Beijing’s swift efforts to seize control of collapsed Inner Mongolia-based Baoshang Bank appears to have tamped down immediate fears of broader credit problems in China.
The collapse has raised investors’ concerns about the risks facing the nation’s small and medium sized banks and smaller companies. But it also appears to have emboldened some foreign fund managers to make renminbi bond investments with the tacit knowledge that Beijing will act to prevent a credit collapse.
On June 16, almost a month (May 24) after the Chinese banking and insurance regulator said it was stepping in to help take over the liabilities of Baoshang via China Construction Bank, the People’s Bank of China (PBoC) said almost all creditors of the failed bank had been paid back their principal in full – although a small number of large investors had to take a 10% haircut on average.
The PBoC has also worked to increase liquidity in the Chinese interbank market by extending credit to small and medium banks, which appears to have helped stave off rising alarm. Nevertheless, the troubles surrounding Baoshang pushed up the yields on some provincial banks’ negotiable certificates of deposit (NCDs) by as much as 10 basis points, according to Reuters.
Some fixed income participants said Baoshang’s fate could be a portent of worsening default rates, despite the best efforts of Beijing.
“We do expect the default rates to start picking up from here in onshore bond markets,” Neeraj Seth, head of Asian credit at BlackRock said, although he noted that the situation didn’t look like it would end up “spiralling into a crisis”.
Seth added that “we have started to see some spill over effects of [worries around Baoshang] in terms of the tightening of the funding for the smaller banks as well as the availability of credit for small and medium enterprises.”
The experience of Baoshang Bank may prompt a more cautious approach among some international investors, a senior head of a European wealth manager said. He said that it would be important for China’s authorities to convince offshore investors of the robustness of its risk-management protocols, to help assuage any apprehensions.
There is also the concern that other smaller banks or non-financial companies such as trusts are similarly directly or indirectly exposed to struggling companies. Most of China’s almost 4,000 smaller banks under-report asset quality problems and higher loan concentration risks from single and related-party borrowers, estimated Fitch Ratings.
It estimates that city and rural banks account for 20% to 25% of the country’s banking-system assets outside of its policy banks, and that most of these smaller lenders fall below the minimum capital thresholds prescribed by the PBoC.
“It is too early to conclude if such a "takeover [of Baoshang by CCB]" will ultimately lead to better governance at the weaker banks and reduce contagion risks to the system,” said Fitch.
The potential rise in default rates comes as China seeks to open up its bond markets to foreign investors. To date, despite some hiccups, foreign investors have been overwhelmingly keen to buy more Chinese credit. Authorities have also tried to smooth out procedural problems to let foreign investors more easily buy Chinese fixed income assets.
CALCULATED GAMBLE
However, rating agencies and investors noted that Beijing’s support of Baoshang Bank indicates that the government is, as of now, still willing to effectively backstop the activities of risky smaller banks to prevent a broader financial malaise.
“There is now an explicit example of intervention from the authorities to indirectly support a small non-systemically important bank to avoid system instability,” Fitch said.
That appears to have led some Asian fund managers to take a calculated gamble. They look set to keep buying Chinese debt and particularly bonds in order to benefit from further liquidity easing efforts by the PBoC to counteract the trade tariffs, which should help raise onshore bond prices.
Their gamble makes sense; it's possible the PBoC will cut interest rates or increase liquidity in the interbank market, causing short-term lending rates to fall. Either would help raise the prices of bonds that offer higher yields.
When it comes to downside risk some investors believe that Beijing won’t let further bond or bank defaults go unchecked. One portfolio manager said on background that he is buying high yield bonds despite the risks in part because of this mitigating factor. Some high yield dollar bonds from Chinese borrowers such as indebted property company Evergrande yield between 10% and 12%.
Other investors argue that with sufficient risk analysis, there are investment opportunities to be found.
“We continue to be constructive on Asia credit and are comfortable maintaining exposure to both high grade as well as high yield Chinese issuers,” said Simon Tan, head of fixed income at Nomura Asset Management in Singapore, arguing that his company’s risk management was up to the task of sorting the wheat from the chaff in Chinese credit.
While global bond fund managers and investors maybe bearish on Chinese debt, Asia-focussed debt folks need to pick their way through a minefield, added another debt fund manager.
