Beijing’s Rules for State Capitalism Are Changing

When Shanghai Chaori Solar Energy, a Chinese solar cell-maker and power-generator, missed an interest payment on its bonds in February 2014, the Chinese government didn’t intervene. As a result, Shanghai Chaori became the first Chinese company to default on servicing its debt — since 1997.

That immediately led to conjecture worldwide that China’s “Lehman Brothers moment” had arrived. In the aftermath of the Shanghai Chaori debacle, experts feared, more defaults would occur and China’s financial markets and stock markets would crash, triggering off an economic crisis — as happened in the U.S. in 2008 after Lehman Brothers went under. Nothing of the sort happened, of course.

A month later, in March 2014, when building materials company Xuzhou Zhongsen Tonghao New Board missed a coupon payment on bonds it had issued last year, the China Securities Regulatory Commission stated that “the market” would handle the problem. Sino-Capital Guaranty Trust, the bond guarantor, eventually paid investors, but Xuzhou Zhongsen became the second Chinese company to default in recent times, again sparking off speculation that China’s moment of reckoning had arrived. But it hasn’t.

In fact, the Lehman Brothers collapse is the wrong analogy to use. China has actually reached its “Dubai moments,” when the line between commercial loans and government debt must be publicly redrawn. That happened in Dubai in late 2008, when housing sales fell dramatically and real estate companies, some of them state-backed, were unable to service debt. Housing prices fell by around 60% over the next two years, and many developers went broke.

Dubai’s growth had been masterminded by its government, with state-owned banks and real estate companies shouldering most of the risk for projects that would not have been normally approved. Deal terms were often altered, so that private companies and banks would be willing to invest heavily in big projects. As a result, Dubai became one of the world’s financial capitals in 10 years’ time.

One of the problems with a state-sponsored development strategy is that it creates the widespread belief that commercial projects enjoy sovereign guarantees. That is, investors assume that if things go wrong with projects, the country’s leaders will help them by getting state-owned companies, banks, and local governments to support them. In the case of Dubai, the assumption was that oil-rich Abu Dhabi would step in if there ever was a major problem.

When Dubai’s real estate companies started collapsing, investors looked to Abu Dhabi, but the response from down the road was chilling: These were commercial loans, pointed out the Abu Dhabi government, and not guaranteed by the state. Over the next years, Abu Dhabi provided some support, but those holding commercial debt had to take significant write-downs. Real estate companies folded, investors incurred losses, and the line between commercial loans and government debt in the UAE was redrawn.

Abu Dhabi’s response at that juncture sounds pretty similar to recent statements from the China Securities Regulatory Committee in response to the two Chinese companies’ defaults. It stated that the situation “would be handled by market rules,” and in a post on Weibo, pointed out that it had “required the bond issuer, broker, and insurer to fulfill their responsibilities to investors.” Business in China is quickly realizing that the rules have been redefined, and that implicit government guarantees on commercial projects no longer exist.

Clearly, China is having its “Dubai moments.” Xuzhou Zhongsen has realized that there will be no government rescue forthcoming. Sino-Capital Guaranty Trust is confronting the reality that insuring commercial bonds is not a risk-free business. The banks have woken up to the fact that they could be stuck with non-performing liabilities. And investors are realizing there is no government guarantee on investments in China, even those associated with the state-owned banks.

What does that imply for China and the world?

One, we are, once again, witnessing the renegotiation of the rules of state capitalism in China. The relationship between the state and business, which is understood implicitly and usually not documented, is being clarified publicly. In China, that’s a pretty normal process.

Two, that process shouldn’t be equated with instability. There will be a knee-jerk tendency to link Chinese companies’ commercial problems with the financial system’s stability. However, the latter relates more to debt and cash levels, not defaults.

Three, investors would do well not to hold bank equity in China, but they shouldn’t worry about bankruptcy either. Many banks remain profitable although several smaller banks will likely need to recapitalize themselves at some point.

Four, concerns should rise about the fate of Chinese private companies, particularly those in real estate, solar, steel, cement, and manufacturing. Not only are many small groups vulnerable to downturns in the real estate market, but also, they operate on the periphery of the relationship between the state and business. When those lines shift, they could go under.

Five, don’t worry much about real estate projects in China. Even if a developer goes bust, it will be left with some construction commitments, and most projects will be put on hold or snapped up by larger players. In Dubai, five years after, the real estate market is growing so rapidly that it is generating concerns that it is over-heating.

Above all, remember that these defaults have not changed the fundamentals, which are still about manufacturing, consumer demand, and rapid urbanization in China.

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