China's first bond default means gain through pain

Default seems certain in China's corporate bond market as the problems of a solar products maker highlights risks in the bond market.

Shanghai Chaori Solar Energy Science & Technology Co.,Ltd, announced on Wednesday that it would not be able to service a second interest payment of 89.8 million yuan (14.7 million U.S. dollars) due on Friday.

The five-year "11 Chaori Bond" issued in 2012 solicits one billion yuan at a coupon rate of 8.98 percent, and is supposed to pay the annual interests on March 7.

"We have managed to secure only four million yuan for the payment as the company still has liquidity issues," said Chaori Solar in a report.

Chaori Solar's failure is the first corporate bond default in China's onshore market.

"The default was, to some extent, expected, given the financial stresses the company had been under for several years," said Zhang Zhiwei, chief China economist with Japan's Nomura Securities.

Government backs defaults?

Chaori Solar is a major photovoltaic (PV) producer, but overcapacity and a soured overseas market have cast a shadow on the PV industry.

Chaori Solar had operating revenue of 685 million yuan in 2013, 953 million yuan down on 2012. The company lost 1.3 billion yuan last year.

Sale of a power station to Greece was key to the company making interests payments, and the collapse of the deal is substantially to blame for the default, a source with Chaori Solar told Xinhua on condition of anonymity.

"We are trying to close the Greek deal at a reasonable price, and pay the interest as soon as possible," said the source.

Shanghai, where the company is headquartered, did not provide a bail-out facility as local governments and state-owned banks once did to avert defaults.

"It is increasingly recognized by regulators that China needs real credit defaults to reduce the moral hazard created by 'implicit guarantees' and to develop a healthy credit market," said Chang Jian, chief China economist at Barclays.

"We expect more, selective defaults to be allowed and more financial risks to be exposed," said Chang.

Default affects market

China's corporate bond market has grown rapidly for years, with outstanding bonds rising from only 800 billion yuan at the end of 2007 to 8.7 trillion yuan in this January, according to Bank of America Merrill Lynch.

The Chaori Solar default will significantly influence the bond market, as it dispells the "zero risk" delusion and warns investors of real risks, said Yang Delong, chief strategy analyst with China Southern Asset Management.

"There may be more defaults during an economic slowdown," Yang predicted.

Chang agrees with Yang that 2014 will be a year of great volatility in domestic financial markets, with defaults and possibly even bankruptcies of small finance houses.

Default risk are especially likely in energy and resource sectors. Other overcapacity industries -- shipbuilding, steel, cement, solar, wind power, property and local government financing -- are also vulnerable, said Chang.

"Sentiment in riskier bond markets may be hurt by the default but less risky sectors may be boosted given China's huge current liquidity," said Chang.

Controllable default benefits

Despite the harm Chaori Solar may bring to the bond market, economists still believe the default will be a good thing for China.

"A normal economy needs those defaults to better price bonds and other debt products," said Ting Lu, Sylvia Sheng and Xiaojia Zhi, economists with Bank of America Merrill Lynch, in a research note.

Nomura Securities' Zhang said the default will help go some way to correct China's financial sector and is positive in the long-term development of the onshore bond market.

Defaults in lackluster sectors will help phase out excess capacity as investors turn away from riskier industries. "More risk exposure will help reduce wasteful investment and bad debt build-up," said Barclays' Chang.

Bond market defaults are generally under control with little chance of contagion. Chinese investor resilience is not that weak, and defaults of some debt products are definitely not on a similar scale to the collapse of a major financial institution, said Bank of America Merrill Lynch's note.

The systemic risk to bond and financial markets from Chaori Solar default is small, and its macro and growth impact is also small, for now, said Chang.

Authorities will step in to provide support should there be "systemic and regional financial risks", averting systemic default and potential meltdown, said Chang. "They have the capacity to take such action," he added.