China bond market defaults are not the sign of a debt crisis but the growing pains of a more sustainable credit system
Chinese corporate borrowers defaulted on a record $25 billion of debt in 2020. For many investors, that would be worrying enough on its own. There are more causes for concern, though. These defaults included several state-owned enterprises, such as Yongcheng Coal & Electricity Holding Group, which would have been unthinkable in previous years. There is a wall of corporate debt about to mature: some RMB7.1 trillion ($1.1 trillion) of domestic bonds and $104 billion of offshore bonds are due in 2021. At the same time, local government borrowing rose by the equivalent of $565 billion in the first half of last year, according to JP Morgan, even as tax revenues were depressed by the Covid-19 pandemic. That is driving market expectations that Local Government Financing Vehicles (LGFVs) will also default on their debts in 2021.
A more nuanced picture
At first glance, this is an alarming situation. Look past the large numbers that are a product of China’s sheer scale and it becomes more nuanced, though. The government has recognised that its domestic credit markets had run out of control since the massive fiscal and monetary expansion that followed the Global Financial Crisis in 2008 and 2009. It is now taking painful – but necessary – action.
As corporate debt grew in the wake of that crisis, so too did China’s shadow banking system of so-called wealth management products, entrusted loans, peer-to-peer loans and other forms of financing. According to the China Banking and Insurance Regulatory Commission, this sector had swelled to have assets worth $12.9 trillion in 2019. The relentless rise of shadow banking added opacity and systemic risk to the credit market. In the China bond market, opacity was increased by inflated ratings that made credit differentiation much harder: two-thirds of bonds rated by China’s local agencies have a AAA or AA+ rating, including those issued by Yongcheng Coal.
Defaults by state-owned firms are a harsh medicine for investors that have long believed in an implicit government guarantee for such debts. Only a handful have been allowed to fail, though, with total defaults by state-owned firms worth $11.1 billion last year. In a market this size, that sends a meaningful message without causing much real damage.
Defaults by large companies that could have been much more destabilizing have also been avoided. China Evergrande Group, which was the world’s most indebted property developer with borrowings of nearly $120 billion last year, was able last September to secure $4.6 billion of funding from government-linked investors that averted this kind of scenario.
Nothing could be more effective in enforcing credit market discipline, though, than a rising default rate. Market-driven investors and lenders now have no choice but to conduct careful analysis of borrowers’ businesses and financial positions. A more cautious approach would clearly point towards tighter financing conditions.
China has reinforced the signal it has sent by allowing more defaults with a much stricter approach to financial regulation. Policymakers have strengthened financing rules for real estate developers like Evergrande, promised a “zero tolerance” approach to abuses in the China bond market, made a credit ratings firm compensate investors in defaulted bonds and drafted stricter regulations for its large fintech companies, which have also become major facilitators of loans.  
Chinese companies and their owners will be taking a keen interest in how more restrained credit markets and tougher financial regulation translate into borrowing conditions on the ground. The People’s Bank of China has said it will pursue a “flexible, targeted and appropriate” monetary policy that supports the country’s recovery from the impacts of the pandemic. According to a Reuters survey of economists, Chinese banks are estimated to have made a record $542.6 billion of loans in January. But this may conceal a longer-term trend of tightening credit conditions. On a monthly basis, loan growth in December fell for the seventh straight month and some analysts expect lending to contract in 2021.
Once the initial shock caused by defaults and tougher regulation has been overcome, more disciplined credit markets – and effective financial regulation – will be better able to support sustainable growth over the long term. If bank lending is indeed more constrained this year, though, Chinese firms and their investors will need to consider alternative sources of liquidity. There will be significant drivers of demand for capital, including refinancing that $1 trillion-plus of debt that comes due in 2021, and China investment opportunities as the country’s economic recovery gathers momentum. We expect private credit – including share-backed financing – to play its part in filling this gap.
This Document is intended solely for accredited investors, sophisticated investors, professional investors, or otherwise qualified investors, as may be required by law or otherwise, and it is not intended for, and should not be used by, persons who do not meet the relevant requirements. The content provided herein is for informational purposes only and is general in nature and not targeted to any specific objective or financial need. The views and opinions expressed in this Document have been prepared by third parties and do not necessarily reflect the views and opinions of EquitiesFirst. EquitiesFirst has not independently examined or verified the information provided herein, and no representation is made that it is accurate or complete. Opinions and information herein are subject to change without notice. The content provided does not constitute an offer to sell (or solicitation of an offer to purchase) any securities, investments, or any financial products (“Offer”). Any such Offer shall only be made through a relevant offering or other documentation which sets forth its material terms and conditions. Nothing contained in this Document shall constitute a recommendation, solicitation, invitation, inducement, promotion, or offer for the purchase or sale of any investment product by First Holdings, LLC or its subsidiaries (collectively, “EquitiesFirst”), nor shall this Document be construed in any way as investment, legal, or tax advice, or as a recommendation, reference, or endorsement by EquitiesFirst. You should seek independent financial advice prior to making an investment decision about a financial product.
This Document contains the intellectual property of EquitiesFirst in the United States and other countries, including, without limitation, their respective logos and other registered and unregistered trademarks and service marks. EquitiesFirst reserves all rights in and to their intellectual property contained in this Document. The Document should not be distributed, published, reproduced or otherwise made available in whole or in part by recipients to any other person and, in particular, should not be distributed to persons in any country where such distribution may lead to a breach of any legal or regulatory requirement.
EquitiesFirst make no representation or warranty with respect to this Document and expressly disclaim any implied warranty under law. You acknowledge that EquitiesFirst is not liable under any circumstances for any direct, indirect, special, consequential, incidental, or punitive damages whatsoever, including, without limitation, any lost profits or lost opportunity, even if EquitiesFirst has been advised of the possibility of such damages.
EquitiesFirst makes the following further statements that may be applicable in the stated jurisdiction:
Australia: Equities First Holdings (Australia) Pty Ltd (ACN: 142 644 399) holds an Australian Financial Services Licence (AFSL Number: 387079). All rights reserved. The information contained on this Document is intended for persons located in Australia only and classified as a Wholesale Client only as defined in Section 761G of the Corporations Act 2001. The distribution of information to persons outside this criteria may be restricted by law and persons who come into possession of it should seek advice and observe any such restriction. The material contained in this Document is for information purposes only and should not be construed as an offer or solicitation or recommendation to buy or sell financial products. The information contained in this Document is intended to be general in nature and is not personal financial product advice. Any advice contained in the Document is general advice only and has been prepared without considering your objectives, financial situation or needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation and needs. You should seek independent financial advice and read the relevant disclosure statements or other offer documents prior to making an investment decision about a financial product.
Hong Kong: Equities First Holdings Hong Kong Limited holds a Hong Kong Securities and Futures Commission Type 1 License and licensed in Hong Kong under the Money Lenders Ordinance (Money Lender’s Licence No. 1839/2020). This Document has not been reviewed by the Hong Kong Securities and Futures Commission. It is not intended as an offer to sell securities or a solicitation to buy any product managed or provided by Equities First Holdings Hong Kong Limited and is only intended for Professional Investors. This document is not directed to individuals or organizations for whom such offers or invitations would be unlawful or prohibited.
Korea: The foregoing is intended solely for sophisticated investors, professional investors or otherwise qualified investors who have sufficient knowledge and experience in entering into securities financing transactions. It is not intended for, and should not be used by, persons who do not meet that criteria.
United Kingdom: Equities First (London) Limited is authorised and regulated in the UK by the Financial Conduct Authority (“FCA”). In the UK, this Document is only being distributed and made available to persons of the kind described in Article 19(5) (investment professionals) and Article 49(2) (high net worth companies, unincorporated associations etc.) of Part IV of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (‘’FPO’’) and any investment activity to which this presentation relates is only available to, and will only be engaged in with, such persons. Persons who do not have professional experience in matters relating to investment or who are not persons to whom Article 49 of the FPO applies should not rely on this document. This Document is only prepared for and available to persons who qualify as Professional Investors under the Markets in Financial Instruments Directive.