Asia’s debt markets have taken a pause, but year-to-date volumes for China dollar debt are at record highs nonetheless.
Chinese issuers have raised $33 billion from the dollar bond market so far this year, more than double the $14 billion raised during the same period last year and exceeding the $29 billion raised during the whole of last year, according to Dealogic.
However, amid these record volumes, there are concerns over the level of borrowings for Chinese companies and the structures such companies use to access the offshore bond markets. In early May, Morgan Stanley downgraded its outlook on Chinese investment-grade state-owned enterprises (SoEs) to neutral, citing the high levels of leverage.
“Leverage among Chinese SOEs has reached record highs,” says Viktor Hjort, head of Asia fixed-income research at Morgan Stanley. “It is three times as high as 2007, before the last financial crisis. If China went into recession today, the credit fallout would be worse than in 2008.”
China’s growth numbers have also been slowing recently, with exports growth slumping to just 1% in May from 14.7% in April. In May, the IMF lowered its growth forecast for China to 7.75% from 8% previously. According to a note by Commerzbank, given the reluctance and unwillingness of the government to pump prime the economy as was seen in 2008, a period of slower growth is expected in coming years.
The rush of supply comes as Chinese companies shift their funding away from onshore loan markets and into dollar debt. In 2012, about 71% of the funding for Hong Kong-listed Chinese SoEs came from onshore loans, 24% from domestic bond markets and 5% from offshore bonds. As more Chinese companies are expected to meet their funding needs through the bond markets, this is expected to fuel further supply.
“The portion from offshore bonds though small is still meaningful and we see that percentage rising, so the supply of China offshore bonds is potentially unlimited,” says Hjort.
Meanwhile, investors have concerns about the bond structures some of the Chinese companies are using to access the market. Many Chinese borrowers issue through an offshore entity, rather than directly through the onshore parent, as onshore guarantees require regulatory approval.
Instead of a guarantee from the onshore parent, these bonds often feature credit enhancements such as keepwell agreements, which are a contractual obligation between the supporting and supported company, and deeds of equity purchase undertaking, which allow an onshore company to buy a stake in subsidiaries held by offshore issuers at a price that is sufficient to honour debt commitments.
However, such agreements are untested, so it is unclear how much protection they would offer investors in the event of a default.
“The tricky issue with credit enhancements such as keepwell agreements and deeds of equity purchase undertaking is that they are only good until they are proven to be wrong,” says Sabita Prakash, head of Asian fixed income at Fidelity. “To date, we have not received any opinion that states that such enhancements are tantamount to a guarantee.”
SoEs often receive a credit uplift from rating agencies due to government ownership, but investors suggest that they ought to be considered on the basis of standalone fundamentals, rather than implied government support.
“When you look at a state-owned enterprise, you can determine how important it is to the Chinese government based on how large it is, whether it is strategically important and look at high leverage and forgive it a little,” says Bryan Collins, fixed-income portfolio manager at Fidelity. “But when you get to the third, fourth or 20th state-owned enterprise, that level of government support has to diminish. The government can’t support them all.”
Credit enhancements also pose difficulties for investors as they are subject to the vagaries of whether such structures will actually protect investors in the event that a company goes into default.
“We don’t want analysis to shift from one of assessing companies profiles to trying to predict regulatory actions or trying to understand if the legal structures will hold,” says Prakash.
