Why uncertainty over China Huarong has echoes of Europe’s debt crisis

Concerns about Greece’s huge public debt burden and the mispricing of risk across the euro zone predated the eruption of Europe’s crisis
Likewise, weaknesses in China’s corporate bond market, and uncertainty over Beijing’s support for troubled SOEs, have been weighing on sentiment

Nicholas Spiro

Published: 2:30pm, 6 May 2021

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On the face of it, the mounting concern over the financial health of China Huarong Asset Management, a distressed debt manager majority-owned by China’s finance ministry, bears little resemblance to the panic that engulfed financial markets a decade ago when Greece’s debt default and possible exit from the euro zone fanned fears about the stability and integrity of Europe’s monetary union.

While the euro zone faced an existential crisis in 2011-12, exacerbated by full-blown sovereign and bank defaults, China is enjoying a rapid recovery from the Covid-19 pandemic and is trying hard to rein in the excesses of recent years.

More importantly, the Communist Party rules China with an iron fist. Policymaking in the 19-member euro zone, by contrast, is akin to herding cats.

Yet, in one crucial and sensitive area for investors – increasing uncertainty about backstops and whether private creditors should be penalised for failing to price risks accurately – the drama around Huarong and the tensions at the heart of Europe’s debt crisis are eerily similar.

Some of the hot-button issues thrown up by the near dissolution of the euro zone – tensions between efforts to reduce moral hazard and the preservation of financial stability, credit rating agencies’ role in flagging up risks and the threat of widespread financial contagion – have reappeared in China’s corporate bond market.

Just as concerns about the sustainability of Greece’s huge public debt burden and the mispricing of risk across the euro zone predated the eruption of Europe’s debt crisis, weaknesses in China’s corporate bond market, and uncertainty over Beijing’s support for troubled state-owned enterprises, have been weighing on sentiment for some time.

However, last month’s dramatic sell-off in the bonds of Huarong – which was triggered by the firm’s failure to release its 2020 results on time, fuelling speculation about a restructuring or default at a company that has long been a byword for opacity and malinvestment – put government support for Chinese SOEs under intense scrutiny, particularly those with large external debts.

Rating agency Fitch’s decision on April 26 to slash Huarong’s rating from A to BBB, the lowest investment grade category (and to assign a junk rating to its perpetual dollar bonds, which have been trading at distressed levels) marked the first time a rating agency had questioned the extent of Beijing’s support for SOEs.

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Fears have eased over Huarong’s US$22 billion in dollar bonds held by foreign investors – which amounts to just over half the outstanding local and offshore bonds of the parent company and its subsidiaries, data from Bloomberg shows. This has reduced the risk of credit market contagion.

However, Beijing has crossed the Rubicon of financial discipline in the state sector. By sending stronger signals that it is rethinking its support for vulnerable SOEs, even systemically important ones like Huarong, the government is laying the groundwork for a new policy regime.

As the acute dilemmas faced by policymakers during the euro-zone crisis revealed, striking the right balance between curbing moral hazard and maintaining financial stability is devilishly hard, and can prove extremely costly if investors believe governments are taking a purist’s view of financial discipline.

This was what happened in the months following Greece’s first bailout in May 2010, which prompted Germany, the European Union’s fiscal disciplinarian-in-chief, to harden its stance on rescue packages for the euro-zone’s stricken economies and banks.

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Over a two-year period, pressure on creditors to shoulder part of the burden for bailouts increased significantly, putting the bonds of vulnerable governments and banks under unprecedented strain, and threatening European integration.

Many German policymakers were convinced that a Greek exit from the euro zone, or Grexit, was necessary to help shore up the rest of the bloc. In the end, however, the purists lost out, partly because of fears over the financial consequences of Grexit for the rest of the euro zone, especially Italy and Spain.

Anti-austerity protesters fly a Greek flag in front of the Parliament building in Athens in July 2015, as then prime minister Alexis Tsipras battled to win lawmakers' approval for a bailout deal to keep Greece in the euro zone. Photo: Reuters

Huarong is not Greece, and Beijing is not Germany. Yet, the dilemmas are similar. Moreover, the stakes for Beijing have risen over the past several years, in part because of the government’s deleveraging campaign, but also because of the increasing participation of foreign investors in China’s corporate bond market.

A report published by JPMorgan on Tuesday noted that China now accounts for half of Asian dollar-denominated corporate debt, up from 15 per cent in 2012. What is more, China’s offshore dollar bond market experienced a record amount of defaults in 2020, which have risen further this year, notably among junk-rated property companies.

It is highly unlikely that Beijing would allow a systemically important SOE like Huarong to go under. But this does not mean that some sort of haircut will not be imposed on bondholders. The persistent uncertainty over Huarong’s fate, and policymakers’ increasing tolerance of defaults at SOEs, show that the pendulum is swinging towards reducing moral hazard.

It was fears about how much further the pendulum would swing in this direction that contributed to the euro-zone crisis. Beijing has more powerful levers at its disposal to keep markets stable. Yet, it should be clear to investors by now that the backstops are not as secure as once assumed.

Nicholas Spiro is a partner at Lauressa Advisory

This article appeared in the South China Morning Post print edition as: Uncertainty over Huarong has echoes of Europe’s debt crisis

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