Pacific Money

It’s Official: China’s Chaori Defaulted

Recent Features

Pacific Money

It’s Official: China’s Chaori Defaulted

The first default in China’s onshore debt market has finally occurred. Now what?

On Friday a Chinese solar company became the first company to default in China’s onshore bond market.

Bloomberg News reports that Shanghai Chaori Solar Energy Science & Technology Co. announced that it will only be able to pay 4 million yuan ($653,990) of an 89.8 million yuan coupon that it is due today. Since the Central Bank started regulating China’s publicly traded domestic debt market in 1997, no defaults have been recorded.

This was not a sign of the health of the market but rather reflected the fact that some government entity has always stepped in to help companies avert a default. In fact, Chaori itself was on the verge of defaulting last March before being bailed out at the last minute by China Securities Depository & Clearing.

The lack of a single default in the bond market has been a serious weakness since investors had no way of knowing how a default in China would be handled. This inevitably impairs their ability to properly assess the degree of risk associated with different bonds. Partly as a result, China’s debt-to-GDP levels have skyrocketed over the past five years or so.

In the long run, then, the Chinese government’s willingness to allow Chaori to default on its debt repayments is likely to strengthen China’s bond markets by creating greater certainty. At the same time, the short-term impact of the default is potentially substantial.

Two Hong-Kong based Bank of America analysts said earlier this week that Chaori’s default could be China’s “Bear Sterns” moment. “We doubt that the financial system in China will experience a liquidity crunch immediately because of this default but we think the chain reaction will probably start,” they wrote in a note, Yahoo! News reported.

Other analysts say these concerns are largely overblown, noting that the corporate bond market in China is just $1.4 trillion while the nation’s foreign currency reserves topped $3.8 trillion at the end of last year. Brian Coulton, a global emerging-market strategist at Legal & General Investment Management in London, told Bloomberg News: “This will likely be the first of many defaults, although I don’t think it’s going to cause a cascading effect in the bond market. Short term, we’re likely to see higher bond yields but in the long term, this will create a better market for pricing credit risk.”

The timing of the default—or more precisely, the timing of the government’s decision not to bail out Chaori—is almost certainly related to the annual meeting of China’s National People’s Congress, which is being held in Beijing this week. The meeting has seen the government continue to promote its economic reform agenda. Allowing the default to occur helps demonstrate its seriousness in implanting this agenda.

It comes as no surprise that the first Chinese company to default on its debt would come from the solar panel business. The Diplomat’s James Parker has long discussed the mounting woes of China’s solar industry, which are the result of a number of factors including “government encouraged over-investment, an astounding run up of debt, government support of value-destroying firms, resulting trade frictions, and the tension between central and local government goals.” Ominously, Parker has characterized the solar industry as a “microcosm for many of the troubles afflicting China’s economy as a whole.”

As for Chaori, its woes may only get worse as it sold 1 billion yuan worth of five-year notes in March 2012 with a variable annual coupon starting at 8.98 percent. When trade on those bonds was halted in July of last year, the yield was 22 percent, according to Bloomberg News.