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A number of local state-owned enterprises (SOEs) defaulted on their debt recently, causing the Chinese fixed income market to sell off and putting upward pressure on bond yields. Yields rose to 3.2% and 3.3% for the 5-year and 10-year China government bond (CGB), respectively, from less than 2.0% and 2.5% in the second quarter.
The SOE corporate bond defaults – rare until recently – have mainly been in northern China, particularly Liaoning and Henan. This region is often seen as the country’s rust belt. We believe the defaults reflect Beijing’s view that the post-pandemic economic recovery is here to stay and that it is thus safe to revive its deleveraging drive and retreat gradually from implicit guarantees.
The Henan provincial government has remained silent since last month’s state-owned mining company default. However, we cannot rule out that it might intervene if the market turmoil becomes unsettling. Indeed, it is far from certain that all local governments are withdrawing their backing for SOEs.
Provinces such as Shanxi, Guizhou and Beijing have acted to maintain their support. Bonds issued by coal mining companies from Shanxi province suffered a sell-off recently as investor worries mounted, but the provincial government quickly announced that it would offer full support for all local SOEs to prevent them from failing.
The Beijing municipal government has also pledged its full backing for SOEs. Guizhou is less developed than most other provinces and leverage is high, but it has so far avoided defaults as its government has proactively devised restructuring plans to preserve investor confidence.
From the central bank’s perspective, we believe it does not want to be caught up in having to clean up the local government bond mess. The recent market sell-off can be seen a solvency issue rather than a liquidity issue.
If the People’s Bank of China were to ease monetary policy in response, that would be good news for CGBs and high-quality credit issuers, but would not help rebuild confidence in vulnerable local SOEs. At present, the situation is not so bad as to require a wholesale monetary bailout. For now, the PBoC is maintaining a neutral policy stance.
All this implies Beijing is allowing bad companies (including local SOEs) to exit the system. This is structurally positive for the Chinese system. The macroeconomic impact should be manageable, though market sentiment will be hurt temporarily as investors wonder where the authorities will draw the line and implement bailouts.
The impact on the Chinese banks should be limited, except for small banks with weak balance sheets. The Chinese banking system is liquid and public confidence in it is still strong. The average capital ratio of the system is more than 10%. This is much more than Basel III regulation requires.
Some small banks may be at risk. Looking at recent experience, Beijing can be expected to allow them to fail or be bought by stronger players.
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