How Bond Defaults Are Changing China's Markets

I've ever seen? Is that? Right? It was so good, it was amazing. It was like a Mongolian barbecued leg of lamb that you grill at your own little table and then you dip it into crushed peanuts and salt, and it was good. I'm allergic to peanuts, but what everything else sounded amazing? All right, Well, next time you come, we will have that without the peanuts. But you know, I hadn't been back to Beijing for like thirteen or fourteen years, and there were so many changes to the city,

like really big ones. Whole areas of it are just unrecognizable to what they look like in two thousand five, two thousand and six. I feel like we should do a whole episode at some point, just like you comparing Beijing over thirteen years. I bet people would be interested in that. I don't think I was as um financially minded back in two thousand five and two thousand six, but I was going to say, one of the biggest changes in that time period has of course been to

China's capital markets. So thirteen years ago, China didn't really have much of a corporate bond market, and now it has a pretty big one, both domestically and dollar denominated off to our bonds as well. But most importantly, China's corporate bond market has had a number of defaults in recent years, and that's a really big change because historically, you know, it was kind of uncertain that the authorities

in China would allow companies to default. So you can imagine, Joe, that makes for an interesting bond market, given that bonds are of course supposed to reflect investors perception of default risk. Yeah. I remember, like, I guess what was at or the first ever Chinese bond default, And I remember thinking like, how is this possible? Like how could you have the first ever bond default. And I almost like thought I was misreading the article, is this idea that there had

never been a defaulted bond before? But obviously, you know, we sort of take for granted the maturity of the US bond market, the US corporate bond market, and then defaults even in good times, you know, they happened from time to time with low rated companies. We sorry take for granted that not all markets are as a mature and sort of market regulated the way the US one is. Yeah, totally.

And I mean I remember in two thousand and fifteen, analysts over at Bank of America Marylanch they published a note that was basically a history of Chinese corporate bond defaults, and there were like two things on there. It was.

It was a pretty short note, as you might imagine, but it raises all these interesting questions about how do you actually develop a corporate bond market almost from scratch, and what sort of distortions or unique characteristics are introduced when you have a big question mark over whether or not defaults will be allowed. And I should just say one of the defining features of China's sort of business system as a whole is the division between private companies

and state owned enterprises. So s O es uh, these big state run conglomerates that are often thought to be government backed or even government guaranteed. Right, Well, I'm interested in learning more about this topic alright. So we actually have the perfect guest to talk about all of this. It's someone who's done a lot of academic work on exactly this topic, as well as a lot of other stuff. It's Juin Pan. She is a professor at the Shanghai

Advanced Institute of Finance at Shanghai Jiaotong University. So, June, thank you so much for coming on. Well, thank you so much for the invitation. It's exciting to hear what what do you and Joe just talked about it. It's

really an interesting topic for me at the moment. Right. So, you actually just published a paper where you were looking at this exact topic, and specifically you were looking at whether or not spreads or risk premiums on China's corporate bonds actually reflect the health the financial health of its companies.

But before we dive into that, um, I wanted to sort of ask you a broader question about how China's financial mark as are currently structured, So corporate bonds are supposed to be market based versus the sort of traditional bank based system of lending in China. And what I mean by market based is investors are setting or influencing funding costs by demanding a certain level of compensation for

perceived risk. So how big of a leap was it or is it for China to move from that bank based system of lending to something that incorporates more market based types of lending. I would say it's a it's a big leap for people like myself who works in a in a financial research area, in a financial market. This is a very encouraging development to see that China's credit market overall, the credit market to be improving. Actually, the speed of the market development was pretty impressive over

the past ten years. It grew into a roughly a street trailing US dollar market, So it has been a pretty impressive development just to the credit market alone. So sorry break it down. What is the split between how much private credit is funded via something we'd recognize as the bond market versus traditional bank lending. So if you think about the ratio for non financial firms in China, so we have a ratio of for market based debt, so including copper bounds and also other type of basically

market traded versus bank loans. In two thousand eight it was about four point six percent, so only a tiny fraction as a racial too to the bank loads. You know, China's financial system is still a bank dominated uh system, not not like in the US. So that number grew from four point six in two thousand and eight a little bit under to be more precise, in two thousand eighteen, and much of that improvement is driven by the corporate the credit market. So walk us through your most recent paper.

So you're you're taking a deep dive into Chinese corporate bonds and you're trying to ascertain whether or not the actual spreads, the risk premiums reflect something fundamental about the financial health of Chinese companies, as they sort of are meant to do in more developed markets. So you know, if a company is perceived to be at a higher risk of defaults, it'll have a higher spread because investors

want to be compensated for that risk. Why did you decide to look into this particular topic in the US pocket this this question has been well researched, So you look at companies of different let's the different fundamental risk in terms of the faults. In academic we have standard models named after the professional button as we called the

murder models. So in a mortor model, we take the firm's baton sheeting information including its leverage, and also we take the firms if the firm is traded with public playlisted equity, we take the equity market information and one of the key information will be the equity volatility. So the murder model will take those fundamental plus equity market information as input and give you an assessment of what's the probability of the fault for the bond issued by

this company. And you can get a sense that there will be a connection between model predicted the faults and the market observed credit spreads. So in the US, if you take an approach of that, you will see that about of the variation in credit spread can be explained by fundamental So we take this as a starting point and we want to see whether in China we see a smiller direction in terms of fundamental house of the

firm and the credit market pricing of the issuer. And and this is our studying point before we get to how well, the model works with the Chinese. Uh, with the Chinese bond market. I'm curious in the US, maybe just talk a little bit about you know, the US is probably close to the sort of ideal free market or free bond market. Is the Merten model robust enough such that one can use it to identify miss pricings or identify arbitrage opportunities between the price of a bond

and the price of an equity. Because you said so, I'm sort of curious whether it's something that's mostly useful from just a pure theoretical perspective, or whether it can sort of form the basis for at least initially attempting to identify overvalued or undervalued bonds. Well, this is a good question. I mean, our financial models are always approxi mentions of the much much richer reality. But this model actually has been used by practitioners. There is uh you

probably have heard of. It's called km V. Yeah, so km V was a it was a company that they exactly the mode model and see the model with the real data and the outcome is the problem. The km these distance to default measure, which is similar to the probability of default measure. I think for those listening who have terminals at home, we have a very good function on the terminal where you can and see your company's KMB. Yeah, I thought I had to uplug the terminal here, but

you can. Actually it has the Merton model and you can change some of the assumptions and so it's very fun. You can sort of measure uh, you know, the gaps between the price of the CDs and distance to default. You can play around with that. It's very fun. And I didn't mean to interrupt your apologize for that. I

would say this model it's not perfect. It's even the Black Show's option pricing for the lives a lot of you know, limitations, but it's a good starting point, a good reference point was to start with, and it's encouraging it. There is a link between the fundamental of the firm

and how it's a bonus priced. And as you move on from the US market to the to the Chinese market, you know will be surprised or maybe not surprised to see that this meant actually should not be taken for granted, as we see in a in a data so imperfections in the Merton model aside, What did your research actually show for the Chinese credit market. Did spreads on China's corporate bonds actually show some sort of link to the

fundamental health of companies or issuers? I mean, I guess another way of asking that question is is the market based system actually working in China? So this question has a know and then a yes. So the note is that the four two zousand fourteen, as as you and the Georges discussed, the four Tusan and fourteen bonds were not allowed to default, so they were zero deforet the prior two thousand and fourteen, so our data was from two thousand ten to two thousand fourteen, would call this

the phase one period. During that period, there is no link fundamental and the credit spread. There is no link between those two. Why wasn't there this idea that they go there were like there was questions about whether default would ever be allowed to happen. What was the fear of there and what was sort of then driving the market? If there was this perception that defaults just weren't going to be a thing. Well, first, let me actually rephrase

my previous statement. I should say conditioning on information in ratings, because China doesn't have rating agencies, so they do rate these different bonds, so conditioning on the ratings from fundamentals that have no uh, additional information, so there is no link. Is I do want to qualify my previous statement um in terms of why defaults was not allowed to happen.

I guess this is not something it's difficult for me to speculate on the regulation regulators, right, But the observation from the market up participants is that these bonds never deflored.

So there is the Chanese saying of bound market pricing face based do you down to this phase that bonds don't defer, So it doesn't really matter about risk compensation because the death's going to get bailed out anyway if it ever ran into trouble, and hence there's actually no differentiation shown in the risk premiums that is actually connected to the fundamental health of the company. But you said that was phase one, So what happened in phase two? Okay?

So we start our phase two from from two thousand fourteen after the first default the front phase two to the first quarter of two thousand eighteen. So over that period you started to see a connection between the film fundamentals and equity marketing information and the what do you call the risk premium of the bonds all credit spreads of this spot the start to develop a link. The link is much weaker than what we've see in the

US market, but this is from our aunt. It looks like a very promising beginning for the Chinese cap credit market in your recent paper, and Tracy mentioned this in the very beginning in the intro. Of course, the Chinese private sector, of the Chinese corporate market is still segmented massively between regular enterprises and state owned enterprises which are state controlled and state back to varying degrees. You also look at what the bond market says about the state

owned s o E sector. What do you see are the differences in terms of how the bond market works for those s O s SO doing place one which is prior to the default. There is not too much differentiation between these two groups. Overall. We do see that a s A HE this government sponsored enterprise, the s as our states on the enterprise, you know, depending on how you call them, let's just call them as as SO.

During phase one as HE does have a little bit of a premium, meaning that their credit spreads a narrower compared to the non ass aly counterparts. Was similar ratings during phase two. If you remember face towards the time from two southern fourteen to eighteen where we started to see the faults, but the defaults happened during that time

was mostly too to the non listed firms. So if you focus on the listed firms, meaning that these firms usually are larger firms in the economy, then the difference between s and now as so as do a pretty mild mild in the sense that during phase three later on they become explosive, but during phase two there was two about twenty basis point in terms of difference in the credit spread. Let me repherence the the s AY issues enjoy about a twenty basis point narrower credit spread

compared to that they are not necessarily counterpart. So the implicit guarantee seems uh to be very much alive for these state owned enterprises, and so they have these lower risk premiums, which means they can attract financing at a lower cost than private companies. I'm wondering do you have any thoughts or insights into how the Chinese authorities might be viewing that discrepancy or that segmentation in the market, Like, is there a desire to put private companies on a

more even funding footing? So to speak with s O E S is that something that China wants? If it may I complete the whole picture before I talk about what UH policies implications. So prior to two thousand eighteen, So so so far we have two phases. One is pretty fault, one is posted fought. But up to two thousand and eighteen, if you look at the data, the

difference between SZE and ANE is mild. It's about twenty basis point of a premium for the s E. But going into two thousand eighteen, this is when the credit market went crazy. This is so there are different regulations. Even prior to to thousand eighteen. There was a de leveraging campaign that started in two thousand and seventeen. So gradually the credit market is was affected by by the regulations.

Especially in two thousand and eighteen, there was a what they called the st management New regulations are as a management which kind of cut the funding or the from the st manager site cut their holdings of the credits bounds. UH put it another way and makes them more discriminating against the USA. That makes them more aware of the credit rest even more so than before. So this is

the time when the segmentation becomes very severe. So the Twente basis point premium enjoyed by the stories exploded to about hundred basis points. Prior, the segmentation between these two markets were was not so severe. Then post two thousand and eighteen it became a really big deal. And along the same time do you see starting to see a lot more efforts for the bias or eu frons. So it sounds like just listening to you so far as

you identify these three phases. So there was the pre default phase going up to everyone enjoyed pretty tight spreads. The bond market didn't tell you very much. Post fourteen you start to get slightly more wider spreads for the private non s O companies and more information from the UM bond market period. They the prices start being more informative. Post eighteen, the spreads get even wider. And in this phase this is due to asset managers being forced to

be more cognizant about credit risk. It sounds like a sort of just an ongoing maturation process. There was a story, and Tracy alerted it to me this morning that actually there is there is an s OE now that it's very close, if not near in default or some sort of bond holders are going to have to take a haircut.

Are we on the verge of a new stage four or phase four whereby the bond market will start to be more meaningful for also the s O sector, the private sees you see them, you actually see private listed. When I say private, I mean s O E issuers who do not have a publicly listed So for this group, we we actually have sent the faults amount this group.

I want to go back to uh my, my earlier question, which was about whether or not it's desirable for the private companies to be on a similar funding um playing field as the s O s because of course, in order for that to happen, I guess you you do need to introduce some sort of default risk into the state owned enterprise sector or you have to eliminate it in the private market, which doesn't seem to be um

what China wants at the moment. So is leveling the playing field between those two sectors when it comes to financing, when it comes to moral hazard, in the bond market. Is that something that's desirable for China. It's it's something desirable, But I just don't see how that would work in this uh corporate bond market. If you put them together, the ally has explicit or implicit government guarantee, while the Nassois have duly compuri Its investors are not discriminating against

the Nassois. But studying at phase three, when you see massive defaults, not massive, but you see increasing amount of defaults happening in the market, the investors are nervous. When they are nervous, they shown away from the nias we issuers. Most of them take only bob and they just block up block that nice wee bots out. But they don't even look at nicely bound. That's the that's the problem, and I just don't At the policy level, it would be difficult to find a way to level the plane

field for for these two groups, especially during crisis. Speaking at the policy level, I want to sort of ask a big picture question. So you mentioned that for for most of history up until very recently, the Chinese economy, most credit was bank credit, and it wasn't There wasn't even really much of a bond market. Uh, if you go back a little bit over a decade, how much of that bank led market is especially by design, whereby authorities who have sort of priorities in terms of investment

can more easily u direct bank lending. And I'm curious if the ongoing growth of the credit market as a meat is a vehicle for financing changes at all the ability of decision makers of political leaders to direct money towards key favored industries, or whether that hasn't really changed much, whether they can still do it except just through a

different avenue. I think having the market based bound uh poper bound market is very important to direct especially direct funding financing sources for the disse because prior to that bank funding was mostly directed at banks leading to firms. So for the NIA slow he's this credit market is actually very important. And up to two thousand eighteen they enjoyed,

uh increased the issuance, they enjoyed the financing. But posted to eighteen, as the market was going through a very stressful period, they have something process actually dried I shouldn't say dried up, but they were increasing steadily. But new issuances by nyas yes, as a fraction of the overall

market decreased the first quarter of two thousand eighteen. So we've talked a lot about I guess the sort of uniqueness of China's corporate bond market at at this current moment in time, and in many ways, it's still developing and maybe it'll get to a similar level to where the US is at the moment, but it's not quite there yet. What do you think this means for international investors?

Because of course, China's corporate bonds are becoming more integrated into international investors portfolios via inclusion in benchmark indusicries, including some that are owned by Bloomberg LP. I should just mention, So what does all of this mean for international investors? How should they be viewing China's corporate ball market At the moment, China's fixed incour market overall is being opening up. You see a lot of relaxing of restrictions that very

much welcome the international investors. Copper body in particular, I think most of the foreign investment right now is focused on the on the yield space, not the spread space, meaning that it's focusing most of the government bomb. But the you always say, the default free bonds, not the credit bouk. Overall, I think this market would would benefit from more international investors, or conversely, maybe there will be opportunities for international investors to pick the right bond to

put a different play. I think if for international investors these companies that issue couple of bonds, these are especially for the sample we started, these are large companies with listed equities, but this could be another way for them to be exposed to the real China in a sense that these are companies doing business in China. John, that was a fascinating conversation and a really good time to have that conversation given what we've just seen in China's

credit markets. So thank you so much for coming on. We really appreciate it. Thank you. That was great, sure, thank you. So. I found that conversation so so interesting. And one of the things I always like about, you know, markets and financial regulation and the development of capital markets is the idea that there can be all these unintended consequences.

So I'm really fascinated by the idea that by introducing the possibility of default into the private market, China has basically inadvertently created this big funding cost segmentation, but also kind of created a potential financial stress point, like the notion that when things get really bad, everyone flees the

private companies and heads into the s OE sector. I find that really interesting, right, I mean, I guess the thing is, it's at some level there's going to be it's hard to imagine the existence of s O s and they're not being a major, uh slanted playing field or tilted playing field on some level, like whether there's a on market or a stock market or whatever. The fact that a bunch of companies are a state backed

that a bunch of aren't. You had imagined that that's going to create an advantage for the state backed ones. But to see how that sort of manifests itself, and even like sort of wrap one's head around the idea of market based pricing of state owned enterprises, it's just extremely strange. It'll be interesting to see how that developed, because if it stayed backed, why would they let it

default at all? And it's very it's kind of hard to wrap one's head around from a sort of US centric perspective, right, So you definitely have questions around this and that company that you mentioned, the state owned enterprise, it's called ta WU and UH it's potentially sort of defaulting on its dollar bonds. UM. This is a big s o E that's based in Tianjin, which is in the Northern province and has been um experiencing a few

economic problems. So this is going to be a really interesting one to watch, like whether not this becomes a watershed moment for s o E s. And again, the policy implications are absolutely fascinating. Is this something that China is actively trying to encourage in order to introduce more differentiation between its s o E s Or is this something that it doesn't actually want to happen, but it's starting to have to countenance the idea of haircuts or

defaults because of its massive debtload and fiscal position. That's sort of the question that we are in. Yeah, and just more generally, I really like the way she broke it down through the different phases because again, I mean,

this is obviously just such an incredibly immature market. It's basically existed for a little over a decade, so I'm sure there will be more phases to come, but so far, what we've seen looks like what you would expect, uh from a sort of maturing, growing industry or part of the capital markets and in the and if you think about how young it is, it kind of makes sense that they never had defaults in the beginning because you sort of, you know, you want to build up an

investor base, you want to have people have confidence in the market overall, so you sort of get the impression the sort of liberalization of the market. It's slow, but

it's also kind of logical, right. I mean, there's definitely teething problems that you would see in any new capital market, but I do think the picture is complicated by the structure of the Chinese economy and the existence of the s O s and it's sort of, um, it's sort of capital markets with Chinese characteristics, right, well put, thank you all right, Well, this has been another episode of the Odd Thoughts podcast. You can follow me on Twitter

at Tracy Alloway. And I'd like to just give a shout out to uh Steve Hoe who's on Twitter and he actually suggested John for an All Thoughts guest. So you can follow Steve at Steve ho that's h o U and then F Steve co F and I'm Joe wisn't thal. You can follow me on Twitter at the Stalwart, and be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M Carlson. And follow all of our podcasts at Bloomberg at the handle at podcasts. Thanks for listening