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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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Emerging Markets

Brazil poised for biggest interest rate increase since 2003

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Banco Central do Brasil updates

Brazil’s central bank is expected to enact its biggest interest rate rise in almost two decades on Wednesday, with economists predicting an increase of 100 basis points to curb the risk of spiralling inflation.

Latin America’s most populous nation is witnessing a sharp acceleration in prices as its economy recovers from the Covid-19 pandemic, pinching households and putting pressure on the Banco Central do Brasil, or BCB, to act.

A weak exchange rate, buoyant worldwide demand for raw materials and rising electricity bills due to the worst drought in almost a century have all contributed to Brazilian inflation that exceeded 8 per cent in the 12 months to June, more than double the official target of 3.75 per cent for 2021.

A majority of economists polled by Reuters expect the BCB’s Selic rate will be lifted from 4.25 per cent to 5.25 per cent, which would be its fourth consecutive rise. The benchmark was at a historic low of 2 per cent until March. The decision is expected on Wednesday evening.

A full percentage point jump would represent a step up from the 75 basis point increases announced after the three previous meetings this year of the rate-setting committee, known as Copom. It would be the sharpest increase since its last 100bp rise in 2003.

As a commodities boom and pandemic-related bottlenecks in global supply chains feed an international debate about whether a return of inflation will be temporary or long-lived, central bankers in some countries are already tightening monetary policy. 

Russia, Mexico and Chile have all recently raised interest rates, while the US Federal Reserve is edging closer to a decision on slowing its massive monetary stimulus.

The BCB, which gained formal autonomy this year, is at the forefront of emerging markets pursuing an aggressive approach, said William Jackson, chief EM economist at Capital Economics.

However, he noted that Brazil’s gross domestic product was still below the level of 2014, before a deep recession struck.

“That would suggest the economy is operating below its potential and that monetary policy should be stimulative,” Jackson said. “But with the inflation threat as it is, there’s a belief that can’t continue for the time being.”

In a country that experienced runaway prices and hyperinflation only a generation ago, monetary policymakers will have to strike a balance between shielding consumers and encouraging growth.

Cristiano Oliveira, chief economist at the business lender Banco Fibra, suggested Copom should accelerate rate increases to bring estimates of future inflation closer in line with its objective.

“In 2022, the centre of the inflation target is 3.25 per cent, but inflation in the previous year should be close to 7.5 per cent. In other words, the central bank has a difficult job ahead of it, which is to reduce the inflation rate by more than 50 per cent”.

Food costs have pushed millions of people into hunger, with unemployment near a record in Brazil since data collection first began in 2012. Transport and housing have also become more expensive lately.

At the same time, low reservoir levels have affected hydroelectricity production, the South American nation’s main source of power, forcing utilities to turn on more costly thermal plants.



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Bolsonaro faces investigation over election fraud claims

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Brazilian politics updates

Brazilian president Jair Bolsonaro’s legal problems have multiplied after a court opened an investigation into his unsubstantiated warnings of voter fraud in presidential elections next year, a probe which could lead to him being disqualified from running.

The judicial inquiry comes as the far-right leader’s ratings are on the slide following accusations of his incompetent handling of the Covid-19 pandemic, which has claimed the lives of more than half a million Brazilians.

Rising living costs and allegations of corruption in vaccine procurement within his administration have damaged Bolsonaro’s standing further.

With political pressure building, the populist has increased attacks on the electronic voting system in recent weeks, reiterating calls for the adoption of printed paper receipts in order to avoid manipulation.

Opponents fear the former army captain is seeking to cast doubt on the legitimacy of the vote, in preparation for refusing to recognise a potential defeat. A group of 18 current and former Supreme Court justices have defended the current ballot system, which was introduced in 1996, insisting that Brazil had eliminated election fraud.

The Superior Electoral Court this week opened an administrative probe into Bolsonaro over his claims, for which he has provided no evidence. It also asked the Supreme Court to investigate whether the president had committed a crime by disseminating fake news about the voting system.

The president hit back on Tuesday. “I will not accept intimidation. I will continue to exercise my right as a citizen, to freedom of expression, criticism, to listen, and to meet, above all, the popular will,” Bolsonaro told supporters in Brasília.

The electoral court’s intervention showed the judiciary was striking back against Bolsonaro’s attacks, said Carlos Melo, a political scientist at Insper in São Paulo. “He [Bolsonaro] is harming the rules of the game, of democracy and the institutions,” he added. “It’s not different to what [Donald] Trump did, and demagogues in other countries. His intention is to question the electoral process without proof.”

Both moves by the electoral court could in theory eventually pave the way for Bolsonaro being barred from standing in the 2022 poll.

“There is a long way until this can bring actual legal consequences against the president which might affect his eligibility,” said Rogério Taffarello, a partner in criminal law at Mattos Filho and professor at the Getúlio Vargas Foundation. “[This] does not mean, of course, that the existence of such investigations cannot generate political consequences”.

The president is already the subject of a criminal investigation into whether he failed to act on warnings about alleged irregularities by public officials in negotiations over vaccine purchases. Bolsonaro and the government deny any wrongdoing.

Protesters have taken to the streets in cities over the past two months calling for the impeachment of Bolsonaro, who in polls is trailing former leftwing president Luiz Inácio Lula da Silva, also a likely frontrunner in next year’s election.

Bolsonaro had long promised to present evidence of cheating in elections, even claiming that the 2018 ballot he won was tampered with. Yet last week he admitted to not holding any proof, only “indications”.

Despite his falling popularity, Bolsonaro retains backing in Congress from an amorphous grouping of centre-right political parties known as the Centrão, or “Big Centre”. Analysts said for now this support appeared to be holding.

Additional reporting by Carolina Pulice



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South Korea looks to fintech as household debt balloons to $1.6tn

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South Korea Economy updates

After her family business of ferrying drunk people home was hit by closures of bars due to Covid-19 curfews and social distancing, Lee Young-mi* found herself juggling personal debts of about Won30m ($26,000).

The 56-year-old resident of Suncheon in South Korea was already struggling to pay off or refinance four credit cards, but now faces the prospect of those debts rapidly multiplying after her husband was diagnosed with cancer.

“We’ve had little income for more than a year as not many people are out drinking until late into the night,” said Lee. “Now my husband won’t be able to work at all for the next three months after his surgery.”

Lee’s story is playing out across Asia’s fourth-largest economy as self-employed workers, who make up nearly a third of the labour force, have seen their incomes reduced sharply due to coronavirus restrictions. Now, after struggling for years to keep a lid on household debts that hit a record Won1,765tn ($1.6tn) in March, Seoul is looking to fintech companies and peer-to-peer lenders for answers. 

Chart showing increase in South Korea's household debt

Among them is PeopleFund, which touts tech-based investment products backed by machine learning that allow borrowers to refinance their higher-interest loans from banks and credit card companies.

The company has loaned at least $1bn to more than 7,500 customers since it was established in 2015. Its products allow borrowers to switch their debts to fixed-rate, amortised loans at annual interest rates of about 11 per cent, a change from the riskier floating rate, interest-only loans common in South Korea. 

PeopleFund has received about Won96.7bn in financing from brokerage CLSA, and along with Lendit and 8Percent is one of the first among the country’s 250 shadow banks to win a peer-to-peer lending licence. 

“The country’s most serious household debt problem is with unsecured non-bank loans, whose pricing has been too high. We can offer more affordable loans to ordinary people unable to receive bank loans,” Joey Kim, chief executive of PeopleFund, told the Financial Times.

The proliferation of digital lenders and fintechs in South Korea, where higher-risk borrowers are often cut off from bank financing, has been encouraged by the country’s government.

“We hope that P2P lenders will help resolve the dichotomy in the credit market by increasing the access of low-income people to mid-interest loans,” said an official at the Financial Supervisory Service.

South Korea’s household debt situation has become more pressing since the onset of the pandemic, with increases in borrowing for mortgages, to cover stagnating wages and to invest in the booming stock market. South Korean households are among the world’s most heavily indebted, with the average debt equal to 171.5 per cent of annual income.

South Korea’s household debt-to-GDP ratio stood at 103.8 per cent at the end of last year, compared with an average 62.1 per cent of 43 countries surveyed by the Bank for International Settlements.

Much of the new debt has been risky. Unsecured household loans from non-bank financial institutions were Won116.9tn as of March, up 33 per cent from four years ago, according to the Bank of Korea, much of it high interest loans taken out by poorer borrowers.

Getting on top of the problem has taken on national importance. In a rare warning in June, the central bank said the combination of high asset prices and excessive borrowing risked triggering a sell-off in markets and a rapid debt deleveraging.

“If financial imbalances increase further, this could dent our mid-to-long-term economic growth prospects,” BoK governor Lee Ju-yeol said in July.

The country’s economic planners, however, are struggling to contain debt-fuelled asset bubbles without undermining South Korea’s fragile economic recovery.

The government has attempted to address the danger by tightening lending rules. Regulators in July lowered the country’s maximum legal interest rate that private lenders can charge their customers from 24 to 20 per cent.

Economists caution that rising debt levels increase South Korea’s vulnerability to an economic shock. 

They also warn that the asset quality of financial institutions could be hit by a jump in distressed loans when the BoK rolls back monetary easing, expected in the fourth quarter.

“Monetary tightening is needed to curb asset bubbles but this will increase the household debt burden, holding back consumption further,” said Park Chong-hoon, head of research at Standard Chartered in Seoul. “The government is facing a dilemma.”

For Lee Young-mi, however, the 11 per cent rate offered by the PeopleFund is still too high. “I am not sure how to pay back the debt.”

*The name has been changed



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