Averted bond default sets worrying precedent

Continued emphasis on stability may hamper efforts to strengthen market

China's interbank bond market narrowly missed a milestone default Wednesday after authorities stepped in at the last minute to help a construction company raise funds to completely repay the principal and interest on a 400 million yuan ($64.59 million) bond.

In this case, while the avoidance of a default may benefit bondholders, experts fear that it may signal a return to the old path, where local governments will continue to bail out troubled companies and avert defaults as a way to ensure market stability amid a slowing economy. Such practices would only lead investors to under-estimate risks based on assumptions that the government will intervene whenever a default is likely. Defaults by weak companies should be allowed to strengthen the long-term development of the country's bond market.

The potential default first jumped into the headlines on July 16, when the construction company, Shanxi Province-based Huatong Road & Bridge Group Co, warned in a statement filed to the Shanghai Clearing House that it might miss principal and interest payments on a 400 million yuan bond, due the following week. The document attributed the possible default to the absence of Huatong's chairman Wang Guorui, who has been assisting with an official investigation involving suspected violations since early July. This incident clearly affected the company's ability to raise short-term fund ahead of the repayment deadline.

Although the amount of money involved in this case is relatively small - only 429 million yuan in total - financial market participants nevertheless took the matter extremely seriously. For one thing, it would mark only the second default in China's corporate bond market - the first involving Shanghai Chaori Solar Energy Science & Technology Co, which failed to make an 89.8 million yuan interest payment in March. What's different this time around is that Huatong would have been the first company to default on a bond principal payment. It would also have notched the first default in China's interbank bond market.

Given the instability a default would likely provoke within the local financial industry, local officials and bond underwriters worked actively with Huatong during the last week before payment was due, with the company rescued at the last minute, media reports said.

Although it is unclear whether local authorities offered funds to the company, a bailout could be justified in a certain sense. Compared to the embattled Chaori, Huatong's fundamentals are solid and its lack of liquidity is mainly due to delayed payments for projects by local government. Unpaid projects in Yangquan alone, where the company is headquartered, already amount to more than 500 million yuan, according to media reports.

However, it cannot be denied that Huatong had problems with its liquidity management and government rescue played a decisive role in averting the default. This compromised policy consistency does not bode well for the long-term development of the country's bond industry.

China's bond market hadn't experienced a default for decades until the Chaori case early this year, a development seen as part of government efforts to give market forces a more decisive role in resource allocation. Yet, the bailout this time, which goes against the central government's previous pledge, may give speculative investors a sense that China's bond products will continue to be default-free as officials prioritize market stability over maturity amid a deepening economic slowdown.

Nevertheless, as GDP growth slows in the world's second-largest economy, Huatong won't be the last to confront default risk. More companies are likely to experience tightened liquidity pressure as their debts come due, while local authorities may not be able to save all of them. China's looming financial constraints invite many complicated questions related to market fairness, transparency and conflicts of interest. A return to earlier interventions will only stoke confusion among investors.

Local authorities should let the market decide who should leave and stop meddling in the name of stability. Policy consistency and respect for market discipline are necessary for the healthy development of the bond market.