PRC 'Bear Stearns Moment': 1st Local Bond Default

They built 'em; buyers didn't come

Chinese businesses have acquired a reputation for being protected by the national or local government in the absence of true "market discipline." That is, they may even be chronic money losers, but they are continually fed cash infusions in the hope that they will eventually turn the corner. However, with new PRC policies coming in spelling the end to subsidized credit, energy and so forth, Beijing has decided to make Chinese firms face the rigors of domestic and international competition. Hence its first impending domestic commercial bond default.

It will come as a surprise to no one following international business that the casualty will be a solar panel maker. These manufacturers have been given generous government supports in the expectation that solar energy will be a growth market of the future. Unfortunately, this scenario has yet to pan out. What's more, the Chinese government is under pressure from the EU and US (among others) for allegedly dumping solar panels. To be sure, the Chinese have also made counter-challenges: following the back-and-forth legal wrangling gives me a frickin' headache.

At any rate, the stay of execution has not been forthcoming for Chaori--the first PRC victim in a solar bloodbath as price wars take their toll from Europe to Asia:

China's first domestic bond default looked set to occur as expected on Friday as there was no sign of a last-minute bailout for solar equipment producer Chaori Solar, an event seen as a landmark for market discipline in the world's second-largest economy.

The loss-making Shanghai Chaori Solar Energy Science and Technology Co Ltd (002506.SZ) warned this week it could only pay out less than five percent of the 89 million yuan ($14.5 million) in interest due on 1 billion yuan worth of bonds issued in 2012.

After a series of near misses in recent years, in which local governments stepped in at the last minute to rescue local champions, analysts say the precedent-setting default is likely to force a re-pricing of credit risk in a market that long assumed even high-yielding debt carried an implicit state guarantee.

"The Chaori default goes to show the government will begin to let the market decide the fate of weak borrowers. This test case indicates the government is addressing the moral hazard issue," said Christopher Lee, managing director of corporate ratings for Greater China at Standard & Poor's in Hong Kong.

So, the implicit bailout has been rolled back. Chaori may be the first demonstration, but don't be surprised if others follow:

Such an adjustment appears well-justified, as analysts expect more defaults on loans, bonds and shadow-bank credit this year. Local governments and firms in industries suffering from overcapacity are the focus of concern.

Last month, a high-yield investment product issued by Jilin Province Trust Co Ltd and backed by high-interest loans to a struggling coal producer failed to repay investors on maturity. Ratings agency Standard & Poor's estimates overall debt in China reached 213 percent of GDP last year, up sharply from 140 percent in 2007. Corporate debt comprises the bulk of this total.

There is nothing wrong with borrowing per se--unless there is significant overcapacity in the borrowers' industries and (unwarranted) expectations that Uncle Mao will bail you out each time you get into trouble. For a lot of Chinese companies nowadays, both unfortunately hold. With some exaggeration, Bloomberg suggests this may be the "Bear Stearns moment" for Chinese credit, after which lenders become far warier:

This could be China’s “Bear Stearns moment,” strategists at Bank of America Corp. said earlier this week, and may prompt investors to reassess credit risks as they did after the troubled U.S. lender was sold to JPMorgan Chase & Co. in March of 2008. Six months later, Lehman Brothers Holdings Inc. collapsed in the biggest bankruptcy in U.S. history.

“This will likely be the first of many defaults, although I don’t think it’s going to cause a cascading effect in the bond market,” said Brian Coulton, a global emerging-market strategist in London at Legal & General Investment Management, which manages some 450 billion pounds ($753 billion) globally. “Short term, we’re likely to see higher bond yields but in the long term, this will create a better market for pricing credit risk.”

The yield on five-year AA- notes rose eight basis points to 7.77 percent on March 5, the most in almost four months. Yields rose a further five basis points to 7.82 percent yesterday. Ratings of AA- or below in China are equivalent to non-investment grades globally, according to Haitong Securities Co.

Welcome to the (somewhat) rougher and tougher China. 

UPDATE 1: Marginal borrowers are canceling bond issuances in the wake of Chaori.

UPDATE 2: PRC yield spreads are (surprise!) widening.