China’s Quiet Lehman Moment; A solar-power company’s default makes investors reconsider assumptions about the government

China’s Quiet Lehman Moment

A solar-power company’s default makes investors reconsider assumptions about the government.

JOSEPH STERNBERG

Updated March 12, 2014 7:09 p.m. ET

The default of Shanghai Chaori Solar Energy Science & Technology Co. last week set off speculation that China has reached its “Bear Stearns moment.” This is the first time a domestic bond has been allowed to default. Economists at Bank of America suggested that it will leave investors queasy about unsustainable debt levels, much as news in 2007 of mortgage-related losses at two Bear Stearns hedge funds triggered doubts about the U.S. housing market.

That doesn’t sound entirely right. A more apt comparison would be to the “Lehman moment” of 2008, when the Lehman Brothers collapse triggered an all-out panic. This isn’t to say that the Lehman moment’s ultimate result—a financial crisis—is coming to China. Rather, it’s an observation about the market psychology that Chaori’s failure encourages.

Note that investors haven’t learned anything they didn’t already know about Chaori, the solar industry, or the Chinese economy. The company long teetered on the precipice, having nearly defaulted on its bond interest a year ago. After an attempted rescue via a stake sale to a state-owned mining firm fell through last year, no one could have believed it was financially healthy.

China’s solar industry has also already had several other bankruptcies or defaults on overseas borrowing. Prices for many solar-related products have plummeted since 2011 as China’s earlier manic ramp-up in production leads to a glut. Beijing is keen to orchestrate a consolidation, hoping that the minor players in a 500-company-strong field will drop out or merge.

As for China’s financial system, credit growth has far outpaced economic growth at least since the blowout monetary stimulus of 2008. Clearly a large proportion of new loans are unlikely to be repaid, since they are not fueling investments that lead to growth.

These realities challenge the “Bear Stearns moment” story. The Bank of America economists who articulated the analogy describe the original Bear moment of 2007 as the time “when the market started to seriously reassess subprime debt risk.” Put another way, the write-downs at the two hedge funds spurred market participants to rethink whether their assumptions about market conditions for housing and debt were still correct, and to start adjusting their behavior.

What is happening as a result of Chaori’s default is something different: Market participants are wondering whether their assumptions about government behavior have been correct. It’s an important distinction.

People have generally assumed that government, whether in Beijing or at the local level, would not allow a domestic default. Chaori seemed to confirm this when its local-government patrons orchestrated a temporary bailout in early 2013. Other small solar companies have enjoyed similar rescues. Now investors have been alerted that the government will let some bonds default after all.

Yet one looks in vain for guidance on how this risk might be quantified. Beijing won’t let the market decide who defaults. If it did, Chaori’s example really would have the salubrious effects that observers have hoped for. Investors would know to start using traditional tools of corporate financial analysis and economic forecasting to reach reasonable conclusions about risk and capital allocation.

Instead, investors must engage in a perpetual guessing game about which of the large and growing set of distressed Chinese companies will be allowed to default, and which won’t. Will officials decide based on a company’s size, or on their plans for its industry? Or will it be political connections? In any case, the deciding factors in capital pricing and allocation still won’t be business merit.

Which is why the best Chaori analogy is Lehman Brothers. One of the reasons Lehman’s collapse triggered a panic was that it introduced a high degree of uncertainty about Washington’s intentions—compounded by a bailout the same week of AIG. Officials had helped save Bear six months earlier, and no one could explain why Lehman couldn’t have been rescued but AIG could. Investors knew about big credit risks, but now they realized they had no reliable guide to Washington’s approach to future events.

Bailouts-for-all is an inefficient policy, but at least it’s consistent. Until Beijing officials articulate the criteria for deciding who is allowed to default—and don’t hold your breath—China still won’t allocate capital efficiently. This also stores up the ingredients for a future panic if someday and in a big case investors discover they didn’t know the government’s mind as well as they thought.

 

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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