Dec 23, 2019 08:26 PM

Fisher: Why Rising Corporate Debt Defaults Are Good News for China

The recent uptick in corporate bond defaults in China is a byproduct of policymakers' growing willingness to allow market forces in the economy.
The recent uptick in corporate bond defaults in China is a byproduct of policymakers' growing willingness to allow market forces in the economy.

Western pundits are at it again, fearing Chinese debt. The recent uptick in corporate defaults — including some state-owned firms — has many claiming Chinese corporations have too much debt, not enough cash and are creating a harsh future. They argue a bad debt tsunami is set to flood the Middle Kingdom. They miss a bigger, more important point. China’s increase in debt defaults lacks the size and scope to derail China’s economy — and it isn’t a sign that greater trouble lies ahead. It’s the opposite! It is a byproduct of China’s increased willingness to allow free market forces in the economy. That’s bullish for China — and the world. Let me explain.

Many Westerners view debt as categorically bad, but it isn’t. Debt is a crucial finance tool in any economy. Used responsibly, debt allows people, companies and governments to finance projects they otherwise couldn’t. People can buy homes and cars. Governments can build new bridges and roads. Companies can expand production facilities, or embark on groundbreaking research and development that will drive future profits. This is why the government’s loan quotas, which dictate how much banks can lend, are a particularly effective economic tool. It is also why rising local government debt coincided with the infrastructure boom.

Over the past five years, companies have increasingly issued debt to boost growth. Fostering a thriving local corporate bond market has long been a key plank in the government’s plans to modernize and open China’s financial markets. They rightly saw it as a way to lure foreign capital, offsetting capital outflows that were shrinking foreign reserves. The corporate bond market opened to international investors through the Bond Connect program, launched in 2017.

Less than a decade ago, the corporate bond market was practically nonexistent. According to S&P Global, after several years growing roughly 50% year-on-year, it now totals around $2.7 trillion, or 19 trillion yuan. Local government debt adds another $2.7 trillion, much of it local government financing vehicles (LGFV), which raise funds for local infrastructure projects, but are widely considered as corporate debt.

Corporate bond issuance has brought many benefits. Most recently, it helped private firms with strong balance sheets access capital while the government tamed the shadow banking industry last year. But critics ignore this. Instead, they argue too many Chinese firms have gotten bloated on debt. They point to private companies’ 4.5% default rate in 2019’s first 10 months, according to the bond rating agency Fitch. That’s up from 0.6% five years ago. Then too, Beijing is slowly starting to let these defaults play out as they would in the western world. Regulators didn’t bail out creditors when LGFV in Hohhot, the capital of the Inner Mongolia autonomous region, recently missed an interest payment — noteworthy, because investors had long presumed local funding entities were immune to default.

But you can’t have a thriving onshore corporate bond market without market forces — and market forces mean defaults will occur. In relatively free markets, bond yields are functions of risk. Investors get paid more to take on additional risk. When investors assume a government guarantee, the pricing mechanism doesn’t work right. Capital flows to less productive companies at the expense of more promising new firms, because investors know the government will bail out the weaklings that fail. Productivity sags. Efficiency wanes.

Officials understand this and have slowly acted to wean investors off the expectation of government rescues — a wise move. Market forces will help weed out weaker firms, getting rid of bloated, inefficient businesses. That will strengthen the economy, help investors price risk and develop more realistic expectations — and help attract more outside capital. Rising defaults are evidence the government is seeing its pledge through. This should inspire confidence among international investors, not wreck it.

What about claims that China’s rising corporate debt will spiral out of control? They’re bunk. Debt levels tell you nothing about what’s really important — the ability of companies to pay interest and principal due on their bonds. Data on private Chinese firms’ debt service ratio — the percentage of income that goes toward paying debt — is lacking. But a good proxy is the Bank of International Settlements’ total private sector debt service ratio, which also includes households. It considers both loans and debt securities, like bonds. Presently it’s at 19.7% — higher than the US’s 14.8%, but below Australia, Belgium, Canada, Denmark, France and several other developed nations. LGFVs also inflate China’s figure, but aren’t a factor in America and elsewhere, potentially skewing the comparison somewhat, making China look worse than it is.

Even if Chinese corporate defaults increase, it isn’t necessarily bad news for stocks. In addition to scale, China debt fears lack the surprise power needed to derail equity markets. Worries about debt have popped up periodically since Chaori Solar defaulted in 2014. Back then, pundits pushed the same doom-and-gloom contagion fears they do now. They never came true.

History supports the idea that rising defaults don’t derail stocks. In a 2010 paper for America’s National Bureau of Economic Research, researchers looked at the 12 three-year periods featuring the highest corporate default levels in U.S. history. Stocks rose in nine of them. How can that be? It’s because debt troubles get priced into the market before default actually happens. As fear of a company’s potential default spreads, its bond prices fall and yields rise. Its stock probably drops, too. But by the time the default happens, its old news that was priced into stocks and has no more power to hurt them. Stocks have moved onward and upward as markets reward the stronger survivors. These are the same long-term benefits China should and will enjoy as market forces gain prominence.

Opening the economy to free market forces is a massive undertaking bound to have unexpected ebbs and flows. But the recent defaults aren’t a sign the process is faltering, as critics contend. Instead, they are a blaring bullish signal letting investors know the new system is working. Rather than using its trillions in foreign exchange reserves to bail out the defaulters or their creditors, the government is displaying its commitment to reform and openness, which global investors should count as positive. In the long run, that will lead to more investment and growth-stoking creative destruction — when efficient investment sparks innovations that replace outdated methods, boosting productivity and growth.

So don’t believe the debt doomsters. China’s latest defaults bring little short-term pain—and big benefits for the country’s long-term future.

Ken Fisher is the founder and executive chairman of Fisher Investments, a money management firm serving large institutions and high net worth individuals globally. He is the author of the books “Super Stocks” and “The Only Three Questions That Count.”

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