the default risk, typically, the greater the compensation investors demand in exchange. So to get truly market-driven interest rates—as officials have pledged—markets need to be able to efficiently price the risk of all investments. If all bank and corporate debt comes with an implicit guarantee, the market can’t really do its job—the bank or company’s creditworthiness takes a back seat. It isn’t priced. If officials step back and allow markets to function like, well, markets, pricing becomes more efficient and markets more transparent.

This would promote a healthier corporate bond market. As investors pay more heed to companies’ creditworthiness, balance sheets and business plans, they’ll likely allocate capital more efficiently. As long as you have the government guarantee—as long as investors think they can count on officials to backstop their industry of choice—investors will throw good money after bad, not caring about corporate profitability and the likelihood the business gets an actual return on that investment. This robs healthier, more productive companies of investment—companies that would ultimately likely use that cash far more efficiently. Take the government out of the equation, and profitability becomes more important, and investors ultimately give stronger companies more capital so they can invest and grow, either incentivizing the weaker firms to get more competitive or languish. It would also likely foster better corporate governance and business planning—the risk of default makes for better corporate accountability.

At least, that’s the ideal. The system will take time to develop, and there will be hiccups along the way. Whether it happens also rests on officials having the resolve to allow defaults and failures. Even after pledging to enable markets to play a “decisive role” at their most recent party plenum, Communist Party leaders have forestalled defaults. One financial “wealth management product”—essentially a securitized package of trust-based loans—nearly defaulted in January, only to be saved at the last minute when the government persuaded strategic investors to step in and provide China Credit Trust Company 3 billion yuan, in an effort to tame jitters over a contagion in the shadow banking sector.

Contagion fears surround Chaori Solar, too. Some have likened the default (assuming it happens) to the two Bear Stearns hedge funds that collapsed in 2007, widely seen as the shot heard round the world in the global financial crisis. Misperceptions about 2007 aside, it seems a huge stretch to say one unprofitable solar firm’s default will trigger fire sales and “repricing” on the scale of the $2 trillion in asset writedowns in the US financial sector after mark-to-market rules forced firms to take paper losses on mortgage-backed debt. China’s markets will almost surely have to make some adjustments—interest rates are likely artificially low. Removing the government backstop would theoretically increase credit risk, causing investors to demand higher interest rates commensurate with creditworthiness.

But that doesn’t mean contagion. It’s not like every single corporate bond issue is threatened. And those that are troubled are likely well known, just as Chaori Solar’s financial troubles (as with much of the global solar community) aren’t breaking news.

If China follows through with this, in our view, it would be long-term positive. Historically, China’s markets haven’t reflected its economic dynamics. In a more market-driven system, over time, this should change—providing global investors more opportunities in the process.