China has had some domestic bond defaults in recent years, but these have been defaults on interest or coupon payments only, not on principal payments, according to Lo.
“Such partial defaults will continue as Beijing continues to retreat from the implicit guarantee policy and structural reforms continue to unfold,” Lo told FSA.
The implicit guarantee policy refers to the fact that state-owned enterprise bonds are widely deemed as fully guaranteed by the government, and the issuers are usually bailed out by the government when in trouble. However, the regulators started to allow the default of these bonds in 2015 to release the government from the role of guarantor.
This has resulted in a sharp increase in the number of Chinese corporate bond defaults.
“Bond defaults happen in all markets. We have seen them happen in Europe, the US and Hong Kong. In China, what’s so special about it is that the default rate used to be zero. Now when you are looking at a 1-2% default rate, you are looking at a sharp increase. We are not going to deny the debt problem in China, but I think it is careful to put things into perspective.
Default exposure
Lo said China debt problems certainly have some impact on China’s fixed income asset class, but the impact is not significant because authorities are pulling away from the implicit guarantee policy only gradually.
“The whole fixed income asset class in China is undergoing some significant changes because of the retreat of the implicit guarantee policy. Within the fixed income asset class in China, investors have to be more sensitive toward differentiation of risk profiles among the Chinese debt issuers. Before, the default rate was zero and people didn’t need to do homework on credit analysis. But now the homework is becoming more important in order for investors to avoid [exposure to] potential defaults.”
Full bond defaults
Lo believes that Chinese authorities will allow full bond defaults on a case-by-case basis. Most likely, they will base their decisions on the potential impact on employment and the financial system, and on the degree of over-capacity of the entity and the debt burden of the local authorities, he said.
In the short-term, authorities would be unlikely allow any local government or companies that have an impact on financial system stability to go into full default, he added.
The purpose of keeping the implicit guarantee policy in a selective mode is to give confidence to onshore investors.
“This is important for China because the Chinese economy is transitioning from an old investment-led model to a new, presumably consumption-led one. The transition is very slow because the public confidence is weak, so Beijing can’t take away the implict guarantee policy completely in one go.”
Authorities would be able to manage a significant rise in defaults, he said.
“There are a lot of resources available for Beijing to mobilise. We are basically talking about savings deposits in China, which amount to about 200% of China’s GDP. This is an idle fund in the system and there are no other alternatives. This is a big chunk of money and it’s a liquidity tool for Beijing to tap.”
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From January to May this year, the performance of the top 10 RMB fixed income funds available for sale in Hong Kong has remained relatively stable despite a sharp increase in the number of onshore bond defaults. During the period, 34 out of 48 RMB fixed income funds show positive returns, according to FE data.
In contrast, the equity markets in Hong Kong and China have had a more volatile ride since the start of the year.
