China: Dealing with defaults

In the past month, three high profile Chinese state owned entities (SOEs) have defaulted on their outstanding bonds, namely Yongcheng Coal and Electricity, Huachen Automotive Group and semiconductor company Tsinghua Unigroup. Not surprisingly, bond market yields have risen sharply in November. In the Chinese corporate bond market for example, the spread between 6 month yields on BBB and AAA- rated bonds (an indicator of default risk) has now increased to 13.6%, its highest level this year. The fact that the Chinese government has let these large SOEs default at all, could be seen as a signal that Beijing wants to introduce more market discipline in the economy. In the longer term that would be a good thing, at least from an efficiency perspective. However, in the short to medium term, it could lead to a host of problems for Chinese companies in general and SOEs specifically, such as credit downgrades, difficulty in raising capital and higher interest rates for debt refinancing. In a tail risk scenario (so not our base case), it could even be the start of a debt crisis.

US China tensions are continuing in full swing. While Xi has officially congratulated Biden, the Trump administration has put further pressure on China. Bloomberg, for example, reports that the US is close to releasing a list of 89 Chinese (aerospace and other) companies, with alleged ties to China’s military. US firms will not be allowed to sell goods and technology to these companies. Earlier this month, Trump signed an executive order which prohibits American investments in 31 Chinese companies that are, according to the US, linked to China’s military.

In addition, the US Congress has passed a bill, that will delist companies from US stock exchanges for not complying to US Auditing rules. One of these rules is letting the Public Company Accounting Oversight Board (PCAOB) review the audits of companies listed on a US exchange. These regulations do not explicitly target Chinese companies. However, Chinese companies have refused to let the PCAOB review their audits (for confidentiality reasons). So although not officially targeted to Chinese companies, the new rules will definitely affect them.

Finally, the Trump administration has reduced the maximum length of visa that can be issued to members of the Chinese Communist Party (CCP) to 1-month, from a maximum of 10-years. One of the implications of this move is that the children of CCP members will no longer be able to study in the US.

In the few months ahead, Trump could very well continue trying to make life harder for China before he leaves office. One reason Trump might do that is because he wants to leave a ‘though on China’ image behind, which might help him if he decides to run for president again in 2024.

The Regional Comprehensive Economic Partnership (RCEP) agreement that China signed on 15 November with 14 other Asian countries has been touted with big numbers as “representing 30% of world GDP and population”. And indeed it is one of the largest trade deals on those measures. Nevertheless, its economic impact for China will not likely be that large in the short term. An earlier study by the Peterson Institute estimated that RCEP will add only 0.4% to China’s real income by 2030. RCEP mostly consolidates existing free trade agreements between Asian countries, its focus is on tariffs alone (which were already low among Southeast Asian countries) and the time span over which tariffs will be reduced is long (20 years). RCEP also does not necessarily mean the end of trade barriers between its signatories, rather that these trade barriers could take a different form. Such ‘non-tariff barriers’ have become the dominant tool for trade protectionism. The main benefit of RCEP for China might be that it further boosts its economic (and thus geopolitical) dominance in Asia via increased trade and interlinkages. Meanwhile, China’s trade tensions with Australia are still continuing, with China recently slapping import tariffs on Australian wine of up to 212%.

China’s October trade data showed stronger than expected exports (up by 11.4% y/y, while the Bloomberg consensus was 9.3%). Imports were weaker than expected (4.7% y/y vs 9.5% consensus). Since imports are mostly driven by domestic demand, this data shows that China’s recovery seems to be underwhelming.

Nominal retail sales have picked up further by 4.3% y/y in October, up from 3.3% y/y last month, although missing the consensus of 4.9%. Domestic demand is indeed picking up, but it seems the speed at which it is strengthening is being overestimated.

For 2020, we hold on to our view that China’s economy will see positive, yet modest economic growth (1.7%). However, we are significantly upgrading our forecast for 2021 year, to 7%. China’s recovery seems to be continuing and there are increasing signs that there will be a safe and effective COVID-19 vaccine available next year. That will help consumer and producer sentiment, in China as well as externally (which will help Chinese exports).

Nevertheless, we are more pessimistic than the Bloomberg consensus for next year, which is 8%. Mainly because we think consumer demand will not come back as quickly as headline GDP growth figures suggest. As we highlighted in our previous monthly outlook, China’s economic recovery is driven by growth in production, while growth in services is lagging behind (Figure 1), with hotels, catering and rental services taking a particularly big hit (Figure 2). Services are a better reflection of consumer demand and we think that consumer demand will continue to lag production. At a certain point this will also affect production itself as one can only keep producing (and building up inventories) for so long, someone has to start buying what you produce.