Chinese Regulators Look at Allowing Debt Defaults

Chinese Regulators Look at Allowing Debt Defaults

Move Would be Deterrent for Reckless Lending Amid a Slowing Economy

LINGLING WEI

March 25, 2014 7:59 a.m. ET

BEIJING—Chinese regulators are experimenting with allowing some debt defaults as a way to fend off reckless lending activities, according to government officials familiar with the matter, the latest sign China’s leaders are pressing ahead on revamping the country’s creaky financial system.

At the same time, the authorities, including China’s central bank and its top securities regulator, are stepping up monitoring of rising credit risks in China, as many corporate and government borrowers are struggling to pay off debt amid a slowing economy.

The moves follow China’s first-ever bond default in early March. Last week, a property developer in the eastern province of Zhejiang failed to repay almost $600 million of loans, a large default for a real-estate firm. On Monday, a rural bank in eastern Jiangsu Province was hit by a rare bank run, the state-run China News Service reported, after rumors emerged about possible bankruptcy.

An official at the bank, called Jiangsu Sheyang Rural Commercial Bank, told The Wall Street Journal on Tuesday that “everything is normal” at the bank and depositors can withdraw as much money as they want.

The China Securities Regulatory Commission, which traditionally has focused on policing the country’s stock markets, plans to form a new division by the end of this month to oversee the corporate bond market, one of the fastest-growing markets in Asia. “With the new division, the hope is to identify default risks faster,” an official with direct knowledge of the matter said.

The new division will also put in place rules governing how defaults should be resolved, the official said. “The basic principle is that the market should be the one that decides who fails and who doesn’t.”

Officials at the People’s Bank of China, the central bank, have echoed that sentiment in recent remarks to market participants. “As long as there is no systemic risk, some defaults resulting from market forces will be allowed,” Pan Gongsheng, a PBOC vice governor, said at a forum in Shanghai on Sunday. “This will encourage market discipline and correct the behavior of the issuers and the investors.”

The central bank has previously said it would increase its effort to monitor risks associated with high-yielding investment products sold by Chinese banks as they increasingly compete for deposits.

Press officials at the CSRC and the PBOC didn’t respond to requests for comment on Tuesday.

The regulatory initiatives come as China’s leadership has pledged to give the market a decisive role in how capital and resources are allocated. Premier Li Keqiang said earlier this month that some debt defaults are “hard to avoid” in what he called a challenging economic environment. Those remarks followed the missed bond payment by a deeply indebted solar-cell maker.

The default by Shanghai Chaori Solar Energy Science and Technology Co., many analysts have said, could help inject some discipline into a swelling debt market long viewed as implicitly supported by the government. Chinese companies sold 1.2 trillion yuan ($193 billion) of bonds last year, almost double the amount in 2011, according to data provider ChinaScope Financial.

But Beijing also faces a tough challenge of allowing some defaults while making sure the country’s debt problem isn’t spinning out of control, economists say. “From a purely economic perspective, controlled risks would be good,” said Li Daokui, an economist at Tsinghua University and a former adviser to China’s central bank. “That’s risk that is localized and is felt by investors without tremendous spillover consequences.”

Mr. Li proposed that China set up procedures for troubled borrowers, including local governments, “to be orderly restructured.” As a sign that a proper mechanism to deal with defaults in China is missing, the trustees of the defaulted bond issued by the solar company, Chaori, last week had to put off the bondholders meeting scheduled for Wednesday because it hadn’t obtained sufficient bondholders’ registration to determine the next course of action.

In recent weeks, stress has been building up in China’s financial system as the world’s second-largest economy continues to decelerate. “Looking at the second quarter, we think the worst of credit risk is far from over,” analysts at China International Capital Corp. said in a March 14 report.

Banks in China currently benefit from an implicit government guarantee that support will be provided if there is a threat of bankruptcy. But Beijing is expected to introduce a deposit-insurance scheme for banks this year, as part of its efforts to liberalize the financial sector. That is expected to ensure a clear but limited protection for depositors.

PBOC Gov. Zhou Xiaochuan, who for years has led the push to remake the financial sector, recently told foreign visitors that the central bank recognizes the need to deal with moral hazard, according to a participant at one of the sessions.

The challenge, Mr. Zhou said, is “sequence and timing,” according to the participant.