Recently, risk appetite continued to be dampened as the market became concerned over increasing bond defaults, in addition to external factors such as trade disputes and turmoil in emerging markets on the back of rising US interest rates and stronger US dollar. The rising bond market volatility has widened credit spreads and depressed corporate bond issuance.
Specifically, this round of credit default events was somehow triggered by the initiation of a set of new asset management policy guidelines which is an important part of the government’s de-leveraging initiatives for the financial sector. The new asset management industry rules have pushed up the funding cost for local Government projects and private enterprises. In addition, macro policies have tightened on multiple fronts under the general guideline of “deleveraging and risk-prevention”, which in turn lead to a notable slowdown of shadow banking and Total Social Financing (TSF) growth.
We do not expect these defaults to lead to systemic concerns as the total defaulted amount is a very small proportion of total outstanding corporate bond liabilities (less than 0.2%1) and policymakers, from our observations, have a firm grip on the market conditions and at the same time, the People’s Bank of China (PBoC) has been quite responsive in providing liquidity relief to the system. The recent moves by the PBoC, including cutting the reserve requirement ratio (RRR) in April and targetted RRR cut to be effective in July and the expansion of collateral acceptances for Medium-term Lending facilities (MLF) with banks, are good evidences of the government’s pro-active approach in managing the risks of excessive liquidity tightening. To further iterate PBoC’s preparedness to act, it issued a statement on June 19 saying that it has placed a high priority to manage the impact of external shocks and may pre-emptively use policy tools to ensure stable domestic liquidity and manage the pace of deleveraging. We believe that its tool kit includes RRR cuts and open market injections, increasing loan quota, accelerating government bond issuance, and fiscal easing as the ultimate support of the economy.
We have noticed that both the PBoC and the top regulators were more willing to take feedback and advice from market participants and experts before making policy decisions in the last 1-2 years. We hold the view that the quality of policy decisions made by the Chinese government has shown a remarkable improvement, admittedly after a number of tough and costly lessons learnt in the last few years. This string of credit defaults may have a negative impact on near-term sentiment as stock market investors are worried about potential domino effects and the shrinkage in financing channels for corporates. We also like to note that there is a potential relaxation of corporate bond issuance approvals from the regulators in the near-term as the issuance had been put on hold on regulators’ window guidance earlier on, which would imply that the government is keen to diligently manage the risks to the broader economy arising from the deleveraging initiatives.
Corporate bond defaults have been taking place in industries such as environmental protection and other urban infrastructure sectors which typically have aggressive private-enterprises embracing high leverage and liability duration mismatch involved. The defaults effectively freeze the new-issuance market of corporate bonds. Moreover, with a stronger risk-conscientiousness in mind, the central government has been eyeing the excessive local infrastructure investments disguised as Private-Public-Partnership (PPP) projects. Around 12% (or Rmb 1.53 trillion) of the planned PPP investment has been revoked from the project inventory between November 2017 and April 20182. This certainly has hamstrung the fixed asset investment impetus to overall GDP growth. Given this, we believe it would be wise to invest in companies with either a very strong operating cash flow to cover their financing needs or well-supported by banks given the robustness of their businesses.
In the short term, the rising defaults may increase bearish sentiments, but these developments will likely contribute to the normalization and resilience of the bond market in China over the long run. Furthermore, tightening credit conditions will likely accelerate industry consolidation as it is becoming more difficult for weaker companies to get funded. Liquidity pressure for Hong Kong listed companies will likely be manageable as they have multiple channels for funding, compared to their onshore peers. Overall, we believe that volatility and uncertainties will dominate in the short term, but economic resilience, thanks to a robust synchronized global recovery and Chinese Government backstop, should offer a more benign and constructive backdrop for the economy in the latter part of the year.
 Source: CICC Research as of June 2018
 Source: CICC Research as of May 2018
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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