China’s Debt Problem Moves Back to the Future

The lack of a 2013-style credit crunch following the crackdown on bonds doesn’t mean all is well for China’s corporate debtors

The Chinese bond market is dead. Long live China’s shadow banks.

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.

The good news is that all this shadowy lending has helped avoid a full-scale credit crunch. The bad news is that shadow finance is expensive, and often lacks proper risk-control mechanisms.

AA-rated corporates, which in February could issue two-year bonds with a yield to maturity as low as 4.6%, now must choose between bonds paying 6%—if they can find buyers at all given the current scrutiny—or trust loans at 7% or higher.

China’s economy remains in decent shape for now—and policy makers are unlikely to tolerate a sharp slowdown ahead of a critical Communist Party meeting this fall where the next generation of leadership will be chosen. But the attack on rising near-term risks in the bond market—while permitting a big rotation back into the shadowy world of trust lending—looks a lot like sacrificing much needed long-term moves toward better pricing of risk in exchange for short-term stability.

And it also begs the question: Once the party conclave is finished this fall, what happens next?

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