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Rash of bond defaults tests China’s fixed income fund market

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China’s fast growing $15tn onshore bond market has been rattled by a wave of defaults by state-owned enterprises that threaten to expose systemic weaknesses across the financial system of the world’s second-largest economy.

More bond defaults are expected to follow as Beijing has indicated that it is no longer prepared to help state-owned debtors that run into trouble. But the ending of China’s deeply entrenched system of implicit government guarantees has left investors struggling to price credit risks.

“More defaults are coming as the Chinese authorities focus on the deleveraging of state-owned enterprises [SOEs] now that the worst of the coronavirus pandemic has passed,” says Chang Li, a China specialist at S&P Global Ratings.

Beijing’s push to impose more market discipline on debt issuers has hit valuations for some bond mutual funds and forced some fixed income managers to suspend buying orders from local retail investors. The instability also threatens to disrupt Beijing’s carefully choreographed plans to draw more participation into the bond market by international investors.

International investors currently own about 3 per cent of China’s onshore bonds, according to BNP Paribas, the French bank, but foreign demand is expected to increase significantly due to the wide yield gap between China and developed markets and the inclusion of Chinese onshore bonds into global fixed income indices.

JPMorgan, Bloomberg and FTSE Russell are in the process of integrating China bonds into some of their widely followed fixed income indices, which will lead to substantial buying by a wide variety of tracker funds. BNP Paribas Asset Management, the bank’s investment arm, reckons index inclusion could lead to inflows of up to $1tn from international investors.

Chi Lo, a senior China economist at BNP Paribas AM, says that investor confidence will be affected by the turmoil.

“The macroeconomic impact should be manageable, though market sentiment will be hurt temporarily as investors wonder where the authorities will draw the line and implement bailouts,” says Mr Lo.

The increased volatility in the bond market also poses new credit risk problems for China’s mutual fund industry, which has just passed its second annual stress test with flying colours, according to regulators in Beijing.

China’s central bank examined 5,906 equity, bond, money market and commodity mutual funds to assess whether they had sufficient liquidity to meet redemption requests by investors. Only a single bond fund failed after a “light” redemption shock and just 52 bond funds failed after a “heavy” redemption shock.

Lan Shen, an economist at Standard Chartered Bank in Shanghai, says the fund stress tests are “reliable” and the results reflect the government’s determination to maintain stability in China’s financial markets.

“The government will try to let market forces play a bigger role in pricing credit and default risks while also standing ready to take decisive action to eliminate any systemic risk if such problems were to emerge,” she says.

But Ivan Shi, head of research at Z-Ben, a Shanghai-based consultancy, says the regulator could be underestimating the extent of the potential problems because the hunt for better returns has driven some smaller asset managers to increase their exposure to bond issuers that are less fundamentally sound.

Regulators have approved new liquidity management tools, such as subscription gates, to help fund managers deal with potential problems.

“It remains unclear how investor confidence might be affected if a manager were to use liquidity management mechanisms,” says Mr Shi.

Regulators’ determination to reassure investors that the mutual fund industry is in good health looks set to be tested severely by the contagion that is now spreading across the bond market. The yield on 5-year Chinese government bonds has risen from less than 2 per cent during the second quarter to 3.2 per cent.

Subscriptions from retail investors have been halted into 13 bond funds since October by managers including China Fund, Taikang AM and Yingda AM.

Problems are now appearing for bonds issued by companies backed by local governments as well as state-owned enterprises following defaults by Brilliance Auto, Tsinghua Unigroup and Yongcheng Coal.

“The defaults among state-owned enterprises have brought China’s bond market to its darkest hour,” says Logan Wright, a Hong-Kong-based analyst at Rhodium Group, a research provider.

A dozen Chinese bond funds have registered a drop of more than 5 per cent in their net asset value following the defaults.

William Xin, head of fixed income at Eastspring China, the Asian asset manager, says the dip in the net asset value of some bond funds was due to their exposure to commercial paper issued by Yongcheng Coal, which was rated AAA prior to the default.

“Short duration bond funds and money market funds only invest in bonds with the highest AAA credit rating. But ratings do not accurately reflect the credit profile of bond issuers that rely on implicit state and local government support,” says Mr Xin.

China has reported bond defaults totalling Rmb120bn in the first 10 months of 2020, compared with Rmb159bn over the whole of 2019, according to Rhodium. Mr Wright cautions that the 2020 data understates the true extent of the problems, alleging that some defaults are being concealed as more SOEs and local government financing vehicles are using private placements to access funding.

Rhodium expects to see more defaults next year among property companies and bonds issued by local government financing vehicles. 

Local and provincial authorities have taken very different approaches when companies they have backed run into financial difficulties, creating uncertainty over whether they will default or negotiate a solution with bondholders.

“The actions of local governments represent risks that need to be priced, rather than sources of support. Investors are joking that they will soon have to read tea leaves to decide which bonds to buy,” says Mr Wright.



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Toyota faces Thai bribery probe over tax dispute

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Toyota is under investigation in Thailand over allegations that consultants hired by the world’s largest carmaker tried to bribe local officials in a tax dispute, according to Thai authorities, court documents and a person with knowledge of the matter.

The probe followed a filing last month in which Toyota revealed that it had reported “possible anti-bribery violations” related to its Thai subsidiary to the US Department of Justice and Securities Exchange Commission.

Toyota is one of the biggest foreign investors in Thailand, where it makes a large range of cars, vans and pick-up trucks for the local market and for export. The country is Toyota’s biggest manufacturing hub in south-east Asia. Prior to the Covid-19 pandemic, car sales had been strong in a market, where it has a 31 per cent share.

This month, Thailand’s Court of Justice said in a statement that it would take action against any of its judges found to have taken bribes. The statement, which the court described as a move to “clarify facts” in a news report on a foreign website, directly referenced a tax dispute involving Toyota.

“If the Court of Justice has received information or explicitly found that any judge committed an act of corruption to their duty, whether it is about bribery or not, the Court of Justice will resolutely investigate and punish any action which dishonours judges, undermines the neutrality of the court, or causes society [to] lose faith in the Thai justice system,” it said.

According to the court, the case involved a tax dispute worth Bt10bn ($320m) between Toyota Motor Thailand and tax authorities over imports of parts for its Prius hybrid model. 

The affair dates back to 2015, when Toyota’s Thai subsidiary was accused by local customs authorities of understating taxes by claiming that the imported Prius vehicles were assembled from completely knocked down kits, or imported parts that were later assembled in Thailand.

CKDs would have been subject to a discounted tax rate under a Japanese-Thai free trade agreement, but if the cars were fully assembled before being imported they would have attracted a much higher rate. 

Toyota appealed against a decision by customs authorities to impose a higher duty in 2015, but lost. 

Thailand’s Court of Justice has said that it had accepted a petition to review the case, but had not yet begun hearing it.

In its regulatory filing last month, Toyota warned that the US investigations regarding its Thai subsidiary could result in civil or criminal penalties, but the company has not disclosed any detail on the allegations.

In a statement, Toyota said it was co-operating with the investigations and declined to comment on the tax dispute in Thailand. “We take any allegations of wrongdoing seriously and are committed to ensuring that our business practices comply with all applicable government regulations,” it said.

The SEC and the DOJ declined to comment.



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Boris Johnson cancels India trip after Covid cases surge in country

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UK prime minister Boris Johnson’s trip to India this month has been cancelled as the country battles a new variant and a surge in coronavirus cases that is overwhelming hospitals.

A joint statement by the British and Indian governments said the decision to scrap the visit scheduled for next week was prompted by the “current coronavirus situation”.

The trip, during which Johnson had hoped to discuss the prospects of a closer trading partnership with India, was initially planned to run for four days but had been scaled back. The two leaders will speak remotely instead, with plans to meet in person later this year.

The cancellation came as India’s capital city region has been put under lockdown and authorities have prohibited the use of oxygen except for essential services, as the country battles a surge in coronavirus cases that is overwhelming hospitals.

India continues to set single-day records of coronavirus cases, reporting more than 273,000 new infections and 1,619 deaths on Monday, with the number of new cases growing by an average of 7 per cent a day, one of the fastest rates in any big country.

The surge is believed to be linked to a new B.1.617 variant that was first discovered in the country.

British health officials are investigating whether the variant should be reclassified from a “variant under investigation” to a “variant of concern” following the discovery of 77 cases in the UK.

“To escalate it up the ranking we need to know that it’s increased transmissibility, increased severity, or vaccine-evading, and we just don’t have that yet, but we’re looking at the data on a daily basis”, Dr Susan Hopkins, a senior medical adviser at Public Health England, said on Sunday.

Officials in Delhi announced it would impose a strict lockdown for a week, following Mumbai and other cities that have already placed curbs on movement.

States are running short of beds, drugs and oxygen, leading the central government to restrict use of the gas. “The supply of oxygen for industrial purposes by manufacturers and suppliers is prohibited forthwith from 22/04/2021 till further orders,” the central government said.

Arvind Kejriwal, chief minister of Delhi, said “oxygen has become an emergency” in the region because its quota had been diverted to other states. He warned there were “less than 100 ICU beds” available.

The new restrictions have been imposed even as Prime Minister Narendra Modi and his ruling Bharatiya Janata party have hosted huge political rallies and allowed religious festivals attended by tens of thousands of maskless people in recent weeks.

Amit Shah, India’s home minister, told the Indian Express newspaper that he was “concerned” about the variant and the “surge is mainly because of the new mutants of the virus”. But he was “confident we will win” over the disease and said there was not yet a need to impose a national lockdown.

Bed shortages in India have forced authorities to re-establish emergency coronavirus hospitals in banquet halls, train stations and hotels that had been shut down following the previous peak in September. Crematoriums in the state of Gujarat and Delhi are running 24 hours a day, while cemeteries are running out of burial spaces.

Coronavirus patients have also been struggling to access medicines. More than 800 injections of remdesivir, an antiviral drug commonly used in India as part of Covid-19 treatment, were stolen from a hospital in Bhopal, Madhya Pradesh, at the weekend.

India is also facing a vaccine supply crunch and has frozen international exports of jabs to meet domestic demand. New Delhi pledged on Friday to increase monthly production of Covaxin, a vaccine made by Indian manufacturer Bharat Biotech, to 100m from 10m by September. The government also said last week that it would fast-track the approval of foreign vaccines in an attempt to boost supply and cleared Russia’s Sputnik V for use in the country.

The majority of the more than 120m Indians that have been vaccinated have received the Oxford/AstraZeneca jab manufactured by Serum Institute of India, the world’s largest manufacturer. The Serum Institute has struggled to increase its monthly capacity of more than 60m doses a month due to a fire at its plant earlier in the year and equipment supply shortages from the US.

Additional reporting by John Burn-Murdoch in London





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The limits of China’s taming of tech

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The record fine handed out this month to Alibaba, the Chinese ecommerce giant, was a welcome step toward combating anti-competitive behaviour. The $2.8bn penalty put Alibaba and other tech companies on notice that creating siloed fiefdoms designed to trap customers and merchants within their ecosystems will not be tolerated.

It was addressing a longstanding problem. Many of China’s ecommerce companies operate “walled gardens” that prevent interactions with rival platforms. For example, Alibaba’s Taobao ecommerce app keeps users from paying for goods using the payment app of rival Tencent. Tencent’s social media app, WeChat, prevents clips from being shared directly from ByteDance’s video-sharing app. 

Last week China’s internet and market regulators signalled the seriousness of their intent. They gave tech companies one month to fix anti-competitive practices, telling them to conduct “comprehensive self-inspections” and “completely rectify” problems, following which they would need to publicly promise to abide by the rules. The aim is create a commercially open and competitive internet.

It is tempting to argue that regulators in the west could take a leaf out of China’s book. But to hold China up as an example of competitive best practice would be to ignore the elephant in the room. Although Beijing is giving its monopolistically-minded internet companies — which are almost all private enterprises — a rap on the knuckles, it shows no sign of applying the same standards to vast swaths of the economy that have been dominated by state-owned giants for decades. 

The market dominance of these behemoths of state capitalism is an issue that affects not only domestic competitors but also foreign multinationals that operate in China. A trenchant joint paper last week from the European Council on Foreign Relations, a think-tank, and the Rhodium Group, a consultancy, took aim at the increasingly unfair advantages that this system gives China.

While it is true that China has opened up sectors such as financial services to foreign capital in recent years and allowed foreign brands to win market share in luxury goods and pharmaceuticals, broad sectors of the economy remain fully or partially closed or to overseas investors. 

Often the barriers erected to block or stymie competition are informal. Authorities can deliberately favour domestic companies in public procurement, are more ready to grant approval for licenses, subject foreign firms to arbitrary inspections or require them to re-engineer products to meet idiosyncratic domestic standards.

Such drawbacks are not new. But they are taking on an extra urgency as Chinese companies become leaders in an increasing number of industries and the country’s technological prowess draws level with the US and Europe in a list of industries. The key problem now, says the ECFR/Rhodium report, is that Chinese multinationals are using the advantage of a protected home market to build up resources that they then deploy in competition with western counterparts abroad.

This sets the scene for friction. China should extend its anti-monopolistic scrutiny from its own privately owned internet companies to several state-dominated sectors of its economy, taking care to open to foreign multinationals as much as domestic competitors. If it decides against doing this — as is likely — it will be furnishing Europeans and Americans with ammunition to argue against extending access to Chinese corporations in their own markets.



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