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China's evolving credit market

One of the BII’s themes for 2021 is about turbocharged transformations in the wake of the pandemic. Among the most dramatic illustrations of that theme is what is happening in the market for Chinese corporate debt, whether onshore or offshore in the Asian U.S. dollar bond market. In both markets, there has been an increase in defaults.1 We see that not as an indication of widespread distress – but to the contrary, an important signal of structural reform.

These defaults show that China is serious about containing financial risks, among them companies, both state-owned and private, that go on borrowing binges and then put the money in unprofitable ventures with little hope of repaying their creditors. China’s efforts to restructure its credit markets should ultimately result in more productive companies and a healthier economy, in our view. These efforts are already attracting strong investor flows into China’s vast debt market.2

While central banks in many developed markets are encouraging companies to take on more debt by keeping rates as close to zero as they can, even as fears about inflation mount, the People’s Bank of China is signaling that it is moving in the opposite direction. Rather than feeding asset prices, it wishes to curb them.

China interbank rates

Chart China interbank rates

Source: BlackRock Investment Institute and People's Bank of China, with data from Refinitiv Datastream, May 2021. Notes : The interbank interest rate shows liquidity conditions and the policy setting of the PBOC.

We expect China to focus on restructuring struggling firms this year precisely because Beijing appears to be confident enough in the strength of the overall economy that it can finally address the problem. We believe that means that policy normalization is alive and well on the mainland – in stark contrast to major economies. See how quickly the PBOC normalized short-term rates and liquidity last year after the initial Covid-19 shock waned and growth roared back in the chart.

By contrast, in April 2020 with the pandemic only just beginning to subside within China, there were few defaults. Beijing then feared that the combination of a series of defaults and bankruptcies at a time when the country had ground to a halt because of Covid-19, could lead to bigger problems in the financial system.

To be sure, there are still many naysayers who have long predicted that China would have a debt crisis similar to those that unfolded across Asia in 1997-98 and in Japan earlier. The People’s Bank of China’s central bank governor Yi Gang has said China's total debt hit about 280% of GDP at the end of 2020.3 Such numbers, along with the steady rise in credit to the private sector – that stood at 224.2% of GDP at the end of the third quarter of 2020, according to the Bureau of International Settlements – underscore the validity of these concerns.4

Beijing has long been frustrated by the widespread belief that there is government backing for virtually every state-owned or state-linked firm on the mainland. This belief has enabled many local government financing vehicles, even in the poorest provinces, to borrow at home and abroad – even with a lack of valuable assets that could be the basis for recoveries in the event of bankruptcy. The central government has long sought to convey the message that this is not the case.

The effort to remove the perceived guarantee of support for virtually any government-linked firm is an important part of the evolution of Chinese debt capital markets. Increased consumption may mean that China will eventually need to attract capital from abroad. We believe that means improving the functioning of its bond market – and improving the differentiation between the strong and the weak issuers.

The very strength of the macro economy leads to greater micro-economic risk, in our view. We believe the message, then, for investors is that rather than flee the corporate bond market, they should be selective. Instead of relying on the government, we believe they need to rely on fundamentals.

1As of early May 2021, firms had failed to make payments on 99.8 billion yuan ($15.5 billion) of onshore bonds, according to Bloomberg-compiled data.

2Net inflows of funds into China hit $88.5 billion, the highest in seven years during the January-March 2021 quarter, according to a Nikkei analysis of data from China's State Administration of Foreign Exchange.

3Source, Reuters News, January 2021.

4Source, Bank of International Settlements, data as of Q3 2020.

Ben Powell
APAC Chief Investment Strategist
Henny Sender
Senior Advisor
Yu Song
Chief China Economist