“Something Has to Break” as China’s Onshore Defaults Hit a New Record

Adem Tumerkan October 4, 2018
Category: Research

Recent news from China has been really ugly.

But what can you expect? They’re trying to fight a trade war against the U.S. – deal with slowing growth – and survive against a stronger U.S. dollar.

And because of these problems – China’s major stock exchanges have really suffered this year.

But – contrary to what the mainstream says – I think things are going to get much worse. . .

 

For starters – the latest Chinese Manufacturing PMI (purchasing manager index) showed a continued downturn. Both in the NBS and Caixin Indexes.

 

Clearly the trade-war with the U.S. is being felt. And with little progress in negotiations between the U.S. and China – expect the near-and-midterm to continue being weak.

Now – Unfortunately – this slow down in the Chinese economy and the loss of sales and income are coming at a bad time. . .

Especially for their corporations.

The combination of a slowing economy, a stronger dollar, and a tightening Federal Reserve is putting pressure on indebted Chinese firms.

 

This is putting China’s elites between a rock and a hard place. . .

That’s because with the trade-war raging on and a tightening Fed – the Communist Party of China will want to ease and help their economy.

The Peoples Bank of China (the Chinese central bank) can cheapen the yuan to try and boost exports. And as I wrote before – the weaker yuan will offset Trump’s tariffs.

For example – if the U.S. places 20% tariffs on all Chinese goods – China simply must devalue the Yuan by 20%. This would offset the increased costs from the tariffs – keeping the price for U.S. consumers unchanged. Basically rendering the imposed tariff worthless.

But the problem with this is Chinese firms have significant dollar-denominated debts. So a stronger dollar makes their debt-burden much harder to service.

Look at it this way – Chinese companies with dollar-debts (liabilities) will watch it grow compared to their falling assets (denominated in the weakening Yuan). And with rising debt burdens always comes the higher risk of default.

Already 2018’s turning out to be a record year for onshore Chinese bond defaults. . .

Goldman noted that in the last two months alone – there were at least eight new defaults.

Did the weakening yuan since early summer spark this troubling trend?

To put this in context – there were only 11 new defaults between January and July (seven months) in 2018.

One recent default was the Neoglory Holding Group – a conglomerate firm. They defaulted in late September from missing principal payments on debt.

The company had this to say. . . “Due to the impact of factors including macro leverage, a tightening of bank credit and private enterprise financing difficulty, the company’s liquidity has exhibited problems and led to an inability to make required interest and principal payments on this bond in time.”

Another recent default was the Gangtai Group – a gold and jewelry firm. They weren’t able to meet the put-payment on a 500-million yuan corporate bond.

A statement from the company read… “It is known that the issuer is facing a serious situation of insufficient liquidity, and until the present time it has yet to achieve effective improvement.”

So after including the 11 defaults between Jan – July, this brings the total to 19 new defaults in only the first 10 months of 2018. . .

This is a record year for both new defaults and the amount of bonds being defaulted on. 

 

All this is why back in late August – I wrote a piece on how I was betting against China’s economy and their currency – the yuan. If you missed it – you can read it here.

Soon, instead of focusing on ‘positive GDP growth’ and ‘increasing middle class wealth’, investors will fixate on short-term dollar debts owed by Chinese companies. And their potential risk of default.

They always do.

For now, China has a lot of cash to help firms and prevent a run on the yuan. China’s government has well over $3 trillion in dollar reserves.

But no doubt they will have to use much of this to bail out companies and prop up institutions.

We know that China’s economy is slowing. And they will most likely further weaken the yuan in attempt to boost growth and exports. Turning this trade-war in to a full blown currency war (which is already beginning). 

How else will they escape the Trump Tariffs and slowing domestic growth?

But here’s the kicker. . .

Unfortunately – by weakening the yuan – indebted corporate balance sheets in China will suffer. This will lead to more defaults, collapsing share prices, unemployment rising, and higher inflation.

Never forget that China’s main focus is to prevent social unrest. They will do whatever it takes to keep the peace.

But one way or another – something will have to break.

The yuan or corporate China. 

 

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