C&B Notes

China’s Debt Shell Game

As China’s corporate bond market dries up, the country’s shadow bank market has returned as a source of capital. When will the carousel stop turning?

Beijing’s full-frontal assault on financial market leverage this spring has driven bond yields skyward, but hasn’t sparked the systemic credit crunch that many feared.  That doesn’t mean the risks have disappeared: cash-strapped firms have avoided more defaults by skulking back to high-interest shadow lenders instead.  With industrial profits up 14% on the year in the first quarter, firms can probably afford to pay up for expensive loans from sources other than banks and the bond market for now. But forcing firms to refinance at exorbitant rates — and without the real, albeit limited, market discipline of China’s bond market — is storing up trouble for the future.  And foreign investors eyeing Chinese bonds through the brand new Hong Kong bond connect should be wary of taking the plunge: Corporate debt might look like a bargain now, but firms are mostly shifting risks around rather than eliminating them.

Back in the days before China’s bond market took off, hard-up corporate borrowers used to rely heavily on nonbank lenders like trusts, which sell retail investment products and channel the proceeds into high-interest loans.  High-profile repayment problems triggered a crackdown on these trusts in 2013 and 2014, which helped push marginal borrowers into China’s nascent corporate-bond market instead.  Now, as regulators have become increasingly concerned about leveraged bets on bonds, that process has moved into reverse.  Corporate-bond debt rose 30% from early 2015 to mid-2016, but issuance is now in free fall: Debt outstanding fell 58 billion yuan ($8.5 billion) in the first quarter of 2017.  Meanwhile, trust lending, which had almost ground to a halt by mid-2015, has roared back: It rose nearly 700 billion yuan ($103 billion) in the first quarter alone.  Other forms of shadow bank lending, including direct company-to-company loans, have also staged sharp recoveries as the bond market has withered.

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