3RD October 2016

Arminius monitors bond defaults on a global basis, not only because of the disruption which they cause to financial markets and the banking sector, but also because of the lasting damage which they inflict on the real economy. Chart 1 below shows how bond defaults have risen sharply in the last eighteen months.

Most of the increase in defaults so far is a direct consequence of the halving of oil prices in 2014. Many US shale oil producers had funded their development expenditures by issuing junk bonds when oil was over USD$100 per barrel and with oil at USD$50 they no longer had sufficient cash flow to meet their obligations. The red dots in the chart below represent US shale oil producers and they account for a majority of the defaults in 2015 and 2016 – but not all of them.

Chart 1: Number of Defaulted Corporates


There are signs that bond defaults are spreading. US corporate indebtedness (excluding the financial sector) has risen from USD$2 trillion before the GFC to USD$6 trillion now. Banks are excluded from this measure because tighter regulation has forced them to reduce their balance sheet leverage. Many US companies have been lacking profitable investment opportunities, so they have chosen to buy back their own shares and they have funded the buybacks by taking on more debt at unprecedentedly low interest rates. In 2015, 25.8% of S&P500 companies bought back their own shares. Not to state the obvious, but that is a quarter of the entire index. As corporate profits fell this year, however, the number and size of buybacks has halved, presumably because boards became more concerned about prudent financial management. The net effect, however, is that corporate leverage has risen since the GFC.

This is not to say that the GFC is about to recur. Turkey’s sovereign debt has just been downgraded to junk, and other countries will follow, but the amount of low quality sovereign debt is simply not big enough to cause a crisis. Defaults on investment-grade bonds will continue to be very rare, whether sovereign or corporate. But for companies which have issued junk bonds, higher leverage means increased vulnerability to external shocks because, as Chart 2 below shows, in the last five years, net debt has been rising while EBITDA has been falling.

Chart 2. US Non-Financials Net Debt


The recent Hanjin insolvency is a case in point. Hanjin is a South Korean shipping company which operates about 150 container ships and bulk carriers. On 31 August it asked a Seoul court to appoint a receiver because it could not meet the obligations of its USD$12 billion in debt. The South Korean government has declined to support Hanjin.

Since the receivership, Hanjin’s numerous creditors have been attempting to gain possession of various assets. Customers want their cargoes unloaded, crews have a maritime lien over each vessel for their unpaid wages, and several ships have been seized by creditors who want to be paid for fuel, port fees, or cargo handling. Many Hanjin ships have been loitering in international waters in the hope of avoiding creditors. The nature of Hanjin’s business means that the receivership will be complex, because it involves untangling maritime law and the differing insolvency laws of many countries.

Because the shipping industry has been in financial difficulties for the last three years, there may well be other insolvencies to come. Even though Hanjin’s ships only make up 3% of global container volumes, the supply disruptions have been painful for US importers and will have a negative impact on economic data for September and October.

Largely unnoticed by the world, China has overtaken the US as a source of bond defaults. So far in 2016, forty-one Chinese companies have defaulted on the principal or interest of their bonds, and two-thirds of these are state owned enterprises (SOEs). These defaults have not made the headlines because:

• the size of most defaults has been relatively modest, i.e. less than USD$1 billion
• the majority of the defaulted bonds are held by Chinese banks
• there are usually ongoing negotiations between the company, the local government and the creditors to achieve some sort of resolution.

Although debt incurred by SOEs might be considered to carry an implicit guarantee from the government, in July 2016 the Finance Minister Lou Jiwei stated that the central government will only get involved if the insolvent enterprise carries systemic risk. The banking regulator has ordered banks to rescue insolvent companies and has issued instructions for creditors to hold meetings and negotiate restructurings, write-downs, or debt-for-equity swaps.

Provincial and city governments, on the other hand, are vitally involved in insolvencies. Even in situations where there is no suggestion of corruption, every local government wants to keep the insolvent enterprise running because it generates jobs and taxes. Just like cars in Victoria and submarines in South Australia.

A very recent example of a successful resolution is Bohai Steel Group, which on 11 September announced a restructuring of its CNY192 billion (USD$30 billion) of debts. Bohai is 100% owned by the city government of Tianjin, which has been negotiating with Bohai’s 105 creditors. A new company will take ownership of Bohai’s most profitable assets and will assume CNY50 billion in debts. The city will inject CNY10 billion into an asset management company which will swap CNY60 billion in current debts for new bonds. The remaining CNY80 billion in debt will stay with the existing company, which will sell off assets to repay what it can. So creditors will face immediate write-downs only on the last CNY80 billion. In an interesting twist, the mayor of Tianjin has just been arrested for corruption, but the debt restructuring looks like it will still proceed.

Chinese insolvency law, however, is so inadequate in practice that many defaults are likely to end up as a complete mess. On 12 September 2016 Guangxi Nonferrous Metals became China’s first SOE to be allowed to liquidate. The company had filed for insolvency last December under the weight of its CNY14.5 billion (USD$2.2 billion) in debt. A reorganization committee of local government and party officials (this is China, remember) failed to find sufficient new investors, so there will be a court-ordered auction of the company’s assets so as to pay employees, taxes and other creditors. Creditors have already complained that the reorganization committee failed to follow rules, failed to release information, and failed to communicate with creditors.

Chart 3. Chinese Debt as a % of GDP

As Chart 3 above shows, China’s debt problem is located in the corporate sector and stems from the rapid growth of corporate debt over the last decade. This is why we expect more insolvencies in China. Most companies in the resources sector – steel, coal, metals and minerals – have been making losses in recent years, and the central government is trying to force closures in the hope of reducing over-capacity and restoring profitability. The companies, aided and abetted by their provincial and city governments, are dragging their feet on closures in the hope that the burden will fall on someone else. It is likely that most of the large companies will survive after some form of restructuring involving debt write-downs, because the resources sectors are carrying about CNY10 trillion (USD$1.5 trillion) in debt.

It is certain that China’s banks will have to suffer most of the write-downs, but the state-owned banks will be recapitalized by the central government, following the precedent of their recapitalization after the last round of SOE losses and debt write-downs in the 1990s. So we are not buyers of Chinese banks in the near future – there won’t be a Lehman moment, but there won’t be any profits for a couple of years.

Chart 4. China’s Total Debt and Nominal GDP


The International Monetary Fund (IMF) and the Bank for International Settlements (BIS) have both recently issued warnings about the dangers of China’s mounting debt pile. Chart 4 above shows the annual growth rates of China’s debt and GDP. It is clear that debt (the solid red line) had been rising much faster than nominal GDP has been. That means the ratio of debt to GDP has been rising steadily. Unlike the US before the GFC, the problems are not in the housing sector, which is relatively under-geared.

The main problem area is in fact the state owned enterprises, which have taken advantage of their supposed government guarantees to pile up bank borrowings. Although SOEs account for only 22% of Chinese GDP, they hold 55% of Chinese debt. The central government has introduced measures to allow banks to sell their bad loans or convert them to equity, but it may be too little, too late. Chart 5 below shows the continuing rise in banks’ non-performing loans (NPLs) to nearly CNY 1.5 trillion (USD$225 billion) by June 2016. The NPL growth rate has slowed to 30%, but it is clear that the bad loans are still rising faster than they can be disposed of.

Chart 5. Chinese Bad Loans


The IMF has also noted that the reported CNY 1.5 trillion in NPLs is an underestimate. The true figure is about three times as much, equivalent to 7% of GDP.

The only encouraging aspect of the Chinese debt mountain is that over 90% of it is held onshore, mostly by China’s largest banks. Because foreign ownership is so small, it is unlikely that the contagion will affect global financial markets. But the restructuring of insolvent companies will depress economic growth in China, which will have negative flow-on to countries exporting to China – such as Australia.

If the Chinese authorities mishandle the recapitalization of the banking sector, the dependence of the Australian economy on China means that Australian investors will have a ringside seat at another financial crisis. Because the central government has a tight grip on the banking sector, this crisis will not be a repeat of the GFC - it will be visible mainly as a foreign exchange crisis, with the Chinese yuan slipping into free fall as it did in August 2015.