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Corporate China will always find a way to borrow

Yields on offshore junk bonds decline while shadow banking activity surges

A hazy sky covers Pudong, Shanghai's financial district. (Photo by Kenji Kawase)

HONG KONG -- Where there is a will there is a way. Cash-hungry Chinese companies apparently continue to leverage up despite Beijing's vow to rein in excessive credit growth and curb nonstandard lending amid increasing reported cases of bankruptcy.

A telling sign is the recent developments in the Chinese offshore dollar bond market, where yields on speculative-grade offerings have been declining steadily. The spread over investment-grade issues -- the premium that investors demand for riskier bonds -- has narrowed by more than 200 basis points since last January, data from S&P Global Ratings shows.

Qiang Liao, senior director for financial institutions ratings at the credit rating agency, suggested that the unusual phenomenon -- which comes against the backdrop of rising U.S. interest rates and widespread concern about Chinese debt overhang -- was fueled by local financial institutions' strong need to deploy their excess dollar liquidity, which dovetails with Chinese companies seeking alternative financing in the face of more difficult access to credit onshore.

"Chinese non-bank financial institutions -- including distressed asset management companies, mutual funds managers, and the larger Chinese brokers -- are among the most active bidders in the Chinese offshore bond markets," said Liao in a conference call, adding that their dollar liquidity was accumulated through offshore bond sales and increased hard-currency savings among local depositors as current account control intensified.

Property developers active

Real estate developers, who are expecting approximately $35.8 billion-worth of offshore bonds to mature by 2020 and who are also facing more difficulties to borrow onshore as the central government tries to cool the housing market, have been the most frequent issuers in the offshore high-yield bond market lately.

Guangzhou-based China Evergrande Group, for instance, launched two U.S. dollar bond issues worth a total of $2.5 billion with a coupon rate of between 7% and 9.5% in March. Chinese developers altogether tapped $11.2 billion from the offshore bond market as of April 20, representing 85% of the total funds they raised through the same channel last year, according to financial data provider Dealogic.

"For companies like distressed asset managers in China, they are familiar with the property development industry. They have been dealing with distressed assets in onshore operation, so there are more ways for them to find the solution. If the issuers fall into trouble, there could be some [counter] efforts to be taken by the parent company to help them out," said Liao, noting that the phenomenon was purely "liquidity-driven" and "divorced from credit fundamentals."

One concern is the buildup of currency risks. "Many Chinese companies tapping the U.S. dollar market have little or no foreign currency revenue," said Liao, adding that foreign exchange hedging is not a common practice among them.

He said such carry trades of recycling dollar funding into higher-yielding offshore Chinese bond issuance, especially by distressed asset managers, might not necessarily be in line with the government's goal of stabilizing the financial system; but they are tacitly accepted because of these asset managers' material investments in the additional tier-1 capital instruments issued by the smaller, and usually unrated, banks on the mainland.

The practice sheds light on the latest makeup of total social financing in the country. This broad measure of credit and liquidity in the economy appeared to have slowed on the back of a marked decline in corporate bond issuance and yuan loan growth. New total social financing increased by 226.6 billion yuan ($32.9 billion) to 6.93 trillion yuan during the first quarter, versus an increase of 2.06 trillion yuan to 6.7 trillion yuan a year earlier, according to the People's Bank of China.

However, nonstandard lending -- usually kept off banks' loan books -- grew in leaps and bounds. Newly entrusted loans, where companies extend loans to one another through banks or financial institutions as intermediaries, rose by 86.2 billion yuan, or 15.7%. New trust loans, where a corporate borrower received proceeds raised from trust plans facilitated by banks, increased by 575.8 billion yuan, or 3.6 times. New bankers' acceptances, which are notes issued by banks promising to pay a fixed amount in the near future, surged by 900.5 billion yuan from a negative growth of 220.5 billion yuan a year ago.

The three components altogether accounted for 29.6% of the country's new total social financing in the first quarter, versus 7.3% a year earlier.

"The PBoC is trying to control total social financing, but total social financing does not include all sorts of credits in the system," said Andrew Collier, managing director at China-focused consultancy Orient Capital Research, citing debt-for-equity swaps, bank investment, and insurance investments among numerous nonstandard financing methods.

"There's a huge demand for credits and loans from local governments and corporates. It's unlikely that the PBoC will be able to resist the demand for credits," he added.

Collier said trusts and wealth-management products were now the weak links in China's financial system, and mentioned that the former was usually badly capitalized while the latter was vaguely collateralized. "In many cases, there are a whole bunch of assets that are used to guarantee a lot of these private loans in the shadow banking market. Unfortunately there is not much due diligence about what these assets are," said Collier, adding that banks tend not to care so much about the quality of these collaterals when they are not guaranteeing the loans.

"Frequently people are just relying on the institutions selling the loans to take care of all that," said Collier, adding that much of the lending through China's shadow banking system is just "reputational," where cross-guarantees are common practice. "I am sure there is much higher default rates among private companies just doing private loans."

Nonperforming northeast

The situation imploded recently in the northeastern part of China and in particular in the coastal province of Shandong, which had aspirations of becoming a regional financial center under the leadership of its former governor Guo Shuqing, who is currently chairman of the China Banking Regulatory Commission.

Shandong-based Qixing Group, an aluminum producer, reportedly defaulted on at least 7 billion yuan of debt in late March, prompting local government intervention and forcing a takeover by its guarantor Xiwang Group, a private industrial conglomerate with a foodstuffs subsidy listed in Shenzhen. Another private company, Shandong Tianxin Group, and its seven affiliates all went bankrupt in February with liabilities totaling 16.3 billion yuan.

Based in the northeastern province of Liaoning, China Huishan Dairy Holdings is also defaulting on loans from a dozen banks including HSBC, Bank of China, Agricultural Bank of China, the banking unit of Ping An Insurance Group, and the Industrial and Commercial Bank of China.

The Hong Kong-listed company was criticized by short-seller Muddy Waters for reporting fraudulent profits in December. Its shares plunged 85% on March 24 when its Chairman Yang Kai and Ge Kun, its executive director responsible for treasury who has been reported missing, sold their shares in the company -- previously pledged for loans -- through an investment vehicle that controls over 70% of the company's issued capital. Yang and Ge are now the remaining members of the board, which has seen a raft of resignations since the liquidity crunch.

Major state-owned commercial banks tend to recognize a relatively high proportion of their loans in the western part of China and the Bohai Rim, which includes the region surrounding Beijing, Tianjin, Hebei, Liaoning and Shandong, as nonperforming. The latter has a bad debt ratio of between 1.5% and 3.05%. Bank of China, which has a different geographic breakdown, said 5.33% of its loans in the northeast are nonperforming.

"China's credit risks will heighten in the course of structural economic transition especially under a tightened monetary policy environment," said Raymond Yeung, chief economist for greater China at ANZ Bank. Yeung was referring to the central bank's recent move to hike short-term borrowing costs in the interbank market. "From a macroeconomic perspective, provinces or industries endowed with excess capacity massively are prone to credit defaults."

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