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We are seeing signs of stress in China’s credit markets, with SOEs, companies linked to local govts & some highly rated firms defaulting on their bonds. Below a thread from Rhodium’s Logan Wright, who sees an erosion in the credibility of local govts w/broader implications 1/9
While defaults have been happening for years, what we are seeing now is new. Why? Because the credibility of local govts as backers of their companies is being questioned. Some market sources believe these govts are deliberately withdrawing their support 2/9
In times of stress, will local governments negotiate with bond holders or will they seek to protect the best assets of the companies and accept defaults? This is the question on the minds of investors. Local authorities seem to be using different approaches so far 3/9
This is what we have called “geographic counterparty risk” – a form of risk specific to China’s system. We discussed this in our recent report, the China Economic Risk Matrix 4/9 https://rhg.com/wp-content/uploads/2020/09/200921_RiskMatrix_FullReport_0.pdf
In brief, bond investors now seem to be looking at the creditworthiness of local govts themselves, rather than the finances of the companies issuing bonds. Even solid firms in localities deemed risky may find themselves cut off from financing. This is highly unusual 5/9
Because this is a new form of financial risk, the market is struggling to price it. Contagion is spreading and larger numbers of firms are now having their creditworthiness questioned. See this story from Bloomberg on how banks are reacting 6/9 https://www.bloomberg.com/news/articles/2020-11-13/china-state-banks-said-to-cut-corporate-bond-exposure-amid-rout?utm_source=google&utm_medium=bd&cmpId=google
What we are witnessing now echoes the dilemma we outlined in Credit & Credibility (link below). Chinese authorities want riskier firms to be subject to market discipline, but cannot know how much credit risk might trigger contagion & a broader selloff 7/9 https://www.csis.org/analysis/credit-and-credibility-risks-chinas-economic-resilience
As we argued in this report, the most likely trigger for a financial crisis in China is not an unforeseen shock like COVID-19, but rather a situation where government guarantees are seen to be weakened, leading markets to reassess price levels across a broad range of assets 8/9
At the moment, we are seeing signs that new forms of credit risk are emerging. This is not a crisis. But the recent corporate bond defaults, the market reaction, and how China’s authorities respond all deserve careful scrutiny in the coming weeks. END
