Barely Stearns in China

Barely Stearns in China

David Keohane | Mar 10 08:06 | 1 comment Share

Texas sharpshooter and a China analyst walk into a bar…

Last week’s default of little Chaori 11, China’s first onshore corporate default, brought with it some analyst hyperbole which has been rightly called out. Leaving aside for a moment this was BofAML’s second Bear Stearns call this year, their point was that Chaori 11 would be the moment that the market started to seriously re-assess financial risk in China. So far, not so much.

From the FT:

Some have expressed fears that the Chaori default could create a domino effect where investors quit the bond market altogether, sparking a liquidity squeeze or a credit crunch.

However, the domestic bond markets have so far treated the default as a non-event. Average yields on investment grade debt have fallen this year, while the spread between highly-rated and low-rated credit has been widening steadily for the past six months – an indication that investors had already begun re-pricing risk.

Everybody knew the bond was in trouble, Choari has just 1,500 employees, is privately owned, and falls under the supervision of the Shanghai government, which is seen as one of the more progressive local authorities. A perfect trial balloon then, but whether its default can really “result in a revelation of risk exposure and correction across the board” is almost as debatable as whether it will start a chain reaction that leads to Lehman. It obviously does pay to keep in mind how panic can spread when information is suppressed but calling this one in advance is… difficult.

That said, and as argued elsewhere, compared to the managed default of Chaori it would seem rather more likely that China’s trust sector provides the catalyst for such a moment. So… here’s some recent stuff on that from Barc (as with most things China it’s difficult to separate optimism from pragmatism):

Q. Are troubled trust products something new?

A. Not really

Three months into 2014, two troubled trust products – China Credit Trust/ICBC’s Chengzhijinkai #1 and Jilin Trust/CCB’s Songhua River #77 – have drawn widespread market attention to China’s trust sector, raising concerns over the impact on banks and the overall financial system. We observe, however, that near-default of trusts is not something new. Since 2012 there have been at least 22 reported cases of troubled trust products amounting to RMB13.7bn in total assets according to media reports (see Figure 1), which accounts for only a small proportion of the total figure of RMB10.9tn in outstanding trust assets by end-2013, according to the China Trustee Association.

In our view, the key focus from a banking sector perspective is the unbroken implicit guarantee in the financial system, which implies extra contingent risks on China banks, especially as asset quality is likely to begin deteriorating amid the current economic slowdown. In particular, we believe the reason recently troubled trusts have drawn such interest include: 1) banks’ involvement in the trusts; 2) the large size of the trusts and borrowers’ liabilities; 3) concentrated risks in the coal sector; and 4) rising concern over the broad asset quality in China’s financial system.

While many of the troubled trusts have technically defaulted by missing payments due or incurring interest losses, there has hardly been a case where a trust product has defaulted on principal. The Chengzhijinkai #1 was bailed out at the last minute by an unidentified third party and, according to recent reports (eg, Wallstreetcn, 27 Feb 2014), investors of Songhua River #77 are likely to be paid first, with money from the borrower’s guarantors.

Q. Why might 2014 be special?

A. Increasing pressure from maturing trusts

We believe this year may be particularly challenging for the trust sector because large numbers of trusts are maturing. On our estimates, for collective trusts – which we believe are riskier than single trusts and more likely to require enforcement of implicit guarantees – there is a total of RMB1.1-1.3tn in interest and principal payments due in 2014. For the whole trust sector, we estimate that RMB4.5tn in products will mature this year, up 77% compared to the actual matured amount of RMB2.6tn in 2013.

In addition, according to data from Trust-Use, we observe that the average maturity of collective trusts has declined since the second half of 2011 to less than two years, which indicates that the borrowers of trust loans would have to roll over their debt more quickly; otherwise they could face liquidity problems and become financially stressed. We believe the increasingly difficult liquidity situation will likely lead to defaults and thus expose risks in the trust sector.

Q. How did recently reported trusts get into trouble?

A. Sector-specific problems with coal companies

Both the troubled Chengzhijinkai #1 and Songhua River #77 are trust loans to coal companies in Shanxi province. In our view, these two are not isolated cases but rather reflect the difficult conditions faced by coal companies in the whole sector, especially those in Shanxi.

We believe the current situation of the coal sector was largely due to the reform initiatives the local government carried out in 2008-09, which have led to: 1) high investment and merger & acquisition activities resulting in large amounts of debt; 2) maturity mismatch in debt structures of coal companies; and 3) unsolved ambiguity and disputes regarding coal mine rights and ownership. Moreover, the decline in coal prices has significantly hurt the sector’s profitability and the high funding costs of trusts may have exacerbated the tighter liquidity situation. Hence, we believe the coal sector contains high risks and that there might be more coal-related defaults going forward.

Q. Is the coal sector a systemic risk?

A. Probably not

While we believe the coal sector is of particularly high risk, we do not consider the sector a systemic threat to China’s financial system. On our estimates, by the end of 2013, total interest bearing debt (IBD) of the coal sector was approximately RMB1.6tn, which consisted of RMB1tn of bank loans, RMB460bn of bonds and RMB130bn of trust products. These are still small amounts compared to total banking system loans of RMB 71.9tn, total outstanding corporate bonds of RMB 8.4tn, and total trust assets under management of RMB 10.9tn at end-2013.

We believe risks in the coal sector are unevenly distributed geographically, and we identify Shanxi, Inner Mongolia and Shaanxi as the provinces that would be most affected by a downturn of the coal sector. Nevertheless, after examining local fiscal conditions, we believe governments in these regions have the capacity to bail out the sector in case of serious problems and prevent any knock-on impact to the local economies or the financial system.

Q. What might happen next?

A. Orderly default is possible and would be a good first step for reform in our view

While it may have protected the public interest in certain cases, we believe sustaining the implicit guarantee for trusts has multiple negative effects on China’s financial system, including diverting investors’ awareness of risks, incentivizing inappropriate sales practices by banks and trust companies, and compromising authorities’ policy targets. Breaking the implicit guarantee behind trust products appears to us to be a necessity, and we believe it would be good for the banking sector in the long run, despite a short-term negative impact on market sentiment.

We think an orderly default is possible, as risks are likely to be unevenly distributed across different sectors and regions. With more proper risk awareness cultivated, defaults could help squeeze funds from troubled sectors to those with better asset quality, and thus enhance risk pricing in the financial system. In our view, the government will likely push reform at a gradual pace, by letting investors bear some, but not all, loss of principal, for example. Should this happen, we expect the average interest rate on trust products to rise and growth of the trusts sector and TSF to slow, at least in the short term.

In our view, the government might be more comfortable with allowing trusts to default when other regulations, including more comprehensive shadow banking rules and a financial safety net, such as the deposit insurance system, are already in place. We expect an accelerated pace of reform in 2014, likely after the National People’s Congress Conference in March.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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