What Does the Chaori Default Mean for the Chinese Financial Markets?

March 7, 2014, will go down in history as an important day for the RMB bond market. That day, Shanghai Chaori Solar Energy Science & Technology (002506.SZ) failed to make full payment on a RMB 89.8 million (or about US$15 million) coupon of its bond issue. This marked the very first default in the onshore RMB corporate bond market since its inception in 1997. But as Li Keqiang, Chinese premier, has indicated, it probably isn’t the last. At his annual media conference, Li said China is likely to see a series of bond and financial product defaults as the government accelerates financial deregulation and allows more private ownership in the state-dominated sector.

If you are surprised by the fact that a corporate bond market could have operated for over 15 years without a single default, here’s a quick explanation.

There are three groups of stakeholders in a bond default in China and all stand to lose from an actual default:

• Retail investors have a hard time grappling with the concept of investment losses. For decades, Chinese families put their savings in deposits with the state banks, whose creditworthiness was never challenged. The Shanghai Stock Exchange has only a 23-year history, so investors are still largely experimenting. Most investors probably have not even remotely considered the possibility of losing money from a bond investment. To make matters worse, most bonds are sold to retail investors through state banks, giving many the impression that bond investments are no different than deposits. When markets inevitably drop, as they do from time to time, unhappy investors in the United States blame their brokers. Well, at least some of them do. Chinese investors, on the other hand, are more likely to protest in front of government offices. With the Chinese government’s strong preference for political stability, defaults that may lead to investor unrest are avoided at all cost.
• Governments across all levels — such as state, provincial, and city — want more than just stability. Local government officials’ careers are built on generating economic growth, often by pumping money into the state-owned enterprises, or SOEs, under their purview. Instead of allowing a bond to default, officials generally would prefer to pressure state banks into providing more funding for SOEs with financial difficulties.
• State banks are willing participants in this process. By supporting the SOEs in question, they are saving their own skin as well. These behaviors certainly remind us of the recent “near misses” in the shadow banking system in China (see: “Shadow Banking Is Hurting China’s Banks — And That’s a Good Thing“).

As such, no one has any incentive to allow a bond to default. If a bond issuer is saved from default, all stakeholders win. However, the public at large, which has to foot the bill in the form of a government bailout, loses. Market efficiency is also sacrificed.

So how is Chaori different? Why did the stakeholders let this happen? It turns out that it is quite different. Chaori is not an SOE. It also operates in an industry that has been struggling financially, not only in China but also around the world. Chaori’s financial problems were not a surprise to the market.

What happened on March 7 was a technical default on a coupon payment, and Chaori is now selling assets to cover the payment. This is more a liquidity issue than a situation in which total assets cannot cover total liabilities. Analysts believe that with restructuring, investors can potentially be made whole.

Professional investors in China do not seem too appalled by this development, either. In fact, many were practically applauding in the Chinese social media, judging by the Weibo posts. This is a much-needed wake-up call to retail investors that investments, even bonds, have inherent risks. A properly functioning capital market needs defaults so that investors do not chase high-risk, high-return projects that eventually may have to be bailed out by the government in the form of additional funding from the state banks. As investors allocate resources in accordance with the proper risk-return trade-off, capital markets will become more efficient.

At least three new bond offerings were called off the same week the news hit the media, so investors clearly did not ignore this incident. If markets begin to price risk into the corporate bonds, and I hope that they will, governments and corporations will face more market limitations in funding their investments. And that’s a big plus.

So what does this mean overall? The American saying “one tree does not make a forest” works well here. As I pointed out, Chaori was allowed to declare insolvency precisely because it would have limited impact. No one expects that, overnight, bond pricing will fully reflect the risks involved, shadow banking will disappear, or local governments across China will make perfect investment decisions.

The Chinese saying “the falling of the first leaf heralds the autumn” works probably even better in this case, though. We witnessed an important moment in the history of the Chinese bond market, an inflection point where investors will start looking to risk analysis for investment decisions rather than second guessing which way the wind, or in this case, government policy, is blowing.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.