Chaori default is a welcome move

Zhang Chengliang / China Daily

Government turns to market forces in battle to bring about corporate change for the better

Chinese companies have borrowed enormous amounts in recent years, with the total outstanding corporate debt reaching an estimated $1.3 trillion (946 billion euros) this year, about 1.5 times China's GDP. Most of this borrowing is from banks, but the growing proportion of corporate borrowing through bond issues has driven China's bond market, now around $4.8 trillion, to become the world's fourth-largest after the United States, Japan and the European Union. Corporate bonds have been the fastest growing part of China's bond market boom, with total amounts borrowed by Chinese companies in that market increasing 10 fold in seven years.

This surge in Chinese corporate borrowing has been made possible by two things: the underlying profitability of much of China's business sector, which has created stronger creditworthiness, and the strong credit growth unleashed by China's monetary authority, the People's Bank of China, in 2009 to offset the negative impact of the US credit crisis.

Now, as the government tries to change China's economic growth model, the question is how to moderate the growth of corporate debt without causing a financial crash. The government has turned to market forces to do this, instead of adopting measures that are difficult to enforce and that can be abused by powerful borrowers with strong government links.

Early last month the solar cell maker Shanghai Chaori Solar Energy Science and Technology Co Ltd announced that it could not pay interest of 89.8 million yuan ($14.5 million, 10.5 million euros) that was due to holders of the 1-billion-yuan bond that Shanghai Chaori had issued in the Shanghai bond market in 2012. The company cited a credit squeeze and its inability to raise funds as the reasons for the default. Last year another Chinese solar panel producer, Suntech, defaulted on a foreign bond. But Chaori's default was the first in China's corporate bond market.

With it, the guarantee implicit in the Chinese bond market of government support for borrowers that could not meet their liabilities suddenly disappeared. The impact on China's booming bond market was immediate. Chinese bond investors, mostly large financial institutions, demanded higher annual returns to compensate them for the increased risk of default. Corporate bonds below the most secure rated levels of AAA suddenly became more expensive. Annual yields on AA- debt rose the day after the announcement by five basis points to 7.82 percent. Equally significant, in the days following Chaori's default, a number of Chinese companies announced they would delay or cancel planned bond issues: Taizhou Kouan Shipbuilding (330 million yuan), Xining Special Steel (470 million yuan) and Suning Chuanzhong (1 billion yuan).

This is not the first time in China, since the beginning of the reform period, that a company has been allowed to default. As long ago as 1988 Shenyang Explosion-Proof Equipment Factory, an unprofitable State-owned company, was declared bankrupt by the Shenyang government, which had introduced the first bankruptcy law in China in 1986. Several years later as the economy boomed, Guangdong Investment Trust and Investment Co raised large sums from foreign lenders who assumed that GITIC was implicitly supported by the central government. The foreign lenders were wrong.

When in 1998 GITIC ran into serious liquidity problems, the central government refused to bail it out. GITIC and many other investment companies around China were wound up and the foreign lenders lost most of their money. But this valuable lesson about debt was lost after the 2008 credit crisis, when the Chinese government was forced to step in to provide huge amounts of liquidity and longer-term financial support to the economy to boost confidence. The budget constraint for Chinese companies, which had tightened after the GITIC default, was loosened once again, allowing innovation and risk-taking as the source of corporate growth to be replaced by almost unlimited access to credit.

Shanghai Chaori's default has been widely commented on as a sign of the fundamental weakness of the country's financial system, and as a warning sign of an inevitable financial crash in China. In fact, it is a sign of health returning to the Chinese financial system, after a long period during which the government seemed to have become stuck in the role of financial underwriter. The inevitable consequence of the government after the 2008 crash playing the role of lender of last resort was that China's corporate and local government debt soared to levels that threatened to become unsustainable.

Chaori's default will have important consequences for the areas of China's economy that suffer from overcapacity, such as steel and solar panels. The country's financial institutions will examine the prospectuses for new bond issues with the following question uppermost in mind: "Does the borrower have the economic ability to continue generating the positive cash flows that will allow it to make the payments of interest and principal to us, the lenders?" In cases where the answer to this question is "maybe not", and where the local government, itself cash-constrained, refuses to stand as guarantor to the new issuer, companies that need quick cash will be forced to re-examine their underlying business models, or even wind up their activities. Thus the problem of overcapacity that plagues parts of the economy will gradually disappear. If this harder budget constraint for Chinese companies is accompanied by higher interest rates, life could become much tougher for many of them.

The government has been unable to order the closure or limit the activities of State-owned companies that presently dominate large parts of the economy, from heavy and light industry, to telecommunications, retailing and financial services. The government knows, though, that if China is to reach its medium- and long-term goals of increasing living standards for everyone, against a backdrop of a fast-aging population, it has to increase productivity and efficiency in the economy. This is something the army of China's entrepreneurs is standing by to do, given the opportunity.

Thus Shanghai Chaori's default is a key moment in the evolution of China's search for a new model for its economy, one that relies on innovation and efficiency rather than massive investment to generate its sales and profits. The marketization of China's financial sector will promote true economic value as the main arbiter of corporate funding, rather than the self-interest of powerful lobbies or local governments that attempt to reach growth and employment targets while maintaining their own positions. Gradually, uneconomic, low-productivity enterprises will be forced to merge or close. Their roles in the economy will be taken by more efficient players, many of which will not be State-owned, but private.

The author Giles Chance is a visiting professor at Guanghua School of Management, Peking University.