Bond Market Bulls Embrace China Debt Downgrade
It appears credit ratings agencies simply get no respect…
Four months after Moody’s downgraded China to A1 from Aa3, unwittingly launching a startling surge in the Yuan as Beijing set forth to “prove” just how “stable” China truly is through its nationalized capital markets, S&P followed suit this week when the rating agency also downgraded China from AA- to A+ for the first time since 1999 citing risks from soaring debt growth, less than a month before the most important congress for Chiina’s communist leadership in the past five years is set to take place. In addition to cutting the sovereign rating by one notch, S&P analysts also lowered their rating on three foreign banks that primarily operate in China, saying HSBC China, Hang Seng China and DBS Bank China Ltd. are unlikely to avoid default should the nation default on its sovereign debt. Following the downgrade, S&P revised its outlook to stable from negative.
“China’s prolonged period of strong credit growth has increased its economic and financial risks,” S&P said.
“Since 2009, claims by depository institutions on the resident nongovernment sector have increased rapidly. The increases have often been above the rate of income growth. Although this credit growth had contributed to strong real GDP growth and higher asset prices, we believe it has also diminished financial stability to some extent.”
According to commentators, the second downgrade of China this year represents ebbing international confidence China can strike a balance between maintaining economic growth and cleaning up its financial sector, Bloomberg reported. The move may also be uncomfortable for Communist Party officials, who are just weeks away from their twice-a-decade leadership reshuffle.
The cut will “have a relatively big impact on Chinese enterprises since corporate ratings can’t be higher than the sovereign rating,” said Xia Le, an economist at Banco Bilbao Vizcaya Argentaria SA in Hong Kong. “It will affect corporate financing.”
“The market has already speculated S&P may cut soon after Moody’s downgraded,” said Tommy Xie, an economist at OCBC Bank in Singapore. “This isn’t so surprising.”
S&P said that its stable outlook “reflects our view that China will maintain robust economic performance over the next three to four years. We expect per capita real GDP growth to stay above 4% annually, even as public investment growth slows further. We also expect the stricter implementation of restrictions on subnational government off-budget borrowing to lead to a declining trend in the fiscal deficits, as measured by changes in general government debt in terms of GDP.”
But bond investors are saying meh to the downgrade and bid bonds back to their richest in 2 months…
The average spread on dollar bonds from the nation’s corporations fell 3.3 basis points on the day to 266, the second largest drop since May 31, according to JPMorgan indexes.
While the timing of the rating cut was less than opportune because China is planning to sell a dollar bond soon, “this might make the Chinese authorities more determined to price a very tight sovereign new issue,” said Jethro Goodchild, head of Asian credit at Aviva Investors.
“It will be an opportunity for the Chinese government to create the image in investors’ minds that they have a coherent and well-articulated plan for the country’s economic growth and fiscal stability.”
But, of course, S&P (and Moody’s) are correct in their downgrade.
All is not at all well under the hood in China and without the endless flood of liquidity (“well we have to put it somewhere”), the reactions to downgrades could be very different.
As we previously noted, China’s dent minefield is worse than ever. Last June, Goldman made a “surprising” finding when it calculated that China real debt load was far higher than it had represented.
In other words, whether due to using shadow banking strategies to cover the true debt load, or simply because Chinese corporations and the government were not booking all their obligations, China was covering up its true debt load. That strategy worked as long as China was flooding its ponzi debt system with far more debt than we maturing or being otherwise taken out.
However, now that Beijing once again appears intent on breaking China’s leverage addition – at least until overnight repo rates soar to 30% or higher as happened in the summer of 2013 when China tried this exercise for the first time – this is changing, but the real catalyst is China’s recent surge in defaults, a development which the local financial system had not had to deal with until as recently as two years ago, as virtually all defaults were settled privately, and usually involved a government bailout of some nature.
Now, with corporate bankruptcies soaring, we are finally getting first hand evidence that Goldman – and many other skeptics – were right, because as Bloomberg reports, “defaults in China are unearthing hidden debt at companies across the country.”
Think of it as nested debt: big companies, themselves reliant on debt, arbing interest expense by providing loans to smaller companies at higher rates, without declaring said loans, or as Bloomberg puts it, “small firms that can’t get loans by themselves have been winning banks over by getting other companies to guarantee their borrowings. The companies making those pledges exclude them from their balance sheets, leaving creditors in the dark. Borrowers often extend the guarantees for each other, raising the risk that failures could ricochet, at a time when increasing borrowing costs have already added to strains.”
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And just in case you needed a reminder, this is what happened when S&P dared to downgrade the US Sovereign rating in 2011…