Opinion: Government debt could bring China’s credit party to a halt

Markets ignore coming glut of new bonds from local governments

Reuters

China's central bank Gov. Zhou Xiaochuan warns of growing corporate debt burdens, but the biggest (and mostly hidden) problems may be with government debt.

HONG KONG (MarketWatch) — China’s economy may have run out of growth before it ran out of credit, but no one told its companies.
One of the biggest China puzzles today is the seemingly never-ending ability of its corporates to access new supplies of credit, without running into trouble or someone saying no.
Some analysts warn that we are looking in the wrong place for distress; it could be building in the government bond market.

This year, China’s easy money policy has been most graphically on display through an unprecedented overseas buying spree by its companies. The latest Chinese company throwing its checkbook around is insurer Anbang with a $13.1 billion cash offer for Starwood Hotels and Resorts HOT, +4.49%   . Earlier ChemChina broke China’s record for outbound merger and acquisition activity with an offer to buy Syngenta SYNN, -0.23%  in cash for $44.1 billion.

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In fact, in the first three months of this year, China outbound M&A activity has rocketed to $102.7 billion, almost equal to the record total of $107.5 billion for the whole of 2015, according to data from Dealogic.
Heavily geared balance sheets appear no hindrance to connected mainland companies being able to access funding.
On Monday, Shanghai shares SHCOMP, -0.60%  rallied after more, cheaper money was promised to China’s brokers for margin financing.
Yet it was possible to detect a hint of caution from the central bank governor at the weekend after the chorus of upbeat commentaries on the economy from China’s leaders in recent weeks.
Zhou Xiaochuan said that “lending as a share of [gross domestic product], especially corporate lending as a share of GDP, is too high” and also that a high leverage ratio is more prone to macroeconomic risk. Corporate gearing in China is now widely estimated at some 160% of GDP.
It is these kinds of concerns that have led Moody’s to downgrade the outlook on China’s sovereign rating at the beginning of March.
Other analysts are also turning their attention to central government debt — which has long been viewed as manageable — as these funding needs could emerge as a new fault line of distress.
Societe Generale said in a new report the government bond market faces an unprecedented supply glut due to combined local and central government bond issuance.
As the market has yet to factor in this exponential growth in government paper, it could lead to disruption, which could potentially spill over into the corporate bond market, they warn.
The upswing in issuance is due to an expanded local government debt swap program (where bad loans from special funding vehicles were swapped for debt) and central and local government fiscal deficits. In total, SG calculates this year could see a total net issuance of 7.58 trillion yuan, up by 2.66 trillion yuan from 2015.
And this paper will keep coming. The latest audit report put the amount of local government debt eligible for being swapped into bonds at a massive 15.4 trillion yuan.
SG says the market does not appear to be pricing in the supply risk in the mid- to long-term end of the market. This could lead to a steepening of the curve when the market pays more attention to the supply.
This potential fallout in the government bond market from the local authority debt cleanup shows that the central government backstop is unlikely to be painless.
Any follow-through, such as higher yields, is likely to have a negative impact on the corporate bond market.
China’s corporate bond market has already been attracting attention as a potential area of stress in recent weeks after an issuance spree amid expectations of increasing defaults.
The added strain with reliance on bond issuance is finding buyers. China’s corporate bond market has benefitted from a switch of retail money away from equities this year, yet it could still be vulnerable to further asset relocation.
Chinese regulators do appear to recognize they need more bond buyers.
Last month, the People’s Bank of China (PBoC) stated that it would allow medium- to long-term foreign institutional investors to access China’s interbank bond market without any quota restriction.
This initiative could get a push if international bond indices include Chinese bonds. Last week J.P. Morgan said it was considering adding China’s government bonds to the J.P. Morgan Government Bond Index-Emerging Markets Global Diversified index.
Still, finding foreign buyers to keep China’s debt party going might look a stretch. They will need more than index inclusion to overcome various concerns from the value of the yuan to transparency.
Within China’s opaque system of state capitalism, it is always difficult to connect the dots on who owns assets, and who is ultimately responsible for debt.
If ultimately that debt stress appears in the government bond market, once again look for the yuan USDCNH, +0.0786%   to come under pressure.