China’s bond market saw a notable rise in defaults in the first half of 2016. The 34 defaults recorded, accounting for around $3 billion, so far this year are already nearly double the defaults in all of last year. This rise is particularly worrying because China is in the midst of an extraordinary surge in the pace of credit growth. Around half of the defaults have come from state-owned enterprises (SOEs), although private firms have seen their fair share. The rise in bond defaults is even more remarkable because local governments have tended to step in to cover any potential missed payments, making defaults very uncommon.
Figure 1 Defaults in China’s bond market
China’s bond market is already the world’s third largest, with around $6 trillion outstanding (including $3 trillion in corporate bonds), behind only the United States ($35T) and Japan ($11T). China recently announced plans to ease restrictions for foreign investors to China’s interbank bond market, but many foreign investors remain skeptical. The skepticism mainly stems from a lack of trust of China’s ratings agencies’ ratings of the bonds, where around 80 percent of Chinese companies are rated AA or above, the third highest rating.
One of the largest bond payments to see a default was by Yingli Solar, one of the world’s leading makers of solar panels. This default could have been serious trouble for China, as it employs around 15,000 employees. But on June 14 Yingli reported its first quarterly profit in five years, and it also said that it is in talks with creditors to restructure its debts.
This rise in defaults has not caused bond yields or spreads to rise. There were serious concerns about China’s bond market in April or this year, when over $15 billion in bond issuance was cancelled, and yield spreads rose considerably. But they have since stabilized and even come down slightly.
Figure 2 China’s 2016 corporate bond yields and spread
Though there is plenty of concern about China’s bond markets, there are a few reasons to be sanguine, including stabilized bond yields. Liquidity in China’s bond market, or the ease of bond trading, has also improved markedly. As mentioned, China has announced it is easing restrictions for foreign investors to invest in the interbank bond market, and though many will stay away, given the relatively high yields, many will take their chances. An increase in foreign investors will contribute to a more competitive bond market and diffusion of best practices. Finally, the ratio of corporate bond defaults to total outstanding corporate bonds is around just one-tenth of 1 percent.
While rising defaults may cause yields to rise and sentiment to drop in the short-term, they should actually be seen as a good omen. Less government support, especially when SOEs are included, is good news for the long-term as moral hazard is reduced. Hopefully, it means firms will be more hesitant in the future to take on more debt than they can handle.