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The Man Who Bet on Chinese Debt

When Chen Yang was fresh out of university, China’s government rarely failed to protect lenders and borrowers. Today, Beijing is allowing the bond market to grow up, forcing Chen and others like him to become experts in credit analysis.

It was 2007, and China’s economy was expanding at a blistering 14 percent a year. At Nanjing University in eastern China, Chen Yang, a finance major, was a year away from graduation. Most of his classmates were streaming into banks and brokerages to take jobs tied to a stock market that was on fire. But at a campus recruitment presentation, an American fixed-income trader pointed Chen in a different direction: bonds.

He took the advice­­—and went on to ride a wave of debt growth that’s proved far bigger than he’d anticipated. From the equivalent of $1.7 trillion at the end of 2007, China’s bond market surged toward $13 trillion by the end of last year.

relates to The Man Who Bet on Chinese Debt

Yang in his Shanghai office. Photographer: Xyza Cruz Bacani for Bloomberg Markets

Now 37, Chen heads fixed-income investment at Shanghai Securities Co. “During the first few years of my trading career,” he says, “I would need my boss’s permission to do a trade over 30 million yuan [$4.5 million]. Now we very often do transactions of hundreds of millions of yuan.”

The boom in demand for borrowing came from all quarters, including state-owned enterprises, government authorities, and private-sector companies. And along the way, foreign investors have piled in: Since mid-2015 policymakers have steadily lowered barriers to entry in an effort to relieve pressure on the yuan’s exchange rate caused by wealthy Chinese moving money out of the country. 

Recently the market has been hit by record defaults, which are starting to reshape how debt is priced. In developed nations, it’s taken for granted that borrowers pay different rates based on their creditworthiness. In China, there was for years an implicit government guarantee on almost all borrowing, lest corporate failures trigger social unrest and endanger the stability of the whole system.

A decade ago bets on bonds were therefore bets on macroeconomics in China. If you thought the central bank was going to raise interest rates, you demanded higher yields and vice versa. Now, when it comes to corporate bonds, Chen says, “We really need to dig deep to reveal individual credit risks.”

Quicktake: Why China’s Bonds Are Defaulting at a Record Pace

The problem with the old template was massive moral hazard. After China unleashed a record wave of credit in late 2008 to combat the impact of the global crisis, policymakers grew alarmed at capital flowing to projects that proved to be of little economic use.

The shift in their attitudes became apparent over time, with a limited number of defaults starting in 2014. The authorities imposed increasingly stringent guidelines for the shadow banking industry. In 2018 borrowers reneged on a record 119.6 billion yuan—more than quadruple the tally for the previous year.

Unproductive, old-line industrial borrowers such as Dongbei Special Steel Group Co. have been among the casualties. Dongbei struggled in an industry hit by overcapacity and China’s slowing growth. The company started defaulting on a series of bonds in March 2016, not long after its chairman was found dead by hanging. The following year, when Dongbei agreed to a workout plan with creditors, it became the first Chinese company to make a deal to reduce principal owed. The haircut: up to 78 percent.

Dongbei was just one of dozens of companies to default on debts as President Xi Jinping and his government championed a reduction in leverage across the economy. When China’s regulators issued a joint statement in December calling for expedited debt disposals among so-called zombie borrowers, it was clear the campaign was far from over. Even so, it came as a surprise in February when Qinghai Provincial Investment Group Co., an aluminum producer, failed to make a coupon payment on a dollar bond on time despite being solidly backed by local authorities.

The message: Get ready for more stress this year.

After university, Chen figured joining a local company rather than a foreign bank would afford him greater opportunities for growth. He started out as one of four fixed-income traders at Bank of Communications Co., one of China’s big state-owned lenders.

Those were the days of near-universal government guarantees. Change came slowly. Even today, local and central government officials sometimes go out of their way to help some borrowers avoid default. But increasingly investors are on the hook. “This is for real,” Chen says. “It’s not just mark-to-market losses, which you can probably mark back up later. It is a cut in your investment principal.”

Chen’s office at Shanghai Securities, which has about 40 billion yuan under management, isn’t far from the Bund district that dates to the turn of the 20th century, when Shanghai was China’s main financial hub. Chen and the firm have both had to adapt to the new realities of the bond business. Some of the time he once spent trading is now devoted to assessing risk. “I also need to travel to visit some of the companies, to do due diligence myself,” he says.

In another market, a strong credit ratings industry might support the risk analysis done by Chen and his team. Yet the ratings put out by the handful of major local companies bear little resemblance to those in developed markets: More than 40 percent of domestic corporate bonds are rated AAA by the top four local companies, compared with just 2 percent in the U.S., according to data compiled by Bloomberg as of Feb. 13.

Take the case of China Minsheng Investment Group, one of the country’s largest private-sector borrowers. The group, whose interests span real estate to renewable energy, failed to make payments to bondholders at the start of February. Shanghai Brilliance Credit Rating & Investors Service Co. had the group’s bonds at AAA before the missed payment—and kept them there after China Minsheng entered talks with creditors to maintain solvency, according to local reports. (Shanghai Brilliance declined to comment on the rating.)

So it’s no surprise that many investors do their own analysis—just as international fund managers do their own work to supplement the research from the three major global ratings companies, which have their own records of fallibility. Chen’s firm hired its first dedicated credit analyst in 2017, added another last year, and recruited two more in January. He says the goal is to hire a fifth analyst by yearend. Shanghai Securities also introduced a new risk management system. Now, Chen says, “even if my fixed-income department is OK with taking the risk of buying certain issuers’ bonds, if it’s not good enough for the firm’s risk assessment, we won’t be able to invest.”

In this environment, defaults can exercise a healthy constraint on bond issuers and investors alike, People’s Bank of China Deputy Governor Pan Gongsheng said at an investment forum in Beijing in January. “These things are good for the long-term and healthy development of China’s bond market,” he said.

The idea of bond vigilantes (as they’re known in other markets) imposing discipline on profligate borrowers appeals to Chen. “Rising defaults among privately owned enterprises are a reflection of the market vigilante,” he says.

In that spirit, the government in 2017 said it would allow foreign credit-rating companies to establish wholly owned units on the mainland. S&P Global Ratings got the regulatory go-ahead at the start of the year and had hired 30 analysts for its Beijing office by late January.

But how effective will the foreign competition be? Local authorities have a history of pulling out the stops to aid distressed corporate debtors deemed important to the economy. It’s hard to imagine they’d put up with a foreign ratings company downgrade that could make refinancing difficult for a troubled borrower.

Still, Simon Jin, chief executive officer of S&P’s new China unit, told Bloomberg News in February that “there is genuine demand for objective and reliable ratings in China” and that his firm plans to adhere to “the same standards of transparency and independent analysis as we do anywhere else in the world.” At the same time, Jin says the company is tailoring its ratings scale to the local market. S&P doesn’t plan to spell out how that scale would compare with those in developed markets.

It will take time for S&P and its competitors to get established in China, says Jean-Charles Sambor, the London-based deputy head of emerging-market fixed income at BNP Paribas Asset Management. If they go into China, he says, the major international ratings companies may find it difficult to analyze the finances of borrowers when they don’t know what kind of state support those borrowers might get. So for money managers, he says, “there is no other solution than doing our own credit research.”

Foreign investment in China’s bond market, which comes mostly from central banks and sovereign wealth funds, has swelled from $63 billion at the start of 2014 to roughly $260 billion in January, making up a little more than 2 percent of the market. Overseas funds have stuck mainly to government bonds and securities sold by three so-called policy banks (state-owned lenders that carry out central government objectives); those categories made up more than 83 percent of their holdings of Chinese domestic debt as of January.

Private-sector institutional investors have been more wary. A test of their appetite looms, with the inclusion of Chinese bonds in global indexes followed by fund managers. The first major world benchmark to add China is the Bloomberg Barclays Global Aggregate Index. In began a phased inclusion April 1, with an initial focus on government and policy bank bonds. (Bloomberg LP, which operates the index, is the parent of Bloomberg Markets.) Two other major index providers, FTSE Russell and JPMorgan Chase & Co., are also reviewing the matter. 

Foreign investors who venture beyond that, into credit, will need to grapple with idiosyncrasies that, as in any emerging market, are quite unlike those in developed markets. Because China’s financial system has been dominated for so long by the state sector, private companies often have gotten creative to secure funding. Their workarounds, including cross guarantees and issuers buying their own bonds, haven’t always been clear to investors.

Meanwhile, China’s economic slowdown and the deleveraging campaign have made it more difficult for private companies to get funding. Such was the case last year for Beijing OriginWater Technology Co., which specializes in wastewater treatment and related technologies. “Before 2018,” says Chief Financial Officer Kan Wei, “we never thought of issuing bonds as a difficult task, particularly for industry leaders like us.”

Yet last year OriginWater sat on the sidelines for months waiting to tap the bond market at a reasonable cost. It finally managed to do so in November, after it got a hand from a local PBOC branch, which worked with underwriters to attach an insurance warrant to the bonds. OriginWater got another boost in January, when a state-owned investment group agreed to take a stake in the company.

As market discipline takes root, however tentatively, in the Chinese bond landscape, Chen tries to strike a balance between the demands of business and his outside interests. He says he enjoys reading books on world history (Neil MacGregor’s A History of the World in 100 Objects) and philosophy (Ray Monk’s Ludwig Wittgenstein: The Duty of Genius). His success in bonds has afforded him plenty of international travel: He says he’s visited more than 40 countries since 2008. A particular interest is Roman ruins, and he’s ventured from Northern England to the Middle East to view them.

Perhaps he would have made more money if he’d gone into stocks, he says, but then he slips into the sort of language that makes it plain where his heart is: “I couldn’t have known the dynamics across assets better if I’d picked the other path. I’m glad about that.” —With Yuling Yang, Charlie Zhu, Lianting Tu, and Yinan Zhao

Hong is a China credit reporter at Bloomberg in Hong Kong. Anstey is managing editor for Asia cross assets at Bloomberg in Tokyo.

By BloomBerg

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